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9054 results in Finance and accountancy

Page 157 of 453

  • 11 - Options – II: Pricing of Options

  • from Part–IV - Options
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 179-193

  • Summary

    As briefly mentioned in chapter 10, the price of an option is the sum of two components: intrinsic value and time value.

    Intrinsic value

    To recapitulate, the intrinsic value of an American option is:

  • • For call options: The difference, if positive, between the current price of the underlying and the strike price of the option.

  • • For put options: The difference, if positive, between the strike price of the option and the current price of the underlying.

    • The intrinsic value of a European option is the difference, if positive, between the current price of the underlying and the discounted present value of the strike price for calls and vice versa for puts.

    As was seen in chapter 10, an option which has intrinsic value is said to be ‘in-the-money’ and one with no intrinsic value is either ‘at-the-money’ or ‘out-of-the-money’. In the case of traded options the premium is usually referred to as the ‘price’ of the option and hence the term pricing refers to how the premium is determined.

    Time value

    As regards the second component, time value, this is due to the fact that even if the price may be unattractive today, future fluctuations may make the option profitable. The time value depends on the interplay of a number of factors:

    Time

    It is obvious that the longer the period of time, the greater are the chances of price fluctuations and vice-versa. Thus, time value generally varies directly with amount of time left to maturity. This leads to the fact that options are wasting assets: as an option's expiration date approaches, its time value diminishes and eventually becomes nil. The only value remaining is the intrinsic worth, if any. Therefore, if an option is not sold or exercised by the expiration date, it becomes worthless. (This is important from an investor's point of view: in contrast to options, underlying assets like shares can be held indefinitely.)

    Extent of the difference between current price and strike price

    An option which is deeply out-of-the-money has a lower time value than an option which is only slightly out-of-the-money. A deep OTM option has a much lower probability of ever becoming profitable than one which is slightly OTM for the same maturity period.

  • 7 - Futures on Equities

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 120-132

  • Summary

    This chapter deals with the special features of futures markets in equity shares, including equity indices (also known as stock futures and stock index futures). The general principles applicable to futures markets are also applicable to futures in equity markets. The raison d'etre of equity futures is to enable the hedging of equity positions.

    A special and rather unusual feature of the equity or ‘stock futures’ market in India is that it is increasingly seen not as a supplement to the cash market but as a substitute. The relatively higher volume of trading on the futures markets in India vis-à-vis the cash stock market appears to be explained by two main factors.

    The first factor is that India's futures market is one of the few that has active futures trading in individual shares (single stock futures) rather than in broad stock market indices. This is partly the legacy of the old Indian badla system that was an indigenous form of forward trading in individual shares that ended in the late 1990s and was replaced by equity futures. Because there are futures markets in individual shares, the Indian equity futures markets allow speculation on specific companies without basis risk. When only index futures are available, an investor in the stock market cannot really use futures to back his view on an individual company. The Indian market allows speculation on individual shares through futures.

    The second factor is margin or leverage. The cost, extent, and ease of leverage is higher through futures:

  • • India's credit markets are not as well developed as in, say, the United States. Getting a loan in order to trade on equities is not easy or quick. The ‘automatic borrowing’ in the futures market (through the fractional margin system) makes things much easier; there is no formal credit agreement nor the attendant transaction costs and time.

  • • When a speculator borrows from a broker to buy stock and takes a long position with, say, a ‘2x’ (two times) leverage, the broker lends money for half the position to the investor and charges him interest.

  • 4 - Futures Trading: Pricing and Hedging

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 51-87

  • Summary

    This chapter covers more advanced aspects of the economics of futures trading. It has two sections. The first deals with the relationship between spot and futures prices while the second discusses the relationship between the ‘basis’ or price spread and hedging effectiveness. The discussion will be based primarily on futures in commodities, but the discussion is also applicable to futures in financial instruments etc., with minor modifications which will be discussed in subsequent chapters.

    The relationship between spot and futures prices

    Intuitively, it is not difficult to see that spot and futures prices must be inter-related. After all they are prices of the same asset, albeit at different points in time, which means that the basic factors affecting supply and demand are the same. Also, the option of delivery (meaning that a futures contract can be closed by means of actually giving or taking delivery of the physical commodity or financial instrument) means that on the maturity date spot and futures prices must be in close proximity. This implies that the difference between the two prices must narrow over time and eventually be whittled down to nil or thereabouts. This leaves the question of how the difference is determined. There are several theories which attempt to explain the relationship between spot and futures prices. The essence of these is set out below. In the following discussion, readers should note that:

  • • when the futures price is higher than the spot price, the futures price is said to be at a ‘contango’; and

  • • when the futures price is lower than the spot price it is said to be at a ‘backwardation’.

    • The expectations approach

    This school of thought, owing its origins to such luminaries as J. M. Keynes, J. R. Hicks and N. Kaldor, sees the futures price as the market expectation of the price at the future date. Thus, the October gold futures price in June is what the market in June expects or forecasts will be the gold price in October. Any major deviation of the futures price from the expected price is likely to be corrected by speculative activity.

  • 8 - Swaps – Part I: Interest Rate and Currency Swaps

  • from Part–III - Swaps
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 135-142

  • Summary

    Swaps are contracts in which two separate streams of cash flow are exchanged or ‘swapped’. The streams could be two different kinds of interest amounts, two currencies or indeed any two differing streams of cash.

    This chapter introduces the conceptual basis of swap contracts and then explains interest rate swaps and currency swaps. The next chapter deals with other types of swaps and some general issues relating to the swaps market.

    Definition

    A swap transaction is a contract by which two or more parties exchange (swap) one set of pre-determined payments for another.

    Some important types of swap are the following:

  • An interest rate swap is an agreement between two parties to exchange interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period.

  • A currency swap is an agreement between two parties to exchange payments or receipts in one currency for payments or receipts in another.

  • An equity swap is an agreement between two parties to exchange dividends and/or capital returns on an underlying share with another equity flow or interest flow, in the same or different currencies.

    • Currency swaps slightly predated interest rate swaps, but the latter now predominate in volume. Equity swaps are more recent but growing fast. Swaps can also combine some of the features of interest rate and, say, currency swaps. Thus, a fixed rate payment in dollars might be swapped for a floating rate payment in yen. Such transactions are more complex.

    A key feature of swaps is that they deal with a set of cash flows involving multiple periods, not a one-time cash flow. This is an important distinction between swaps and futures or options, both of which deal with a single expected cash flow at one specified time in the future. In a swap, invariably there are multiple dates involved where one or more income streams would need to exchange hands. Sometimes the two cash flows are paid gross to each other, while in some cases, the amount due is ‘netted’ and the net amount due from one party to another is transferred.

  • 6 - Currency Futures

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 113-119

  • Summary

    Any company or individual with dealings in foreign exchange, whether through imports or exports or through inward or outward investments, lending or borrowing, faces some degree of exchange rate risk. Currency forwards or futures are forward or futures contracts with a foreign currency as the underlying. Thus, a contract for the purchase of US dollars denominated in Indian rupees is effectively a contract on the Indian rupee – US dollar exchange rate (referred to as INR: USD). Currency forwards or futures can therefore also be referred to as exchange rate forwards or futures. The basic pricing and trading structure of currency futures and forwards is not different from examples of equity or commodity futures that were seen in previous chapters, but this chapter will explore some of the special features of currency forwards and futures in greater detail. In the foreign exchange markets, a three letter convention is commonly used to refer to currencies – INR for Indian Rupees, USD for US Dollars, GBP for Great Britain Pounds, JPY for Japanese Yen etc.

    Typically, hedging needs of smaller firms and for short durations are served better by standardised exchange-traded futures, whereas larger firms with specialised needs and more long-term hedging requirements often go to the forward (OTC) market. Forward contracts are typically entered into through banks, either directly or through a foreign subsidiary. Many India-based multi-nationals, for example, access INR-USD OTC forwards of various kinds in the Singapore market.

    Example 6.1

    In March, P Ltd., an importer of paper and pulp machinery has a contractual requirement to pay USD 100 million in September, and any pre- or post-payment is not advantageous from an interest rate or liquidity point of view. The rupee revenue from selling these imported machines in the domestic (Indian) market is more or less predictable but P Ltd. still bears the currency risk due to the amount payable being denominated in a foreign currency. The current exchange rate is INR 60 per USD and the forward rate for September is also INR 60 per USD. (Interest rate on rupees and dollars is assumed to be zero in this example – thus there is neither a carrying cost nor a yield.)

  • 9 - Swaps – Part II: Other Swaps

  • from Part–III - Swaps
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 143-152

  • Summary

    This chapter looks at some more kinds of swap transactions and at certain general issues relating to swap markets.

    Equity swaps

    An equity swap is an arrangement by which one party pays to the counter-party an amount based on the value of the shares in a company, and receives from the counter-party an amount of fixed or floating interest on an equivalent notional value. In effect, an equity position is converted into a deposit or debenture.

    Example 9.1

    X Ltd owns a large stake of one lakh shares in Y Ltd, a quoted sister company. The shares are currently quoted at 1,000 per share. X is apprehensive that the price of Y's shares may fall, but does not want to sell its stake as that would mean relinquishing its say over the management of Y Ltd. Instead it enters into an equity swap with Z Ltd, a financial institution, whereby

    i. X will pay Z annually the value of all dividends declared by Y plus or minus any net appreciation or depreciation in the share price (from the base value of 1,000) on its one lakh shares.

    ii. Z will pay X annually the market floating rate of interest on a sum of 10 crore, being the market value of X's holding at the time of the swap.

    Financially, the effect of an equity swap is the same as that of selling the shares outright. However, the shareholder may wish to retain the shares for reasons of control (as in the Example above) or to avoid capital gains tax, or to avoid giving a negative signal to the market. (For example, a sale of Tata Motors shares by Tata Sons might provoke general bearishness in Tata Motors shares, which can be avoided through an equity swap.) The disadvantage is that there is a transaction cost. Depending on the prevailing market sentiment, a premium may have to be paid by one or other party to attract the counterparty and there will usually be a margin for the intermediary.

  • 20 - Portfolio Management and Derivatives

  • from Part–VII - Portfolio Management and Management of Derivative Risks
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 301-306

  • Summary

    Derivatives create new investment opportunities. This chapter examines techniques which are used in portfolio management with particular reference to derivatives.

    Readers are likely to have heard of Lehman Brothers, the once-famous and now-notorious American investment bank which became bankrupt in 2008. Figure 20.1 below shows the price of the shares of Lehman Brothers from 2004 to 2008. It was difficult to predict that Lehman Brothers would go bankrupt when it was hitting all-time highs in early 2007. Even in early 2008 its share price was higher than in 2004. Within a few months, it collapsed. Clearly the market valuation did not reflect the company's inherent position and the stock market did not have the right information as would have been expected under textbook finance theory.

    Consider the hypothetical case of a person whose entire portfolio of investments consisted of only the shares of Lehman Brothers. He would have lost all his money. And if he was leveraged through futures, margin loans etc., then there would have been large margin calls as well in which extra payments over and above the initial equity had to be paid to the broker.

    The conventional answer would be that the investor should have diversified into other shares. And indeed, compared to a portfolio invested entirely in Lehman Brothers, a diversified portfolio of equities would have done better. But almost all broad-based equity indices lost half, if not more, of their net worth during the period from late 2007 to early 2009 which marked the global financial crisis. Thus, diversification into other equities would have provided only limited protection. This illustrates that true diversification does not mean just different equities; it entails diversification across asset classes as well, with equities constituting just one asset class. Government bonds, corporate bonds, convertible debentures, preferred shares, precious metals, other commodities and cash or short-term bank deposits/money market investments, real estate etc. are other asset classes. Having some exposure to them in one's portfolio in 2008 would have cushioned the fall more than a pure equity portfolio.

  • 21 - Management of Derivative Risks

  • from Part–VII - Portfolio Management and Management of Derivative Risks
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 307-317

  • Summary

    There can be no doubt that derivatives are powerful tools for risk management. If used improperly, however, derivatives can produce disastrous results. With derivatives becoming increasingly important, it has become crucial for banks, financial institutions and indeed non-financial companies to properly assess, manage and account for risks arising from derivatives transactions. While many earlier chapters have dealt with the use of derivatives in the management of risk, this chapter deals with the management of risks arising from the use of derivatives.

    Enterprise risk management – covering not only financial but many other kinds of risk – is a rapidly expanding subject by itself. This chapter is a brief and introductory overview of the main principles and practices relating to a subset of those risks – the risks arising from derivatives.

    An enterprise is subject to many kinds of risk and derivatives are just one and not necessarily the most important. Nevertheless, several characteristics of derivatives make them ‘special’ and different from management of many other types of financial risk. First and foremost, derivative instruments are highly ‘geared’. Because of this, it is possible in certain kinds of derivative transactions to lose far more than the original capital deployed in the transaction. In a normal business deal, with an investment of 10 million the maximum loss that can be suffered is 10 million or thereabouts. However, if 10 million is deployed in a derivative transaction as margin through writing of options or a speculative futures contract, it is quite possible to lose 100 million, that is, ten times the value of the capital put in. This is the single most important reason why derivative transactions require a much tighter supervision and control mechanism.

    Secondly, derivative markets move at great speed. The markets are open virtually on a twenty four-hour basis, due to the integration of various exchanges across the world. Big price movements can occur overnight. (This is a feature they share with stock and spot foreign exchange markets.)

    Thirdly, several derivative transactions fall into a grey area between hedging and speculation. Derivative securities used as hedges are a risk-reducing device, but derivatives used for speculation become a risk-enhancing device.

  • Preface to the Second Edition

  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp xvii-xviii

  • Summary

    In the 19 years since the first edition of this book appeared, much has changed. There was a time when the Western expert consensus was that financial markets should be largely left alone and that derivatives should be regulated as lightly as possible. That has changed after the global financial crisis of 2008. There is now greater caution about the effects of derivatives on the economy.

    Derivatives were relatively insignificant in Indian financial markets in 1998 and were just beginning to recover from decades of severe restrictions, imposed at a time when the government pursued a ‘socialistic pattern of society’. Today, India has active derivative markets not only in commodities but also in various financial instruments (so much so that there have been criticisms that equity derivatives trading in India has reached excessive proportions vis-à-vis the cash markets). Meanwhile, the Indian economy too has grown faster than the global average. In short, derivatives are more significant now in Indian markets and Indian markets are more significant in global terms.

    Amidst all the changes, one fact remains unchanged: derivatives are an important feature of a modern market economy and are here to stay. They matter not only to developed markets but to emerging markets as well. Therefore, a basic understanding of how these markets work is essential for those who participate in these markets, those who aspire to work in them and those who comment on them, but also for those who seek to study the economy. Students of commerce, business and finance, bankers and accountants, analysts and financial journalists, non-financial economists and managers – all need a basic understanding of the essentials of derivatives markets. Yet, most books on derivatives are geared to specialists and they often take a mathematical approach.

    This book aims to enable the general reader – whether student, practitioner, banker, commentator or investor – to gain a basic understanding of the derivatives markets and how they operate. It does not presume any prior knowledge of derivatives. The response to the first edition (which went into nine reprints till 2010) indicated that it succeeded in good measure in attaining that objective. It is the authors’ sincere hope that this edition will do the same.

  • 3 - Futures and Forwards

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 37-50

  • Summary

    As pointed out in chapter 1, futures trading, or more accurately forward trading, was the first form of derivatives trading. This chapter reviews the basic concepts of futures trading – its functions, the mechanism by which risk is transferred, the role of speculation and related issues. At the outset, it is necessary to understand clearly what futures trading means.

    Definitions

    A forward contract is an agreement between two parties to buy or sell, as the case may be, a commodity (or financial instrument or currency or any other underlying) on a pre-determined future date at a price agreed when the contract is entered into.

    The key elements are that:

    • the date on which the underlying asset will be bought/sold is determined in advance; and

    • the price to be paid/received at that future date is determined at present.

    Example 3.1

    In the month of August, a rice mill agrees to buy 2.35 tonnes of rice of IR-8 variety from X, a farmer, in the following February at a price of 38,000 per tonne. This is a forward contract. Note that the farmer will receive (and the mill will pay) 38,000 x 2.35 = 89,300 in February irrespective of whether the market price in February is 40,000 per tonne or 36,000 per tonne. According to its terms, this contract may or may not be transferable by the mill or the farmer to any other person and accordingly may be called a ‘transferable’ or a ‘non-transferable’ forward contract.

    A futures contract is a contract to buy or sell, a standard quantity of a standardised or pre-determined grade(s) of a certain commodity at a pre-determined location(s), on a pre-determined future date at a pre-agreed price. If this definition is studied carefully, the differences between a futures contract and a forward contract become apparent:

    a. There is no reference to an agreement ‘between two parties’ – this is because futures contracts are almost always entered into through an intermediary (the exchange or its clearing house) that acts as the buyer to each seller and seller to each buyer. This is illustrated below:

    The absence of a one-to-one relationship between the buyer and seller also means that these contracts are freely transferable.

  • 17 - Accounting and Taxation

  • from Part–VI - Accounting, Taxation and Regulatory Framework
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 257-281

  • Summary

    This chapter deals with the accounting and tax treatment of derivatives transactions. These are specialised topics in themselves and this chapter can only serve as an introduction to the subject.

    Accounting for derivatives

    The increase in the range and complexity of derivative instruments, increased regulatory attention to accounting for derivatives after the global financial crisis, and differing accounting standards and rules in different countries, combine to make this subject exceptionally complicated. Indeed, derivatives accounting is probably the single most complicated topic in the field of accounting. This section presents a simplified summary intended to give the reader an exposure to the main concepts and issues.

    Basic principles

    The basic principles that govern accounting for derivatives can be summarised as follows:

  • a. Derivatives must be shown in the balance sheet at ‘fair value’ (see below), and all changes in fair value must normally be recognised in the profit and loss account (also referred to in this chapter simply as ‘P & L’). Thus, not only realised profits and losses, but also unrealised profits and losses must be recognised; not only must they be recognised but normally they should be recognised as part of current profits or losses. This is known as ‘fair value accounting’. This is in contrast to the normal accounting convention of prudence or conservatism which would imply not recognising unrealised gains.

  • b. The general principle in (a) above will not apply if the derivative is a hedge. To qualify as a hedge, a derivative transaction or position must meet certain criteria. The general principle for derivatives which are used as hedges is that their accounting treatment must correspond to the treatment of the asset or liability being hedged. This treatment is known as ‘hedge accounting’.

    • Fair value

    The term ‘fair value’ is important in relation to accounting for derivatives. Fair value is the price that would be received to sell an asset/paid to transfer a liability in an orderly transaction between market participants. It must be an ‘arm's length’ transaction where the parties are independent of each other, have no relationship to each other and where each is trying to protect his /its own interests. Where there is quoted market value established in a liquid and transparent market, fair value is the same as market value.

Page 157 of 453