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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?
Answer
Derivative is a generic term for contracts like futures, options and swaps. The values of these contracts
depend on value of the underlying assets, called bases. For example if A agrees to buy 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 buying US$ 1 lakh from B at Rs. 50/$ and selling them at
market rate on maturity Rs. 50.20/$. The dollar in this case is the underlying asset. The value of the
contract depends on the exchange 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 right to sell (put
option) specified quantity of underlying asset on a specified future date at specified price (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 buy but has no obligation to do so. Clearly the
call option holder shall exercise his right to buy provided 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 the amount gained by the holder.
A put option holder has the right to sell but has no obligation to do so. Clearly the put option holder 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 option holder does not exercise his right to
sell, he loses the entire premium paid. The writer gains the 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 than by 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 reversing contract are same. The accounts between the
parties are therefore settled by receipt/payment of price differential. Since actual delivery is not intended,
the underlying asset for 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 cash flow for a
specified period. For example X may agree to pay fixed 12% interest on US$ 1 lakh for 3 years to Y in
exchange of Y paying him variable interest LIBOR + 100 bp on same amount for same number of years. The
amount of principal is normally notional. The parties settle their accounts by net receipt/payment of interest
differential. For example, if LIBOR is 11.5%, i.e. if the 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.
Answer
Options are contracts to buy or sell specified quantity of specified commodity at specified price (strike
price or exercise price) on a specified future date. Depending on the underlying commodity, an option
contract can be stock option contract, having shares of specified company as underlying commodity, index
option, having stock market index, i.e. market portfolio as underlying commodity or currency option
having foreign currency as underlying commodity. The standardisation of option contracts permit them to be
bought and sold in organised exchanges through clearing house, which acts as a counterparty, i.e. it buys a
contract when an investor sells it and sells a contract when an investor buys it. The seller of an 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 specified quantity 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 than the exercise price, i.e. when he can buy
from the writer at lower price (exercise price) for selling 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 specified quantity 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 less than the exercise price, i.e. when he can buy from the
market at lower price (settlement price) for selling at higher price to the writer (exercise price) to book a gain.
The option contracts are rarely settled by actual delivery of the underlying commodity. The usual practice
of a holder of call when he elects exercise his right to buy at exercise price from the writer is to sell the
commodity to the writer again at settlement price. No delivery of commodity is needed because parties to
the agreements are same. The writer however pays price differential (Settlement Price - Exercise Price) to
the writer. Likewise, the usual practice of a holder of put when he elects exercise his right to sell at exercise
price to the writer is to buy the commodity first from the writer at settlement price. No delivery of
commodity again is needed 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 example given
-2-
below illustrates how an importer can hedge his foreign currency exposure by a currency option.
An importer is willing to buy one US$ 1 lakh after 3-months at current exchange rate Rs. 50/$. Premium on 3month call on US$ is Rs. 0.50/$. Cost per US$ if the importer buys a call at exercise price Rs. 50 is shown
below for different possible exchange rates after 3 months.
Rate at which bought
Premium paid Differential Received as call holder
from bank after 3 months
Net cost per US$
Rs./$
Rs.
Rs.
Rs.
0 to50
0.50
00.50 to 50.50
50.01 and above
0.50
0.01 and above
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 case rupee is strengthened
against dollar.
Problem 1: Mr. Investors buys a stock option of ABC Co. Ltd. in July 2003 with a strike price on 30/07/03 of
Rs. 250 to be expired on 30/08/04. The premium is Rs. 20 per unit and the market lot is 100. The margin to be
paid is Rs.120 per unit. Show the accounting treatment in the books 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.
Solution
Books of Mr. Investor
Date
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 100
To Bank
12,000
(Margin money deposited with clearing house)
30/08/03 Profit & Loss A/c
2,000
To Equity Stock Option Premium (Option
2,000
premium paid is transferred to Profit & Loss
A/c as expense on settlement of stock option)
30/08/03 Bank
12,000
To Deposit for Margin Money (Refund of
12,000
margin money received on settlement of stock
option)
30/08/03 When option is settled by delivery
Shares of ABC Ltd.
25,000
Rs. 250x100
To Bank
13,000
(Shares acquired at strike price on exercise of
stock option)
30/08/03 When option is settled in cash
Bank
1,000
100x (Rs.260-Rs.250)
To Profit on Settlement
1,000
(Price differential received on exercise
of stock option)
30/08/03 Profit on Settlement
1,000
To Profit & Loss A/c
1,000
(Price differential earned is transferred
Profit & Loss A/c as income on settlement of
stock option)