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ICWAI Group IV/ Stage IV (Final)
Advanced Financial Accounting & Reporting
Topic: Accounting for Equity Index and -Equity Stock Futures and
Options
1. What are derivatives and what are its
characteristics?AnswerDerivative is a generic term for contracts
like futures, options and swaps. The values of thesecontracts
depend on value of the underlying assets, called bases. For example
if A agrees tobuy US$ 1 lakh from B at Rs. 50/$ (exercise price),
after 3 months and exchange rate is Rs.50.20/$ on maturity, the
value of the contract is Rs. 20,000 i.e. the sum A can gain by
buyingUS$ 1 lakh from B at Rs. 50/$ and selling them at market rate
on maturity Rs. 50.20/$. Thedollar in this case is the underlying
asset. The value of the contract depends on theexchange rate on
maturity (maturity price) and hence is a derivative. In the present
case,the derivative is a future.In case of options, one party ,
called option holder, acquires a right to buy (call option) or
rightto sell (put option) specified quantity of underlying asset on
a specified future date at specifiedprice (exercise price) from/to
the other party, called the option writer. The option holder
pays
premium to the option writer in exchange for the right. A call
option holder has the right to buybut has no obligation to do so.
Clearly the call option holder shall exercise his right to
buyprovided the maturity price exceeds the exercise price. His net
gain/loss is [(Maturity Price -Exercise Price) - Premium paid]. In
case a call option holder does not exercise his right to buy,he
loses the entire premium paid. The writer gains the amount lost by
the holder or loses theamount gained by the holder.A put option
holder has the right to sell but has no obligation to do so.
Clearly the put optionholder shall exercise his right to sell
provided the exercise price exceeds the maturity price.His net
gain/loss is [(Exercise Price - Maturity Price) - Premium paid]. In
case a put optionholder does not exercise his right to sell, he
loses the entire premium paid. The writer gainsthe amount lost by
the holder or loses the amount gained by the holder.Derivative
contracts, e.g. futures and options are usually settled by
reversing trade rather thanby actual delivery. The reversing trade
consists of buying the underlying asset at maturity price
from the party to whom the underlying asset is sold at exercise
price by the original contract.The actual delivery is avoided
because the parties to the original contract and reversingcontract
are same. The accounts between the parties are therefore settled
byreceipt/payment of price differential. Since actual delivery is
not intended, the underlying assetfor a future or option can be
market index, which cannot be delivered but has a price.Swaps are
private arrangements between two parties to exchange a defined
stream of cashflow for a specified period. For example X may agree
to pay fixed 12% interest on US$ 1 lakhfor 3 years to Y in exchange
of Y paying him variable interest LIBOR + 100 bp on same amountfor
same number of years. The amount of principal is normally notional.
The parties settle theiraccounts by net receipt/payment of interest
differential. For example, if LIBOR is 11.5%, i.e. ifthe variable
interest rate is 12.5%, X will receive US$ 500 (0.5% on US$ 1 lakh)
from Y.
2. Explain currency options related to foreign exchange.
AnswerOptions are contracts to buy or sell specified quantity of
specified commodity at specifiedprice (strike price or exercise
price) on a specified future date. Depending on the
underlyingcommodity, an option contract can be stock option
contract, having shares of specifiedcompany as underlying
commodity, index option, having stock market index, i.e.
marketportfolio as underlying commodity or currency option having
foreign currency as underlyingcommodity. The standardisation of
option contracts permit them to be bought and sold inorganised
exchanges through clearing house, which acts as a counterparty,
i.e. it buys acontract when an investor sells it and sells a
contract when an investor buys it. The seller ofan option contract,
called writer collects option premium from the buyer of option
contract,called the writer. There are two kinds of option
contracts, viz. call options and put options.In case of call
option, the holder pays the premium but may require the writer to
sell specifiedquantity of underlying commodity (foreign currency
for currency options) at exercise price on
maturity. This he does if market price on maturity, called
settlement price is greater thanthe exercise price, i.e. when he
can buy from the writer at lower price (exercise price) forselling
at higher price in market (settlement price) to book a gain.In case
of put option, the holder pays the premium but may require the
writer to buy specifiedquantity of underlying commodity (foreign
currency for currency options) at exercise price onmaturity. This
he does if market price on maturity, called settlement price is
less than theexercise price, i.e. when he can buy from the market
at lower price (settlement price) for sellingat higher price to the
writer (exercise price) to book a gain.
The option contracts are rarely settled by actual delivery of
the underlying commodity. Theusual practice of a holder of call
when he elects exercise his right to buy at exercise price fromthe
writer is to sell the commodity to the writer again at settlement
price. No delivery ofcommodity is needed because parties to the
agreements are same. The writer however paysprice differential
(Settlement Price - Exercise Price) to the writer. Likewise, the
usual practice ofa holder of put when he elects exercise his right
to sell at exercise price to the writer is to buy
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the commodity first from the writer at settlement price. No
delivery of commodity again isneeded because parties to the
agreements are same. The writer however pays price
differential(Exercise Price - Settlement Price) to the writer.
The currency options are very useful tools of hedging against
foreign currency risk. The ex-ample given below illustrates how an
importer can hedge his foreign currency exposure by acurrency
option.
An importer is willing to buy one US$ 1 lakh after 3-months at
current exchange rate Rs. 50/$.Premium on 3-month call on US$ is
Rs. 0.50/$. Cost per US$ if the importer buys a call atexercise
price Rs. 50 is shown below for different possible exchange rates
after 3 months.
Rate at which boughtfrom bank after 3 months
Premium paid Differential Received as callholder
Net cost perUS$Rs./$ Rs. Rs. Rs.
0to50 0.50 00.50 to 50.5050.01 andabove
0.50 0.01 andabove
50.50
If rupee is weakened against dollar, the maximum the importer
may need to pay is Rs. 50.50/$. This the importer achieves without
having to sacrifice the possibility of paying less in caserupee is
strengthened against dollar.
Problem 1: Mr. Investors buys a stock option of ABC Co. Ltd. in
July 2003 with a strike price on30/07/03 of Rs. 250 to be expired
on 30/08/04. The premium is Rs. 20 per unit and the marketlot is
100. The margin to be paid is Rs.120 per unit. Show the accounting
treatment in thebooks of buyer when:(i) The option is settled by
delivery of the asset, and(ii) The option is settled in cash and
the index price is Rs. 260 per unit.SolutionBooks of Mr.
InvestorDate Rs. Rs.30/07/03 Equity Stock Option Premium 2,000 Rs.
20x100
To Bank 2,000(Premium paid to buy stock option)
30/07/03 Deposit for Margin Money 12,000 Rs.120 x 100To Bank
12,000(Margin money deposited with clearinghouse)
30/08/03 Profit & Loss A/c 2,000To Equity Stock Option
Premium (Optionpremium paid is transferred to Profit &Loss A/c
as expense on settlement ofstock option)
2,000
30/08/03 Bank 12,000To Deposit for Margin Money (Refund ofmargin
money received on settlement ofstock option)
12,000
30/08/03 When option is settled by deliveryShares of ABC Ltd.
25,000 Rs. 250x100
To Bank 13,000(Shares acquired at strike price onexercise of
stock option)
30/08/03 When option is settled in cashBank 1,000 100x
(Rs.260-
Rs.250)To Profit on Settlement(Price differential received on
exerciseof stock option)
1,000
30/08/03 Profit on SettlementTo Profit & Loss A/c
(Price differential earned is transferredProfit & Loss A/c
as income onsettlement of stock option)
1,0001,000
