Financial Derivatives

Area to be covered 1. General about derivatives which includes definitions, type, classification market and use of the same. 2. As 11 and announcement of the ICAI and Companies Act and Impact thereof. (2006,2008,2009) 3. Document required to be check while audit 4. Practical Example of the cases observed during the audit General About derivative What is derivative Derivative is an instrument who derives their value form another assets which is called underlying assets. The value/ price of derivative instrument are depends upon the price of underlying assets. The underlying assets can be the anything e.g. currency, commodity Index, securities, bonds or any other assets. In other words Derivative is an instrument whose characteristics and value depend upon the characteristics and value of underlying assets. In simple words, Derivatives indicates an instrument that has no independent value and its value is entirely derived from the value of the variables. Derivatives can be dependent on almost any variables. For example x has entered into a contract with y to buy 1kg gold at a price of Rs. 15/- lacs on a date which six month from the contract date. in this case contract to buy gold is become the derivative instruments which derive its value for the value of gold (underlying assets). B. Characteristics of the derivative: A derivatives cash flows or fair value must fluctuate or vary based on the changes in an nderlying variable. The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying. The contract can be readily settled by net cash payment. Benefits of the derivative Instruments

A.

C.

Derivatives help in transferring risks from risk-averse people to risk-oriented people. Derivatives assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets and thereby, render both cash and derivatives markets more efficient. Derivatives catalyze entrepreneurial activities. By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of capital across the economy and thus, increasing productivity in the economy. Derivatives increase the volume traded in markets because of participation of riskaverse people in greater numbers. Derivatives increase savings and investment in the long run.

D.

Uses of derivatives i

Generally derivatives instruments are used to mitigate the risk of economic losses arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Hedging: Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. Speculation: Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Arbitrage: in this case Arbitrageurs are operators who operate in different markets simultaneously, in pursuit of profit and eliminate mis-pricing in securities across different markets.

The Difference between three palyers are as follows HEDGERS Help in minimizing exposure to an unwanted business risk that can be faced from Potential future movements in Market. They Insurance investor. provide to the SPECULATORS To bet on the direction of Market variables i.e. whether price will go up or down (i.e. increase or decrease). Derivative provides a way in which a type of leverage can be obtained. Speculation in case of futures gives very large potential loss/ gain. And in case of options loss is set limited to the amount paid for option. ARBITRAGEURS Operate in two or more market simultaneously. Act for taking advantage of a price differential. They take off setting positions in two or more instruments to lock in profits Lesser risk oriented operation.

Fixation of the price is done, that hedger will pay / receive for the asset. Offers a way for investor to protect themselves against price movement in future while still allowing them to benefit from the favorable price movements.

ii

TYPES OF DERIVATIVES
FORWARD CONTRACT FUTURE CONTRACT OPTION CONTRACT SWAPS CONTRACT

Forward Contracts Its a most simple agreement where settlement takes place on a specified date in the future at todays pre-agreed price. It is in contrast with a spot contract, which is an agreement to buy and sell on spot and at daily basis. It trades for delivery at future time i.e. certain specified date in future for a certain specific price. In simple words this is the contract to buy /sell a specified underlying on a future date, but the price for which is agreed on the date of the contract. On the date of the contract there is no exchange of cash flows. The payment agreed is exchanged for the underlying on the date of the maturity of the contract. The forward price generally tends to be higher than the current price. An ideal forward price without an opportunity for arbitrage would be the Spot Price + Cost of Carry (including the interest cost) less the future value of any intervening income. Forward contracts are very useful to eliminate uncertainty about future movement in the prices of the underlying. These are used extensively in the currency market to lock in the local currency value for future cash flows contracted in a foreign currency. The contract is obligatory and default on the maturity has the same consequences as any credit default event. Hence whether the spot has moved in favour or against the purchaser of the forward contract he has to settle on the contract and take his gain or loss resulting from price movements. Future Contracts Future Contracts is an agreement to buy and sell an asset at a certain future time for a certain price. Unlike forwards they are traded on daily basis and are standardized exchangetraded contracts, two parties do not necessarily know each other but Exchange provides mechanism that gives them a guarantee regarding honor of contract. Futures are more liquid in nature and afford greater commercial convenience. In simple Futures are nothing but forward contract traded on an exchange. To make the contracts suitable for trading on exchanges, it becomes necessary to standardise the contracts. The best feature of any Futures contract is that the exchange guarantees performance under the contract. To discharge its responsibilities, a margin is collected upfront from the seller and the buyer. Thereafter the contracts are settled on a daily basis. That is the person who loses on the Futures contract will pay the loss into the exchange and the same will be passed on to the counter party who gained on the contract. Option contracts Options are wonderful product in themselves if only because they are the only contracts that provide the buyer of the option with a right without any corresponding obligation. Hence it iii

provides protection while affording an opportunity to ride on the gains. For instance if an exporter has a receivable amount of 25000 US dollars, due three months hence he could enter into a forward contract to sell the dollar at the current forward price of say 46.8. Instead he could enter into a option to sell the dollar at the price of say 46.4 and pay an option premium of 30 paise. Now if the rupee trades below 46.4 he will certainly exercise his put option and sell the rupee for the price of 46.4. On the other hand if rupee were to fall to 47.25 on the maturity date he can simply ignore his option contract and sell the dollars at the current market price of 47.25. When you enter into an option contract to buy any underlying asset it is called a call option and the right to sell is called a put option. Call Option: It gives holder the right to purchase the underlying asset a specified quantity of a security at a set strike price at some time on or before expiration. Put Option: It gives holder the right to sell the underlying asset a specified quantity of a security at a set strike price at some time on or before expiration. There are two type of option contract which are as under: American Options Traded anytime till the date of Maturity. Mostly, the options that are traded in exchnage are American. Europeon Options Traded only on Maturity/ Expiration date specifically. In comparison they are generally easy to analyse. Swaps Contracts Swaps are custom designed contracts between two counter parties to exchange a series of cash flows over a predefined period of time and at pre-specified intervals. The contract would stipulate all the requirements that determine the exchange of cash flows. In certain cases the exchange of cash flows are net [cash flows in same currency] and in other cases they are gross [different currencies]. The generic swap that trades in the market include a plain vanilla swap which enables one to change from a fixed or a floating rate to the other, a currency swap is one in which there is an exchange of foreign currency against local currency and cross currency swap which has exchange of interest and principle in two different currencies. The usual structure of a cross currency swap is to pay fixed interest and principle in one currency and receive a floating rate and principle in another currency. Types of swaps are: Interest rate swaps It eliminates the barriers caused by regulatory structure. Interest rate swaps help exchange a fixed rate of interest with a variable rate. Currency swaps iv

2)

It is an exchange of one currency with another. Generally through the banks who acts as dealer in between the parties. Treatment of foreign exchange difference and derivate loss and gain as per AS-11 and other announcement issued by the ICAI and the Ministry of the Companies Affaires. Accounting Standards 11 (The Effects of Changes in Foreign Exchange Rates) does not deal with all the derivative instruments, however para 36 to 39 deals with the Forward contracts which are as under:Forward Exchange Contracts 36. An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The premium or discount arising at the inception of such a forward exchange contract should be amortised as expense or income over the life of the contract. Exchange differences on such a contract should be recognised in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognised as income or as expense for the period. 37. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate at the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated at the latter of the date of inception of the forward exchange contract and the last reporting date. (This Standard is applicable to exchange differences on all forward exchange contracts including those entered into to hedge the foreign currency risk of existing assets and liabilities and is not applicable to the exchange difference arising on forward exchange contracts entered into to hedge the foreign currency risks of future transactions in respect of which firm commitments are made or which are highly probable forecast transactions. A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates and a forecast transaction is an uncommitted but anticipated future transaction). Announcements of ICAI- 2006 As per the announcement of ICAI in 2006 every enterprises is required to disclosed the criteria applied for recognition and measurement of the derivative instrument which are used by the enterprises for hedging or for other purposes and the criteria applied for recognitions and measurement of income and expenses arising from such instruments. Further to provide v

information regarding the extent of risk to which an enterprise exposed, it should, as a minimum; make the following disclosure in its financial statements. (a) Category wise quantitative data about derivative instruments that are outstanding as at the balance sheet date, (b) The purposes, viz, hedging or speculation, for which such derivative instrument have been acquired, and (c) The foreign currency exposure that are not hedged by a derivative instruments. This announcement is applicable in respect of financial statement for the accounting periods ending on or after 31st March 2006. Announcements of ICAI- 2008 As per the announcement of ICAI dated 29th March 2008 in case of an entity does not follows AS-30, Keeping in view the principle of prudence as enunciated in AS-1, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to the market. Notification of MCA- 2009 On 31st March 2009 MCA through notification has inserted para 46 in the Accounting standard 11 which is as under. In the companies (Accounting Standards)Ruler,2006 in the annexure under the heading (B Accounting Standards) in the sub heading AS-11 relating to effects of changes in foreign exchange rates after para 45 , the following shall be inserted namely :In respect of Accounting periods commencing on or after 7th December 2006 and ending on or before 31st March 2011, at the option of the enterprise (such option to be irrevocable and to be exercised retrospectively for such accounting period, from the date this transitional provision comes into force or the first date on which the concerned foreign currency monetary item is required, whichever is later, and applied to all such foreign currency monetary items, exchange differences arising on reporting of long term foreign currency monetary items at rates different from those at which they are initially recorded during the period, or reported in previous financial statements, in so far as they relate to the acquisition of a depreciable capital asset can be added to or deducted from the cost of the asset and shall be depreciated over the balance life of the asset and in other cases can be accumulated in a foreign currency monetary item translation difference account in the enterprises financial statements and amortized over the balance period of such Long Term Asset / Liability but not beyond 31st March 2011 by recognition as income or expense in each of such period with the exception of exchange differences dealt with in accordance with para 15 for the purpose of exercise of this option and asset or liability shall be designated as a long term foreign currency monetary item. if the asset or liability is expressed in a foreign currency & has a term of 12 months or more at the date of origination of the asset or liability any difference pertaining to accounting periods which commenced on or after 7th dec.2006 previously recognized in the P&L A/C. before the exercise o0f the option shall be reversed in so far as it relates to the acquisition of depreciable capital asset by addition or deduction from the cost of the asset & in other cases by transfer to foreign currency monetary item translation in different a/c. in both cases by dr. or cr. As the vi

cases may be to the general reserve if the option stated in this Para is exercised disclosure shall be made of the fact of such exercise of such option & of the amount remaining to be amortized in the financial statements of the periods In which such option is exercised & in every subsequent period so long as any exchange difference remains unamortized The above statement said about the available option for the treatment of Exchange Difference arising on reporting of long term monetary item at rates from those different from those at which they were initially recorded during the period or reported in previous financial statement. However it does not specify treatment of derivative gain / loss on account of long term monetary items. However according to the FAQs (Question no.9) on the above said notification published by the ICAI this notification applies to long term foreign currency monetary items (including foreign currency derivative) to which AS -11 applies. For other cases announcement of ICAI dated 29th March 2008 will apply. Details /documents required to be checked during the course of audit, a. Bank reconciliation statements and bank balance confirmation and detailed checking of Loans & Advances. b. Board Resolution for authorization to entered into the derivative contracts c. Derivatives deals entered with parties/ bank. d. Settlements advice from banks w.r.t realised gain /losses. e. Bank confirmation for outstanding derivatives contracts with bank. f. MTM loss /gain working from bank as at balance sheet date. g. Foreign exchange policy under ECB guidelines of the Company. h. Detail checking of finance cost and gain /loss on foreign exchange difference. i. Check the realised gain /loss on account of derivative contracts from the Bank statements and settlement advices. 4) For practical example please refer Excel sheet attached, out of them some example will be discuss in seminar.

vii