DERIVATIVES – INTRODUCTION & ACCOUNTING

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The provided content gives an introduction to derivatives and outlines their accounting aspects. Here's a breakdown of the key points:

Introduction to Derivatives:

  1. Definition of Derivatives: Derivatives are financial contracts whose value depends on the performance of an underlying asset, such as commodities, debt instruments, currency, or stocks.

  2. Types of Derivatives:

    • Commodity Derivatives: Derivatives with underlying assets like agricultural commodities or precious metals.
    • Financial Derivatives: Derivatives with underlying assets like debt instruments, currency, share price indices, or equity shares.

  3. Risk Management Tools: Derivatives are used as risk management tools to hedge against price fluctuations and to speculate on future price movements.

Future Contracts:

  1. Definition: A futures contract is an agreement to buy or sell an underlying asset at a specified future date and price. These contracts are standardized and traded on exchanges.

  2. Underlying Assets: Futures can have underlying assets like agricultural commodities or financial assets like stocks and bonds.

  3. Obligations: Buyers commit to purchasing, and sellers commit to delivering, the underlying asset at the agreed-upon price and date.

  4. Margin: Both parties are required to deposit initial margin to cover potential losses. Daily changes in the contract's value are marked to market (MTM).

  5. Settlement: Contracts can be closed before expiry by taking an opposite position in the market. Settlement can involve physical delivery or cash settlement, depending on the type of contract.

Option Contracts:

  1. Definition: Options are contracts that give the holder the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset at a specified price on or before a future date.

  2. American vs. European Options: American options can be exercised anytime before expiry, while European options can only be exercised on the expiry date.

  3. Rights and Obligations: Options involve a buyer (holder) who has the right but not the obligation and a seller (writer) who has the obligation but not the right to fulfill the contract.

Accounting Aspects:

  1. Initial Margin: Initial margin paid for futures contracts is recorded in an "Initial Margin" account. It can be paid in cash or collateral.

  2. Mark to Market (MTM): Daily changes in futures contracts are marked to market, and the difference is settled in cash. MTM margin is recorded in an "MTM Margin" account.

  3. Final Settlement: On contract expiry, the profit or loss is computed as the difference between the final settlement price and the contract price. It's recognized in the Profit and Loss account.

  4. Open Interest: Open interest is the number of open contracts that have not been closed or settled. Debit balances in MTM accounts represent potential losses, while credit balances represent potential gains.

  5. Option Contracts Accounting: Premium paid for option contracts is recorded in an "Option Premium" account. Premium received is recognized as income in the "Option Premium" account. The difference between the market premium and the paid premium may be provisioned for.

  6. Disclosures: Accounting policies, details of outstanding contracts at year-end (open interests), and other disclosures are required as per accounting standards and regulatory guidelines.

Overall, the content provides a comprehensive overview of derivatives, their types, and their accounting treatment. It covers the key aspects of futures and options contracts and highlights the importance of disclosure and prudent accounting practices in derivatives trading.

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