Wednesday, November 30, 2011
Wednesday, September 7, 2011
Corporate Credit Rating
What Is A Corporate Credit Rating?
Before you decide whether to invest into a debt security from a company or foreign country, you must determine
whether the prospective entity will be able to meet its obligations. A ratings company can help you do this. Providing
independent objective assessments of the credit worthiness of companies and countries, a credit ratings company
helps investors decide how risky it is to invest money in a certain country and/or security.
Credit in the Investment World
As investment opportunities become more global and diverse, it is difficult to decide not only which companies but
also which countries are good investment opportunities. There are advantages to investing in foreign markets, but the
risks associated with sending money abroad are considerably higher than those associated with investing in your
own domestic market. It is important to gain insight into different investment environments but also to understand the
risks and advantages these environments pose. Measuring the ability and willingness of an entity - which could be a
person, a corporation, a security or a country - to keep its financial commitments or its debt, credit ratings are
essential tools for helping you make some investment decisions.
The Raters
There are three top agencies that deal in credit ratings for the investment world. These are: Moody's, Standard and
Poor's (S&P's) and Fitch IBCA. Each of these agencies aim to provide a rating system to help investors determine
the risk associated with investing in a specific company, investing instrument or market.
Ratings can be assigned to short-term and long-term debt obligations as well as securities, loans, preferred
stock and insurance companies. Long-term credit ratings tend to be more indicative of a country's investment
surroundings and/or a company's ability to honor its debt responsibilities.
For a government or company it is sometimes easier to pay back local-currency obligations than it is to pay foreigncurrency
obligations. The ratings therefore assess an entity's ability to pay debts in both foreign and local currencies.
A lack of foreign reserves, for example, may warrant a lower rating for those obligations a country made in foreign
currency.
It is important to note that ratings are not equal to or the same as buy, sell or hold recommendations. Ratings are
rather a measure of an entity's ability and willingness to repay debt.
The Ratings Are In
The ratings lie on a spectrum ranging between highest credit quality on one end and default or "junk" on the other.
Long–term credit ratings are denoted with a letter: a triple A (AAA) is the highest credit quality, and C or D
(depending on the agency issuing the rating) is the lowest or junk quality. Within this spectrum there are different
degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a
number.
Thus, for Fitch IBCA, a "AAA" rating signifies the highest investment grade and means that there is very low credit
risk. "AA" represents very high credit quality; "A" means high credit quality, and "BBB" is good credit quality. These
ratings are considered to be investment grade, which means that the security or the entity being rated carries a level
of quality that many institutions require when considering overseas investments.
Ratings that fall under "BBB" are considered to be speculative or junk. Thus for Moody's a Ba2 would be a
speculative grade rating while for S&P's, a "D" denotes default of junk bond status.
Here is a chart that gives an overview of the different ratings symbols that Moody's and Standard and Poor's issue:
Sovereign Credit Ratings
As previously mentioned, a rating can refer to an entity's specific financial obligation or to its general creditworthiness.
A sovereign credit rating provides the latter as it signifies a country's overall ability to provide a secure investment
environment. This rating reflects factors such as a country's economic status, transparency in the capital market,
levels of public and private investment flows, foreign direct investment, foreign currency reserves, political stability, or
the ability for a country's economy to remain stable despite political change.
Because it is the doorway into a country's investment atmosphere, the sovereign rating is the first thing most
institutional investors will look at when making a decision to invest money abroad. This rating gives the investor an
immediate understanding of the level of risk associated with investing in the country. A country with a sovereign
rating will therefore get more attention than one without. So to attract foreign money, most countries will strive to
obtain a sovereign rating and they will strive even more so to reach investment grade. In most circumstances, a
country's sovereign credit rating will be its upper limit of credit ratings.
Conclusion
A credit rating is a useful tool not only for the investor, but also for the entities looking for investors. An investment
grade rating can put a security, company or country on the global radar, attracting foreign money and boosting a
nation's economy. Indeed, for emerging market economies, the credit rating is key to showing their worthiness of
money from foreign investors. And because the credit rating acts to facilitate investments, many countries and
companies will strive to maintain and improve their ratings, hence ensuring a stable political environment and a more
transparent capital market.
Before you decide whether to invest into a debt security from a company or foreign country, you must determine
whether the prospective entity will be able to meet its obligations. A ratings company can help you do this. Providing
independent objective assessments of the credit worthiness of companies and countries, a credit ratings company
helps investors decide how risky it is to invest money in a certain country and/or security.
Credit in the Investment World
As investment opportunities become more global and diverse, it is difficult to decide not only which companies but
also which countries are good investment opportunities. There are advantages to investing in foreign markets, but the
risks associated with sending money abroad are considerably higher than those associated with investing in your
own domestic market. It is important to gain insight into different investment environments but also to understand the
risks and advantages these environments pose. Measuring the ability and willingness of an entity - which could be a
person, a corporation, a security or a country - to keep its financial commitments or its debt, credit ratings are
essential tools for helping you make some investment decisions.
The Raters
There are three top agencies that deal in credit ratings for the investment world. These are: Moody's, Standard and
Poor's (S&P's) and Fitch IBCA. Each of these agencies aim to provide a rating system to help investors determine
the risk associated with investing in a specific company, investing instrument or market.
Ratings can be assigned to short-term and long-term debt obligations as well as securities, loans, preferred
stock and insurance companies. Long-term credit ratings tend to be more indicative of a country's investment
surroundings and/or a company's ability to honor its debt responsibilities.
For a government or company it is sometimes easier to pay back local-currency obligations than it is to pay foreigncurrency
obligations. The ratings therefore assess an entity's ability to pay debts in both foreign and local currencies.
A lack of foreign reserves, for example, may warrant a lower rating for those obligations a country made in foreign
currency.
It is important to note that ratings are not equal to or the same as buy, sell or hold recommendations. Ratings are
rather a measure of an entity's ability and willingness to repay debt.
The Ratings Are In
The ratings lie on a spectrum ranging between highest credit quality on one end and default or "junk" on the other.
Long–term credit ratings are denoted with a letter: a triple A (AAA) is the highest credit quality, and C or D
(depending on the agency issuing the rating) is the lowest or junk quality. Within this spectrum there are different
degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a
number.
Thus, for Fitch IBCA, a "AAA" rating signifies the highest investment grade and means that there is very low credit
risk. "AA" represents very high credit quality; "A" means high credit quality, and "BBB" is good credit quality. These
ratings are considered to be investment grade, which means that the security or the entity being rated carries a level
of quality that many institutions require when considering overseas investments.
Ratings that fall under "BBB" are considered to be speculative or junk. Thus for Moody's a Ba2 would be a
speculative grade rating while for S&P's, a "D" denotes default of junk bond status.
Here is a chart that gives an overview of the different ratings symbols that Moody's and Standard and Poor's issue:
Sovereign Credit Ratings
As previously mentioned, a rating can refer to an entity's specific financial obligation or to its general creditworthiness.
A sovereign credit rating provides the latter as it signifies a country's overall ability to provide a secure investment
environment. This rating reflects factors such as a country's economic status, transparency in the capital market,
levels of public and private investment flows, foreign direct investment, foreign currency reserves, political stability, or
the ability for a country's economy to remain stable despite political change.
Because it is the doorway into a country's investment atmosphere, the sovereign rating is the first thing most
institutional investors will look at when making a decision to invest money abroad. This rating gives the investor an
immediate understanding of the level of risk associated with investing in the country. A country with a sovereign
rating will therefore get more attention than one without. So to attract foreign money, most countries will strive to
obtain a sovereign rating and they will strive even more so to reach investment grade. In most circumstances, a
country's sovereign credit rating will be its upper limit of credit ratings.
Conclusion
A credit rating is a useful tool not only for the investor, but also for the entities looking for investors. An investment
grade rating can put a security, company or country on the global radar, attracting foreign money and boosting a
nation's economy. Indeed, for emerging market economies, the credit rating is key to showing their worthiness of
money from foreign investors. And because the credit rating acts to facilitate investments, many countries and
companies will strive to maintain and improve their ratings, hence ensuring a stable political environment and a more
transparent capital market.
Why Public Companyies Go Private
Why Public Companies Go Private
A public company may choose to go private for a number of reasons. An acquisition can create significant financial
gain for shareholders and CEOs, while the reduced regulatory and reporting requirements private companies face
can free up time and money to focus on long-term goals. Because there are advantages and disadvantages to going
private as well as short- and long-term issues to consider, companies must carefully weigh their options before
making a decision. Let's take a look at the factors that companies must factor in to the equation.
Advantages of Being Public
Being a public company has its advantages and disadvantages. On the one hand, investors who hold stock in such
companies typically have a liquid asset; buying and selling shares of public companies is relatively easy to do.
However, there are also tremendous regulatory, administrative, financial reporting and corporate governance bylaws
to comply with. These activities can shift management's focus away from operating and growing a company and
toward compliance with and adherence to government regulations.
For instance, the Sarbanes-Oxley Act of 2002 (SOX) imposes many compliance and administrative rules on public
companies. A byproduct of the Enron and Worldcom corporate failures in 2001-2002, SOX requires all levels of
publicly traded companies to implement and execute internal controls. The most contentious part of SOX is Section
404, which requires the implementation, documentation and testing of internal controls over financial reporting at all
levels of the organization.
Public companies must also conduct operational, accounting and financial engineering in order to meet Wall Street's
quarterly earnings expectations. This short-term focus on the quarterly earnings report, which is dictated by external
analysts, can reduce prioritization of longer-term functions and goals such as research and development, capital
expenditures and the funding of pensions, to name but a few examples. In an attempt to manipulate the financial
statements, a few public companies have shortchanged their employees' pension funding while projecting overly
optimistic anticipated returns on the pension's investments.
Advantages of Privatization
Investors in private companies may or may not hold a liquid investment. Covenants can specify exit dates, making it
challenging to sell the investment, or private investors may easily find a buyer for their portion of the equity stake in
the company. Being private frees up management's time and effort to concentrate on running and growing a
business, as there are no SOX regulations to comply with. Thus, the senior leadership team can focus more on
improving the business's competitive positioning in the marketplace. Internal and external assurance, legal
professionals and consulting professionals can work on reporting requirements by private investors.
Private-equity firms have varying exit time lines for their investments depending on what they have conveyed to their
investors, but holding periods are typically between four and eight years. This horizon frees up management's
prioritization on meeting quarterly earnings expectations and allows them to focus on activities that can create and
build long-term shareholder wealth. Management typically lays out its business plan to the prospective shareholders
and agrees on a go-forward plan. This covers the company's and industry's outlook and sets forth a plan showing
how the company will provide returns for its investors. For instance, managers might choose to follow through on
initiatives to train and retrain the sales organization (and get rid of underperforming staff). The extra time and money
private companies enjoy from decreased regulation can also be used for other purposes, such as implementing a
process-improvement initiative throughout the organization.
What It Means to Go Private
A "take-private" transaction means that a large private-equity group, or a consortium of private-equity firms,
purchases or acquires the stock of a publicly traded corporation. Because many public companies have revenues of
several hundred million to several billion dollars per year, the acquiring private-equity group typically needs to secure
financing from an investment bank or related lender that can provide enough loans to help finance (and complete) the
deal. The newly acquired target's operating cash flow can then be used to pay off the debt that was used to make the
acquisition possible.
Equity groups also need to provide sufficient returns for their shareholders. Leveraging a company reduces the
amount of equity needed to fund an acquisition and is a method for increasing the returns on capital deployed. Put
another way, a company borrows someone else's money to buy the company, pays the interest on that loan with the
cash generated from the newly purchased company, and eventually pays off the balance of the loan with a portion of
the company's appreciation in value. The rest of the cash flow and appreciation in value can be returned to investors
as income and capital gains on their investment (after the private-equity firm takes its cut of the management fees).
When market conditions make credit readily available, more private-equity firms are able to borrow the funds needed
to acquire a public company. When the credit markets are tightened, debt becomes more expensive and there will
usually be fewer take-private transactions. Due to the large size of most public companies, it is normally not feasible
for an acquiring company to finance the purchase single-handedly.
Motivations for Going Private
Investment banks, financial intermediaries and senior management build relationships with private equity in an effort
to explore partnership and transaction opportunities. As acquirers typically pay at least a 20-40% premium over the
current stock price, they can entice CEOs and other managers of public companies - who are often heavily
compensated when their company's stock appreciates in value - to go private. In addition, shareholders, especially
those who have voting rights, often pressure the board of directors and senior management to complete a pending
deal in order increase the value of their equity holdings. Many stockholders of public companies are also short-term
institutional and retail investors, and realizing premiums from a take-private transaction is a low-risk way of securing
returns.
Balancing Short-Term and Long-Term Considerations
In considering whether to consummate a deal with a private-equity investor, the public company's senior leadership
team must also balance short-term considerations with the company's long-term outlook.
• Does taking on a financial partner make sense for the long term?
• How much leverage will be tacked on to the company?
• Will cash flow from operations be able to support the new interest payments?
• What is the future outlook for the company and industry?
• Are these outlooks overly optimistic, or are they realistic?
A private-equity firm that adds too much leverage to a public company in order to fund the deal can seriously impair
an organization in adverse scenarios. For example, the economy could take a dive, the industry could face stiff
competition from overseas or the company's operators could miss important revenue milestones.
If a company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds.
It will then be harder for the company to raise debt or equity capital to fund capital expenditures, expansion or
research and development. Healthy levels of capital expenditures and research and development are often critical to
the long-term success of a company as it seeks to differentiate its product and service offerings and make its position
in the marketplace more competitive. High levels of debt can thus prevent a company from obtaining competitive
advantages in this regard.
Management needs to scrutinize the track record of the proposed acquirer based on the following criteria:
• Is the acquirer aggressive in leveraging a newly acquired company?
• How familiar is it with the industry?
• Does the acquirer have sound projections?
• Is it a hands-on investors, or does the acquirer give management leeway in the stewardship of the
company?
• What is the acquirer's exit strategy?
Conclusion
A take-private transaction is an attractive and viable alternative for many public companies. As long as debt levels
are reasonable and the company continues to maintain or grow its free cash flow, operating and running a private
company frees up management's time and energy from compliance requirements and short-term earnings
management and may provide long-term benefits to the company and its shareholders
A public company may choose to go private for a number of reasons. An acquisition can create significant financial
gain for shareholders and CEOs, while the reduced regulatory and reporting requirements private companies face
can free up time and money to focus on long-term goals. Because there are advantages and disadvantages to going
private as well as short- and long-term issues to consider, companies must carefully weigh their options before
making a decision. Let's take a look at the factors that companies must factor in to the equation.
Advantages of Being Public
Being a public company has its advantages and disadvantages. On the one hand, investors who hold stock in such
companies typically have a liquid asset; buying and selling shares of public companies is relatively easy to do.
However, there are also tremendous regulatory, administrative, financial reporting and corporate governance bylaws
to comply with. These activities can shift management's focus away from operating and growing a company and
toward compliance with and adherence to government regulations.
For instance, the Sarbanes-Oxley Act of 2002 (SOX) imposes many compliance and administrative rules on public
companies. A byproduct of the Enron and Worldcom corporate failures in 2001-2002, SOX requires all levels of
publicly traded companies to implement and execute internal controls. The most contentious part of SOX is Section
404, which requires the implementation, documentation and testing of internal controls over financial reporting at all
levels of the organization.
Public companies must also conduct operational, accounting and financial engineering in order to meet Wall Street's
quarterly earnings expectations. This short-term focus on the quarterly earnings report, which is dictated by external
analysts, can reduce prioritization of longer-term functions and goals such as research and development, capital
expenditures and the funding of pensions, to name but a few examples. In an attempt to manipulate the financial
statements, a few public companies have shortchanged their employees' pension funding while projecting overly
optimistic anticipated returns on the pension's investments.
Advantages of Privatization
Investors in private companies may or may not hold a liquid investment. Covenants can specify exit dates, making it
challenging to sell the investment, or private investors may easily find a buyer for their portion of the equity stake in
the company. Being private frees up management's time and effort to concentrate on running and growing a
business, as there are no SOX regulations to comply with. Thus, the senior leadership team can focus more on
improving the business's competitive positioning in the marketplace. Internal and external assurance, legal
professionals and consulting professionals can work on reporting requirements by private investors.
Private-equity firms have varying exit time lines for their investments depending on what they have conveyed to their
investors, but holding periods are typically between four and eight years. This horizon frees up management's
prioritization on meeting quarterly earnings expectations and allows them to focus on activities that can create and
build long-term shareholder wealth. Management typically lays out its business plan to the prospective shareholders
and agrees on a go-forward plan. This covers the company's and industry's outlook and sets forth a plan showing
how the company will provide returns for its investors. For instance, managers might choose to follow through on
initiatives to train and retrain the sales organization (and get rid of underperforming staff). The extra time and money
private companies enjoy from decreased regulation can also be used for other purposes, such as implementing a
process-improvement initiative throughout the organization.
What It Means to Go Private
A "take-private" transaction means that a large private-equity group, or a consortium of private-equity firms,
purchases or acquires the stock of a publicly traded corporation. Because many public companies have revenues of
several hundred million to several billion dollars per year, the acquiring private-equity group typically needs to secure
financing from an investment bank or related lender that can provide enough loans to help finance (and complete) the
deal. The newly acquired target's operating cash flow can then be used to pay off the debt that was used to make the
acquisition possible.
Equity groups also need to provide sufficient returns for their shareholders. Leveraging a company reduces the
amount of equity needed to fund an acquisition and is a method for increasing the returns on capital deployed. Put
another way, a company borrows someone else's money to buy the company, pays the interest on that loan with the
cash generated from the newly purchased company, and eventually pays off the balance of the loan with a portion of
the company's appreciation in value. The rest of the cash flow and appreciation in value can be returned to investors
as income and capital gains on their investment (after the private-equity firm takes its cut of the management fees).
When market conditions make credit readily available, more private-equity firms are able to borrow the funds needed
to acquire a public company. When the credit markets are tightened, debt becomes more expensive and there will
usually be fewer take-private transactions. Due to the large size of most public companies, it is normally not feasible
for an acquiring company to finance the purchase single-handedly.
Motivations for Going Private
Investment banks, financial intermediaries and senior management build relationships with private equity in an effort
to explore partnership and transaction opportunities. As acquirers typically pay at least a 20-40% premium over the
current stock price, they can entice CEOs and other managers of public companies - who are often heavily
compensated when their company's stock appreciates in value - to go private. In addition, shareholders, especially
those who have voting rights, often pressure the board of directors and senior management to complete a pending
deal in order increase the value of their equity holdings. Many stockholders of public companies are also short-term
institutional and retail investors, and realizing premiums from a take-private transaction is a low-risk way of securing
returns.
Balancing Short-Term and Long-Term Considerations
In considering whether to consummate a deal with a private-equity investor, the public company's senior leadership
team must also balance short-term considerations with the company's long-term outlook.
• Does taking on a financial partner make sense for the long term?
• How much leverage will be tacked on to the company?
• Will cash flow from operations be able to support the new interest payments?
• What is the future outlook for the company and industry?
• Are these outlooks overly optimistic, or are they realistic?
A private-equity firm that adds too much leverage to a public company in order to fund the deal can seriously impair
an organization in adverse scenarios. For example, the economy could take a dive, the industry could face stiff
competition from overseas or the company's operators could miss important revenue milestones.
If a company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds.
It will then be harder for the company to raise debt or equity capital to fund capital expenditures, expansion or
research and development. Healthy levels of capital expenditures and research and development are often critical to
the long-term success of a company as it seeks to differentiate its product and service offerings and make its position
in the marketplace more competitive. High levels of debt can thus prevent a company from obtaining competitive
advantages in this regard.
Management needs to scrutinize the track record of the proposed acquirer based on the following criteria:
• Is the acquirer aggressive in leveraging a newly acquired company?
• How familiar is it with the industry?
• Does the acquirer have sound projections?
• Is it a hands-on investors, or does the acquirer give management leeway in the stewardship of the
company?
• What is the acquirer's exit strategy?
Conclusion
A take-private transaction is an attractive and viable alternative for many public companies. As long as debt levels
are reasonable and the company continues to maintain or grow its free cash flow, operating and running a private
company frees up management's time and energy from compliance requirements and short-term earnings
management and may provide long-term benefits to the company and its shareholders
Mortgage backed Securities
Mortgage-backed security
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by
the principal and interest payments of a set of mortgage loans. Payments are typically made
monthly over the lifetime of the underlying loans
However not all securities backed by mortgages are considered mortgage-backed securities.
Housing Bonds (Mortgage Revenue Bonds) are backed by the mortgages which they fund, but
aren't MBSs.
Residential mortgages in the United States have the option to pay more than the required
monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because
curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an
MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily
properties (such as apartment buildings, retail or office properties, hotels, schools, industrial
properties and other commercial sites). The properties of these loans vary, with longer-term
loans (5 years or longer) often being at fixed interest rates and having restrictions on
prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
History
In 1938, a governmental agency named the National Mortgage Association of Washington was
formed and soon was renamed Federal National Mortgage Association (FNMA or Fannie Mae). It
was chartered by the US government as a corporation which buys Federal Housing
Administration (FHA) and Veterans Administration (VA) mortgages on the secondary market,
pools them, and sells them as "mortgage-backed securities" to investors on the open market.
FNMA was privatized in 1968 as a "government sponsored enterprise" listed on the stock
exchange.
Additionally, the 1970 Emergency Home Finance Act created a new secondary mortgage market
participant, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) to support
conventional mortgages originated by thrift institutions. The Act also allowed FNMA to buy
conventional mortgages in addition to FHA & VA.
Freddie Mac competed in the secondary market, where Fannie Mae had enjoyed a monopoly.
Market size and liquidity
Mortgage backed securities can be considered to have been in the tens of trillions, if Credit
Default Swaps are taken into account.
The total market value of all outstanding mortgages at the end of the first quarter of 2006 was
approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger
than the market value of outstanding asset-backed securities. The MBS market overtook the
market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
2005: USD 967 billion
2004: USD 1,019 billion
2003: USD 2,131 billion
2002: USD 1,444 billion
2001: USD 1,093 billion
The high liquidity of most mortgage-backed securities means that any investor wishing to take
a position need not deal with the difficulties of theoretical pricing described below; the price
of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a
drop in prepayment rates (a critical business risk for any company specializing in refinancing)
and certain predatory lending schemes.
Structure and features
Weighted-average maturity
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the
mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an
average across mortgages, as distinct from concepts such as weighted-average life and
duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let's consider a mortgage pool with just three mortgage loans
that have the below mentioned outstanding mortgage balances, mortgage rates, and months
remaining to maturity.
Loan Outstanding Mortgage
Balance
Mortgage
Rate
Remaining Months to
Maturity
Each Loan's
Weighting
Loan
1 $200,000 6.00% 300 22.22%
Loan
2
$400,000 6.25% 260 44.44%
Loan
3
$300,000 6.50% 280 33.33%
The weightings are computed by dividing each outstanding loan amount by total amount
outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts
at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists
of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)
= 66.67 + 115.56 + 93.33
= 275.56 Months or 276 months after rounding
Weighted-average coupon
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages
in the pool, weighted by their original balances at the issuance of the MBS.
Why and where we use WAM and WAC
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis
for the computation of cash flows from that mortgage passthrough. Just as we describe a bond
by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for
example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month
WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that
the investor would receive if he/she holds this mortgage passthrough security (or simply
mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The
difference goes to servicing (i.e., costs incurred in collecting the loan payments and
transferring the payments to the investors) the mortgage loans in the pool.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some
securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from
other mortgage-backed instruments the qualifier pass-through is used, in the same way that
'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
Pass-through mortgage-backed security is the simplest MBS, as described in the
sections above. Essentially, a securitization of the mortgage payments to the mortgage
originators. These can be subdivided into:
o Residential mortgage-backed security (RMBS) - a pass-through MBS backed by
mortgages on residential property
o Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by
mortgages on commercial property
Collateralized mortgage obligation (CMO) - a more complex MBS in which the
mortgages are ordered into tranches by some quality (such as repayment time), with
each tranche sold as a separate security.
Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to
pay down the loan's principal and partly used to pay the interest on it. These two
components can be separated to create SMBS's, of which there are two subtypes:
o Interest-only stripped mortgage-backed securities (IO) - a bond with cash
flows backed by the interest component of property owner's mortgage
payments.
o Principal-only stripped mortgage-backed securities (PO) - a bond with cash
flows backed by the principal repayment component of property owner's
mortgage payments.
Varieties of underlying mortgages in the pool:
Prime: conforming mortgages: prime borrowers, full documentation (such as
verification of income and assets), strong credit scores, etc.
Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some
way, often lower documentation (or in some other way: vacation home, etc.)
Subprime: weaker credit scores, no verification of income or assets, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as
set by FannieMae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are
not MBS can also have these subtypes.
Covered bonds
In Europe there exists a type of asset-backed bond called a "covered bond" (commonly known
by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany
when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated
since the creation of a law governing the securities in Germany in 1900. The key difference
between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make
loans and package them into Pfandbriefe keep those loans on their books. This means that
when a company with mortgage assets on its books issue the covered bond its balance sheet
grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities
payments.
Uses
Risk, Return, Rating & Yield relate
There are many reasons for mortgage originators to finance their activities by issuing mortgagebacked
securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital
market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for
additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the
origination of an underlying mortgage (private market transaction) and the yield
demanded by bond investors through bond issuance (typically, a public market
transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with
other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more
traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve
various financial ratios, utilise capital more efficiently and achieve compliance with
risk-based capital standards.
Pricing
Theoretical pricing
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit
risk) and interest rate (IR) exposure.The MBS adds a third risk: early redemption (prepayment).
The number of homeowners in residential MBS securitizations who prepay goes up when
interest rates go down. One reason for this phenomenon is that homeowners can refinance at a
lower fixed interest rate. Commercial MBS often mitigate this risk using call protection
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of
MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of
the IR model, and the sophistication of the prepayment IR dependence, to the point that no
closed form solution (i.e. one you could write it down) is widely known. In models of this type
numerical methods provide approximate theoretical prices. These are also required in most
models which specify the credit risk as a stochastic function with an IR correlation.
Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
Interest rate risk and prepayment risk
Theoretical pricing models must take into account the link between interest rates and loan
prepayment speed. Mortgage prepayments are most often made because a home is sold or
because the homeowner is refinancing to a new mortgage, presumably with a lower rate or
shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they
receive the money, because it tends to occur when floating rates drop and the fixed income of
the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a
spread to government bonds.
There are other drivers of the prepayment function (or prepayment risk), independent of the
interest rate, for instance:
Economic growth, which is correlated with increased turnover in the housing market
Home prices inflation
Unemployment
Regulatory risk; if borrowing requirements or tax laws in a country change this can
change the market profoundly.
Demographic trends, and a shifting risk aversion profile, which can make fixed rate
mortgages relatively more or less attractive.
Credit risk
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying
the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high
because:
1. The mortgage originator will generally research the mortgage taker's ability to repay,
and will try to lend only to the credit-worthy.
2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against
homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the
full faith and credit of the US Federal government. This is not the case with Fannie Mae
or Freddie Mac, but these two entities have lines of credit with the US Federal
government; however, these lines of credit are extremely small when compared with
the average amount of money circulated through Fannie Mae or Freddie Mac in one
day's business. Additionally, Fannie Mae and Freddie Mac generally require private
mortgage insurance on loans in which the borrower provides a down payment that is
less than 20% of the property value.
3. Pooling many mortgages with different default probabilities creates a bond with a
much lower probability of total default, in which no homeowners are able to make
their payments (see Copula). Although the risk neutral credit spread is theoretically
identical between a mortgage ensemble and the average mortgage within it, the
chance of catastrophic loss is reduced.
4. If the property owner should default, the property remains as collateral. Although real
estate prices can move below the value of the original loan, this increases the solidity
of the payment guarantees and deters borrower default.
If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating
of the bonds would be very much lower. Part of the reason is the expected adverse selection
against borrowers with improving credit (from MBSs pooled by initial credit quality) who would
have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).
Real-world pricing
Most traders and money managers use Bloombergand Intex to analyze MBS pools. Intex is also
used to analyze more esoteric products. Some institutions have also developed their own
proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact
round lots ($1 million+).
For "vanilla" or "generic" 30-year pools (FN/FG/GN) with coupons of 4% - 7%, one can see the
prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due
to the actual pools not being shown. These are forward prices for the next 3 delivery months
since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed.
A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a
"pay-up" depending on characteristics. These are called "specified pools" since the buyer
specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR
or PSA. When a mortgage refinances or the borrower prepays during the month, the
prepayment measurement increases.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they
are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every
dollar that's prepaid, possibly significantly decreasing the yield. This is likely to happen as
holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the lowcoupon
MBS pool was bought at a discount. This is due to the fact that when the borrower pays
back the mortgage he does so at "par". So if the investor bought a bond at 95 cents on the
dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is
unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS
pools are loan amount ranges that each mortgage in the pool must pass. Typically, high
premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance
command the largest pay-ups. Even though the borrower is paying an above market yield, they
are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The large number of factors needed, makes it difficult to calculate the value of an MBS
security. Quite often, market participants do not concur resulting in large differences in
quoted prices for the same instrument. Practitioners constantly try to improve prepayment
models and hope to measure values for input variables implied by the market. Varying liquidity
premiums for related instruments as well as changing liquidity over time, makes this a
devilishly difficult task
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by
the principal and interest payments of a set of mortgage loans. Payments are typically made
monthly over the lifetime of the underlying loans
However not all securities backed by mortgages are considered mortgage-backed securities.
Housing Bonds (Mortgage Revenue Bonds) are backed by the mortgages which they fund, but
aren't MBSs.
Residential mortgages in the United States have the option to pay more than the required
monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because
curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an
MBS is not known in advance, and therefore presents an additional risk to MBS investors.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily
properties (such as apartment buildings, retail or office properties, hotels, schools, industrial
properties and other commercial sites). The properties of these loans vary, with longer-term
loans (5 years or longer) often being at fixed interest rates and having restrictions on
prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely prepayable.
History
In 1938, a governmental agency named the National Mortgage Association of Washington was
formed and soon was renamed Federal National Mortgage Association (FNMA or Fannie Mae). It
was chartered by the US government as a corporation which buys Federal Housing
Administration (FHA) and Veterans Administration (VA) mortgages on the secondary market,
pools them, and sells them as "mortgage-backed securities" to investors on the open market.
FNMA was privatized in 1968 as a "government sponsored enterprise" listed on the stock
exchange.
Additionally, the 1970 Emergency Home Finance Act created a new secondary mortgage market
participant, the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) to support
conventional mortgages originated by thrift institutions. The Act also allowed FNMA to buy
conventional mortgages in addition to FHA & VA.
Freddie Mac competed in the secondary market, where Fannie Mae had enjoyed a monopoly.
Market size and liquidity
Mortgage backed securities can be considered to have been in the tens of trillions, if Credit
Default Swaps are taken into account.
The total market value of all outstanding mortgages at the end of the first quarter of 2006 was
approximately USD 6.1 trillion, according to The Bond Market Association. This is much larger
than the market value of outstanding asset-backed securities. The MBS market overtook the
market for US Treasury notes and bonds in 2000.
According to The Bond Market Association, gross U.S. issuance of agency MBS was:
2005: USD 967 billion
2004: USD 1,019 billion
2003: USD 2,131 billion
2002: USD 1,444 billion
2001: USD 1,093 billion
The high liquidity of most mortgage-backed securities means that any investor wishing to take
a position need not deal with the difficulties of theoretical pricing described below; the price
of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.
Reasons (other than speculation) for entering the market include the desire to hedge against a
drop in prepayment rates (a critical business risk for any company specializing in refinancing)
and certain predatory lending schemes.
Structure and features
Weighted-average maturity
The weighted-average maturity (WAM) of an MBS is the average of the maturities of the
mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an
average across mortgages, as distinct from concepts such as weighted-average life and
duration, which are averages across payments of a single loan.
To illustrate the concept of WAM, let's consider a mortgage pool with just three mortgage loans
that have the below mentioned outstanding mortgage balances, mortgage rates, and months
remaining to maturity.
Loan Outstanding Mortgage
Balance
Mortgage
Rate
Remaining Months to
Maturity
Each Loan's
Weighting
Loan
1 $200,000 6.00% 300 22.22%
Loan
2
$400,000 6.25% 260 44.44%
Loan
3
$300,000 6.50% 280 33.33%
The weightings are computed by dividing each outstanding loan amount by total amount
outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts
at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists
of three loans is computed as follows:
WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)
= 66.67 + 115.56 + 93.33
= 275.56 Months or 276 months after rounding
Weighted-average coupon
The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages
in the pool, weighted by their original balances at the issuance of the MBS.
Why and where we use WAM and WAC
WAM and WAC are used for describing a mortgage passthrough security, and they form the basis
for the computation of cash flows from that mortgage passthrough. Just as we describe a bond
by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for
example, "this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month
WAM."
Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that
the investor would receive if he/she holds this mortgage passthrough security (or simply
mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The
difference goes to servicing (i.e., costs incurred in collecting the loan payments and
transferring the payments to the investors) the mortgage loans in the pool.
Types
Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some
securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from
other mortgage-backed instruments the qualifier pass-through is used, in the same way that
'vanilla' designates an option with no special features.
Mortgage-backed security sub-types include:
Pass-through mortgage-backed security is the simplest MBS, as described in the
sections above. Essentially, a securitization of the mortgage payments to the mortgage
originators. These can be subdivided into:
o Residential mortgage-backed security (RMBS) - a pass-through MBS backed by
mortgages on residential property
o Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by
mortgages on commercial property
Collateralized mortgage obligation (CMO) - a more complex MBS in which the
mortgages are ordered into tranches by some quality (such as repayment time), with
each tranche sold as a separate security.
Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to
pay down the loan's principal and partly used to pay the interest on it. These two
components can be separated to create SMBS's, of which there are two subtypes:
o Interest-only stripped mortgage-backed securities (IO) - a bond with cash
flows backed by the interest component of property owner's mortgage
payments.
o Principal-only stripped mortgage-backed securities (PO) - a bond with cash
flows backed by the principal repayment component of property owner's
mortgage payments.
Varieties of underlying mortgages in the pool:
Prime: conforming mortgages: prime borrowers, full documentation (such as
verification of income and assets), strong credit scores, etc.
Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some
way, often lower documentation (or in some other way: vacation home, etc.)
Subprime: weaker credit scores, no verification of income or assets, etc.
There are also jumbo mortgages, when the size is bigger than the "conforming loan amount" as
set by FannieMae.
These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are
not MBS can also have these subtypes.
Covered bonds
In Europe there exists a type of asset-backed bond called a "covered bond" (commonly known
by the German term Pfandbriefe). Pfandbriefe were first created in 19th century Germany
when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated
since the creation of a law governing the securities in Germany in 1900. The key difference
between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make
loans and package them into Pfandbriefe keep those loans on their books. This means that
when a company with mortgage assets on its books issue the covered bond its balance sheet
grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities
payments.
Uses
Risk, Return, Rating & Yield relate
There are many reasons for mortgage originators to finance their activities by issuing mortgagebacked
securities. Mortgage-backed securities
1. transform relatively illiquid, individual financial assets into liquid and tradable capital
market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for
additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the
origination of an underlying mortgage (private market transaction) and the yield
demanded by bond investors through bond issuance (typically, a public market
transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with
other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more
traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve
various financial ratios, utilise capital more efficiently and achieve compliance with
risk-based capital standards.
Pricing
Theoretical pricing
Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit
risk) and interest rate (IR) exposure.The MBS adds a third risk: early redemption (prepayment).
The number of homeowners in residential MBS securitizations who prepay goes up when
interest rates go down. One reason for this phenomenon is that homeowners can refinance at a
lower fixed interest rate. Commercial MBS often mitigate this risk using call protection
Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of
MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of
the IR model, and the sophistication of the prepayment IR dependence, to the point that no
closed form solution (i.e. one you could write it down) is widely known. In models of this type
numerical methods provide approximate theoretical prices. These are also required in most
models which specify the credit risk as a stochastic function with an IR correlation.
Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.
Interest rate risk and prepayment risk
Theoretical pricing models must take into account the link between interest rates and loan
prepayment speed. Mortgage prepayments are most often made because a home is sold or
because the homeowner is refinancing to a new mortgage, presumably with a lower rate or
shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they
receive the money, because it tends to occur when floating rates drop and the fixed income of
the bond would be more valuable (negative convexity). Hence the term: prepayment risk.
To compensate investors for the prepayment risk associated with these bonds, they trade at a
spread to government bonds.
There are other drivers of the prepayment function (or prepayment risk), independent of the
interest rate, for instance:
Economic growth, which is correlated with increased turnover in the housing market
Home prices inflation
Unemployment
Regulatory risk; if borrowing requirements or tax laws in a country change this can
change the market profoundly.
Demographic trends, and a shifting risk aversion profile, which can make fixed rate
mortgages relatively more or less attractive.
Credit risk
The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying
the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high
because:
1. The mortgage originator will generally research the mortgage taker's ability to repay,
and will try to lend only to the credit-worthy.
2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against
homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the
full faith and credit of the US Federal government. This is not the case with Fannie Mae
or Freddie Mac, but these two entities have lines of credit with the US Federal
government; however, these lines of credit are extremely small when compared with
the average amount of money circulated through Fannie Mae or Freddie Mac in one
day's business. Additionally, Fannie Mae and Freddie Mac generally require private
mortgage insurance on loans in which the borrower provides a down payment that is
less than 20% of the property value.
3. Pooling many mortgages with different default probabilities creates a bond with a
much lower probability of total default, in which no homeowners are able to make
their payments (see Copula). Although the risk neutral credit spread is theoretically
identical between a mortgage ensemble and the average mortgage within it, the
chance of catastrophic loss is reduced.
4. If the property owner should default, the property remains as collateral. Although real
estate prices can move below the value of the original loan, this increases the solidity
of the payment guarantees and deters borrower default.
If the MBS was not underwritten by the original real estate & the issuer's guarantee the rating
of the bonds would be very much lower. Part of the reason is the expected adverse selection
against borrowers with improving credit (from MBSs pooled by initial credit quality) who would
have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).
Real-world pricing
Most traders and money managers use Bloombergand Intex to analyze MBS pools. Intex is also
used to analyze more esoteric products. Some institutions have also developed their own
proprietary software. TradeWeb is used by the largest bond dealers ("primaries") to transact
round lots ($1 million+).
For "vanilla" or "generic" 30-year pools (FN/FG/GN) with coupons of 4% - 7%, one can see the
prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due
to the actual pools not being shown. These are forward prices for the next 3 delivery months
since pools haven't been cut — only the issuing agency, coupon and dollar amount are revealed.
A specific pool whose characteristics are known would usually trade "TBA plus {x} ticks" or a
"pay-up" depending on characteristics. These are called "specified pools" since the buyer
specifies the pool characteristic he/she is willing to "pay up" for.
The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR
or PSA. When a mortgage refinances or the borrower prepays during the month, the
prepayment measurement increases.
If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they
are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every
dollar that's prepaid, possibly significantly decreasing the yield. This is likely to happen as
holders of higher-coupon MBS have good incentive to refinance.
Conversely, it may be advantageous to the bondholder for the borrower to prepay if the lowcoupon
MBS pool was bought at a discount. This is due to the fact that when the borrower pays
back the mortgage he does so at "par". So if the investor bought a bond at 95 cents on the
dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is
unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.
The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS
pools are loan amount ranges that each mortgage in the pool must pass. Typically, high
premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance
command the largest pay-ups. Even though the borrower is paying an above market yield, they
are dissuaded to refinance a small loan balance due to the high fixed cost involved.
Low Loan Balance: < 85k
Mid Loan Balance: Between 85k - 110k
High Loan Balance: Between 110k - 150k
Super High Loan Balance: Between 150k - 175k
TBA: > 175k
The large number of factors needed, makes it difficult to calculate the value of an MBS
security. Quite often, market participants do not concur resulting in large differences in
quoted prices for the same instrument. Practitioners constantly try to improve prepayment
models and hope to measure values for input variables implied by the market. Varying liquidity
premiums for related instruments as well as changing liquidity over time, makes this a
devilishly difficult task
Bond Market
The ABCs Of The Bond Market
Want to improve your portfolio's risk/return profile? Adding bonds creates a more balanced portfolio, strengthening diversification and calming
volatility. You can get your start in bond investing by learning a few basic bond market terms.
On the surface, the bond market may seem unfamiliar, even to experienced stock investors. Many investors make only passing ventures into
bonds because they are confused by the apparent complexity of the market. Bonds are actually very simple debt instruments, if you understand
the terminology. Let's take a look at that terminology now.
1. Basic Bond Characteristics
A bond is simply a type of loan taken out by companies. Investors loan a company money when they buy its bonds. In exchange, the company
pays an interest "coupon" at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the
loan.
Unlike stocks, bonds can vary significantly based on the terms of the bond's indenture, a legal document outlining the characteristics of the
bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important
features to look for when considering a bond.
Maturity
The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the company's bond
obligation will end.
Secured/Unsecured
A bond can be secured or unsecured. Unsecured bonds are called debentures; their interest payments and return of principal are guaranteed
only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is
a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.
Liquidation Preference
When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it
begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and stockholders get whatever is left over
Coupon
The coupon amount is the amount of interest paid to bondholders, normally on an annual or semiannual basis.
Tax Status
While the majority of corporate bonds are taxable investments, there are some government and municipal bonds that are tax exempt, meaning
that income and capital gains realized on the bonds are not subject to the usual state and federal taxation.
Because investors do not have to pay taxes on returns, tax-exempt bonds will have lower interest than equivalent taxable bonds. An investor
must calculate the tax-equivalent yield to compare the return with that of taxable instruments.
Callability
Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the
company, usually at a slight premium to par.
2. Risks of Bonds
Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required.
Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news
for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of
continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment.
Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the
investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates.
The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther
out into the future
3. Bond Ratings
Agencies
The most commonly cited bond rating agencies are Standard & Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its
obligations. Ratings range from 'AAA' to 'Aaa' for "high grade" issues very likely to be repaid to 'D' for issues that are in currently in default.
Bonds rated 'BBB' to 'Baa' or above are called "investment grade"; this means that they are unlikely to default and tend to remain stable
investments. Bonds rated 'BB' to 'Ba' or below are called "junk bonds", which means that default is more likely, and they are thus more
speculative and subject to price volatility.
Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the
ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are
considering .
4. Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other
yield measurements that are used in certain situations.
Yield to Maturity (YTM)
As said above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to
maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor's
actual return will differ slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excel's RATE or YIELDMAT (Excel 2007
only) functions for this computation. A simple function is also available on a financial calculator.
Current Yield
Current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by
dividing the bond's annual coupon amount by the bond's current price. Keep in mind that this yield incorporates only the income portion of return,
ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual
coupon payment by the par value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current
bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.
Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called
bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call
date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate this yield using Excel's YIELD or IRR functions, or with a
financial calculator.
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In
this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are
hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel's YIELD or IRR
functions, or by using a financial calculator.
Conclusion
Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. An investor need only
master these few basic terms and measurements to unmask the familiar market dynamics and become a competent bond investor. Once you've
gotten a hang of the lingo, the rest is easy.
Want to improve your portfolio's risk/return profile? Adding bonds creates a more balanced portfolio, strengthening diversification and calming
volatility. You can get your start in bond investing by learning a few basic bond market terms.
On the surface, the bond market may seem unfamiliar, even to experienced stock investors. Many investors make only passing ventures into
bonds because they are confused by the apparent complexity of the market. Bonds are actually very simple debt instruments, if you understand
the terminology. Let's take a look at that terminology now.
1. Basic Bond Characteristics
A bond is simply a type of loan taken out by companies. Investors loan a company money when they buy its bonds. In exchange, the company
pays an interest "coupon" at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the
loan.
Unlike stocks, bonds can vary significantly based on the terms of the bond's indenture, a legal document outlining the characteristics of the
bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important
features to look for when considering a bond.
Maturity
The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the company's bond
obligation will end.
Secured/Unsecured
A bond can be secured or unsecured. Unsecured bonds are called debentures; their interest payments and return of principal are guaranteed
only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is
a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.
Liquidation Preference
When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it
begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and stockholders get whatever is left over
Coupon
The coupon amount is the amount of interest paid to bondholders, normally on an annual or semiannual basis.
Tax Status
While the majority of corporate bonds are taxable investments, there are some government and municipal bonds that are tax exempt, meaning
that income and capital gains realized on the bonds are not subject to the usual state and federal taxation.
Because investors do not have to pay taxes on returns, tax-exempt bonds will have lower interest than equivalent taxable bonds. An investor
must calculate the tax-equivalent yield to compare the return with that of taxable instruments.
Callability
Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the
company, usually at a slight premium to par.
2. Risks of Bonds
Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required.
Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news
for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of
continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment.
Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the
investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates.
The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther
out into the future
3. Bond Ratings
Agencies
The most commonly cited bond rating agencies are Standard & Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its
obligations. Ratings range from 'AAA' to 'Aaa' for "high grade" issues very likely to be repaid to 'D' for issues that are in currently in default.
Bonds rated 'BBB' to 'Baa' or above are called "investment grade"; this means that they are unlikely to default and tend to remain stable
investments. Bonds rated 'BB' to 'Ba' or below are called "junk bonds", which means that default is more likely, and they are thus more
speculative and subject to price volatility.
Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the
ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are
considering .
4. Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other
yield measurements that are used in certain situations.
Yield to Maturity (YTM)
As said above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to
maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor's
actual return will differ slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excel's RATE or YIELDMAT (Excel 2007
only) functions for this computation. A simple function is also available on a financial calculator.
Current Yield
Current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by
dividing the bond's annual coupon amount by the bond's current price. Keep in mind that this yield incorporates only the income portion of return,
ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual
coupon payment by the par value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current
bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.
Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called
bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call
date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate this yield using Excel's YIELD or IRR functions, or with a
financial calculator.
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In
this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are
hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel's YIELD or IRR
functions, or by using a financial calculator.
Conclusion
Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. An investor need only
master these few basic terms and measurements to unmask the familiar market dynamics and become a competent bond investor. Once you've
gotten a hang of the lingo, the rest is easy.
Real Estate Mututal Fund
Disclosing Net Asset Value
When investors talk, publicly traded companies listen. A number of real estate companies
have responded to investor and analyst interest by disclosing their calculation of net asset
value (NAV) on a per-common-share basis. Investors and analysts look to a real estate
company's per-share NAV and the relationship of this value with the market value of the
company's common stock as a way to determine whether the shares are trading at a
premium or discount to the value of net assets underlying "shareholders' equity."
In addition, investors and analysts can evaluate a company's historic NAV growth and the
past relationship of NAV per share with the company's common stock price. The results
of this analysis can also be used for peer group and sector comparisons.
However, as the article "An Inexact Science" in this issue points out, estimating NAV
may be done in more than one way. Described below are current practices in calculating
and reporting NAV and suggestions for appropriate disclosures.
NAV Components
Although much of the data an investor or analyst requires to calculate NAV is available
in a company's financial statements or notes, many companies are facilitating the process
by presenting their own calculations and by showing the components and assumptions
used within quarterly supplemental operating and financial reports. Some of the
companies that have disclosed their NAV components and/or calculations include:
Acadia Realty Trust (NYSE: AKR), Apartment Investment & Management Co.
(NYSE: AIV), Archstone-Smith (NYSE: ASN), First Industrial Realty Trust, Inc.
(NYSE: FR), Home Properties of New York, Inc. (NYSE: HME), ProLogis (NYSE:
PLD), Sun Communities, Inc. (NYSE: SUI) and United Dominion Realty Trust
(NYSE: UDR).
There are several figures common in a typical NAV calculation. The components
generally include: net operating income (NOI) generated by the consolidated property
portfolio; cash flows from properties owned in unconsolidated subsidiaries; management
or other fee income; values for other assets; liabilities; preferred stock (if any); and the
number of diluted common shares and operating partnership units outstanding at the
valuation date. In some cases, property NOI and cash flows are categorized by property
type and/or location.
The NOI used as a basis for valuing properties generally represents a 12-month-forward
estimate, adjusted for portfolio occupancy normalization, as well as straight-line rents, if
applicable. Additional adjustments may reflect normalized capital expenditures,
dispositions, acquisitions and developments added to the operating portfolio, or other
changes in NOI from the existing portfolio. Management or other fee income generally
represents cash flow from short-term contracts.
Other assets would include development projects, land held for future development or
sale, other investments in unconsolidated subsidiaries, cash and cash equivalents, and
miscellaneous items. The value of properties under development typically reflects the
historical cost-carrying amount adjusted to reflect potential increases or decreases in
value depending on the outlook for the projects' success. The value may be estimated
based on projected net cash flows and current investor yield requirements for the related
assets. Land that is held for development or sale may be similarly valued. Any remaining
assets, as well as liabilities and preferred stock, are usually included in NAV at historical
cost net book value.
The number of common shares and operating partnership units would be measured on a
diluted basis at the date of valuation, reflecting any convertible securities that would
dilute earnings per common share if converted.
NAV Calculation
As shown in the accompanying table, the first step in calculating NAV is to estimate a
value for the consolidated property portfolio by applying a capitalization rate to NOI. A
similar calculation is made for the cash flows generated by properties owned in
unconsolidated subsidiaries. The capitalization rate, which is derived from recent market
transactions and represents current investor yield requirements, is adjusted to reflect the
characteristics of a company's portfolio. Relevant characteristics include property type,
class, age, and location, as well as the quality of in-place leases/tenants. In some cases, a
capitalization rate may be developed based on characteristics of individual or groups of
properties. To take into account capital expenditures, companies may either adjust NOI or
the capitalization rate.
Sample NAV Components and Calculation
($ in thousands)
NOI – Forward 12-month estimate $345,678
Adjustment for straight-line rents (if applicable) (12,345)
NOI from property portfolio* $ 333,333
Divide by NOI capitalization rate 8.5%
Value of property portfolio $3,921,565
Management or other fee income $9,876
Divide by appropriate capitalization rate 20.0%
Value of management or fee income $49,380
Add other assets:
Development projec $654,321
Land held for future development or sale $123,456
Other investments in unconsolidated
subsidiaries
$56,789
Cash and equivalents $45,456
Other miscellaneous assets $54,321
Gross value of assets $4,905,288
Deduct:
Total liabilities
$1,889,899
Preferred stock $150,000
Net Asset Value $2,865,389
Divided by total diluted common
shares/operating partnership units 123,456
Net Asset Value per share $23.21
Sensitivity analysis:
Net Asset Value per share based on NOI
capitalization rate 50 basis points higher than
calculated above $ 21.45
Net Asset Value per share based on NOI
capitalization rate 50 basis points lower than
calculated above $ 25.20
* Operating properties, including properties owned in unconsolidated subsidiaries
The next step in calculating NAV would be to estimate a value for the management or fee
income by applying a capitalization rate to projected cash flows.
The values for all other assets are added to the estimated value of the property portfolio
and management or fee income to calculate the gross value of the company's assets. Then
total liabilities and preferred stock are deducted to arrive at the net value of the
company's assets. Finally, total diluted common shares/operating partnership units are
divided by the NAV to determine NAV per share.
Cautions and Conclusions
Some observers have cautioned against relying on NAV because the estimate is based on
a degree of subjectivity. Others suggest that NAV is a necessary analytical tool because a
real estate company's net assets measured by depreciated historical cost is irrelevant to an
analysis of the relationship between the company's underlying net assets and its common
share price.
To enhance the reliability of property valuations, actual operating results generated in
periods immediately preceding the valuation date are generally used to calculate 12-
month-forward NOI estimates. To compensate for the subjectivity of capitalization rate
selection, a company could provide a sensitivity analysis of the NAV calculation. For
example, the analysis could calculate per-share NAV using a range of capitalization rates
that would provide a per-share NAV range based on reducing or increasing capitalization
rates by 25 or 50 basis points.
Another consideration in the analysis of NAV is that the calculation usually looks at only
one point in time and therefore may exclude important company transactions. This can be
addressed by making adjustments for the potential impact on NAV from recent or
pending acquisitions, dispositions, and debt or equity financing transactions. By applying
qualitative judgment to quantitative analysis, NAV can be one of many tools available
from an investor's or analyst's toolbox used to evaluate the investment quality of a real
estate company's common shares.
When investors talk, publicly traded companies listen. A number of real estate companies
have responded to investor and analyst interest by disclosing their calculation of net asset
value (NAV) on a per-common-share basis. Investors and analysts look to a real estate
company's per-share NAV and the relationship of this value with the market value of the
company's common stock as a way to determine whether the shares are trading at a
premium or discount to the value of net assets underlying "shareholders' equity."
In addition, investors and analysts can evaluate a company's historic NAV growth and the
past relationship of NAV per share with the company's common stock price. The results
of this analysis can also be used for peer group and sector comparisons.
However, as the article "An Inexact Science" in this issue points out, estimating NAV
may be done in more than one way. Described below are current practices in calculating
and reporting NAV and suggestions for appropriate disclosures.
NAV Components
Although much of the data an investor or analyst requires to calculate NAV is available
in a company's financial statements or notes, many companies are facilitating the process
by presenting their own calculations and by showing the components and assumptions
used within quarterly supplemental operating and financial reports. Some of the
companies that have disclosed their NAV components and/or calculations include:
Acadia Realty Trust (NYSE: AKR), Apartment Investment & Management Co.
(NYSE: AIV), Archstone-Smith (NYSE: ASN), First Industrial Realty Trust, Inc.
(NYSE: FR), Home Properties of New York, Inc. (NYSE: HME), ProLogis (NYSE:
PLD), Sun Communities, Inc. (NYSE: SUI) and United Dominion Realty Trust
(NYSE: UDR).
There are several figures common in a typical NAV calculation. The components
generally include: net operating income (NOI) generated by the consolidated property
portfolio; cash flows from properties owned in unconsolidated subsidiaries; management
or other fee income; values for other assets; liabilities; preferred stock (if any); and the
number of diluted common shares and operating partnership units outstanding at the
valuation date. In some cases, property NOI and cash flows are categorized by property
type and/or location.
The NOI used as a basis for valuing properties generally represents a 12-month-forward
estimate, adjusted for portfolio occupancy normalization, as well as straight-line rents, if
applicable. Additional adjustments may reflect normalized capital expenditures,
dispositions, acquisitions and developments added to the operating portfolio, or other
changes in NOI from the existing portfolio. Management or other fee income generally
represents cash flow from short-term contracts.
Other assets would include development projects, land held for future development or
sale, other investments in unconsolidated subsidiaries, cash and cash equivalents, and
miscellaneous items. The value of properties under development typically reflects the
historical cost-carrying amount adjusted to reflect potential increases or decreases in
value depending on the outlook for the projects' success. The value may be estimated
based on projected net cash flows and current investor yield requirements for the related
assets. Land that is held for development or sale may be similarly valued. Any remaining
assets, as well as liabilities and preferred stock, are usually included in NAV at historical
cost net book value.
The number of common shares and operating partnership units would be measured on a
diluted basis at the date of valuation, reflecting any convertible securities that would
dilute earnings per common share if converted.
NAV Calculation
As shown in the accompanying table, the first step in calculating NAV is to estimate a
value for the consolidated property portfolio by applying a capitalization rate to NOI. A
similar calculation is made for the cash flows generated by properties owned in
unconsolidated subsidiaries. The capitalization rate, which is derived from recent market
transactions and represents current investor yield requirements, is adjusted to reflect the
characteristics of a company's portfolio. Relevant characteristics include property type,
class, age, and location, as well as the quality of in-place leases/tenants. In some cases, a
capitalization rate may be developed based on characteristics of individual or groups of
properties. To take into account capital expenditures, companies may either adjust NOI or
the capitalization rate.
Sample NAV Components and Calculation
($ in thousands)
NOI – Forward 12-month estimate $345,678
Adjustment for straight-line rents (if applicable) (12,345)
NOI from property portfolio* $ 333,333
Divide by NOI capitalization rate 8.5%
Value of property portfolio $3,921,565
Management or other fee income $9,876
Divide by appropriate capitalization rate 20.0%
Value of management or fee income $49,380
Add other assets:
Development projec $654,321
Land held for future development or sale $123,456
Other investments in unconsolidated
subsidiaries
$56,789
Cash and equivalents $45,456
Other miscellaneous assets $54,321
Gross value of assets $4,905,288
Deduct:
Total liabilities
$1,889,899
Preferred stock $150,000
Net Asset Value $2,865,389
Divided by total diluted common
shares/operating partnership units 123,456
Net Asset Value per share $23.21
Sensitivity analysis:
Net Asset Value per share based on NOI
capitalization rate 50 basis points higher than
calculated above $ 21.45
Net Asset Value per share based on NOI
capitalization rate 50 basis points lower than
calculated above $ 25.20
* Operating properties, including properties owned in unconsolidated subsidiaries
The next step in calculating NAV would be to estimate a value for the management or fee
income by applying a capitalization rate to projected cash flows.
The values for all other assets are added to the estimated value of the property portfolio
and management or fee income to calculate the gross value of the company's assets. Then
total liabilities and preferred stock are deducted to arrive at the net value of the
company's assets. Finally, total diluted common shares/operating partnership units are
divided by the NAV to determine NAV per share.
Cautions and Conclusions
Some observers have cautioned against relying on NAV because the estimate is based on
a degree of subjectivity. Others suggest that NAV is a necessary analytical tool because a
real estate company's net assets measured by depreciated historical cost is irrelevant to an
analysis of the relationship between the company's underlying net assets and its common
share price.
To enhance the reliability of property valuations, actual operating results generated in
periods immediately preceding the valuation date are generally used to calculate 12-
month-forward NOI estimates. To compensate for the subjectivity of capitalization rate
selection, a company could provide a sensitivity analysis of the NAV calculation. For
example, the analysis could calculate per-share NAV using a range of capitalization rates
that would provide a per-share NAV range based on reducing or increasing capitalization
rates by 25 or 50 basis points.
Another consideration in the analysis of NAV is that the calculation usually looks at only
one point in time and therefore may exclude important company transactions. This can be
addressed by making adjustments for the potential impact on NAV from recent or
pending acquisitions, dispositions, and debt or equity financing transactions. By applying
qualitative judgment to quantitative analysis, NAV can be one of many tools available
from an investor's or analyst's toolbox used to evaluate the investment quality of a real
estate company's common shares.
Fund Of Fund
Buying a mutual fund is a bit like hiring someone to fix the brakes on your car. Sure, you
could do the research, buy the tools and fix the car yourself (and many people do), but often
it's not only easier, but also safer to let an expert handle the problem. Mechanics and mutual
funds may cost you a little more in fees, but there is nothing inherently wrong with paying
extra for peace of mind. Mutual funds usually allow investors to skip the murky, confusing
world of stock picking, but what if stocks aren't the asset class you're interested in? With their
million-dollar buy-ins and dangerous reputations, hedge funds were once the exclusive
investment vehicles of the rich and powerful, but now there is a way for regular investors to
get in on the action through a fund of funds.
A fund of funds (FOF) is an investment product made up of various hedge funds - basically, a
mutual fund for hedge funds. They are often used by investors who have smaller investable
assets, limited ability to diversify within the hedge fund arena, or who are not that experienced
with this asset class. In this article we will explore the advantages, disadvantages and risks of
a fund of funds.
Fund of Funds Vs. Hedge Funds
Individual hedge funds often focus on a particular strategy or market segment, tying their
returns to those areas. FOFs, on the other hand, pool investor money and buy individual
hedge funds for their portfolio, thereby holding a number of funds with different strategies.
FOFs provide instant diversification for an investor's hedge fund allocation and the
opportunity to reduce the risk of investing with a single fund manager.
Most hedge funds are sold through private placements which means they have restrictions
imposed upon them under Regulation D of the Securities Act. An important restriction is the
limit on investors who are permitted to invest in the fund. Most hedge fund investors must
meet accredited investor requirements meaning that individuals must have a net worth of $1
million or total income exceeding $200,000.
The convergence between the hedge fund and mutual fund industries is being pushed by
demand from investors to beat the market. Hedge funds traditionally catered to the rich, but
with that niche now served by thousands of funds, new investors are being sought and hedge
funds are going down-market, reducing their investment minimums and seeking creative ways
to allow those who are less well off to access these investment products. One way to get
around the traditional limits on unaccredited investors is to register a hedge fund with the
Securities and Exchange Commission (SEC). Registered FOFs can have lower minimum
investments than private hedge funds and can be offered to an unlimited number of investors.
However, unlike registered mutual funds, there is no secondary market available, so you
won't be able to sell your investment readily
Fees and Expenses
Hedge funds typically charge asset-based fixed fees that range between 1-2%, but these fees
can go all the way to 3% or even 4% annually. Incentive or performance fees may also be
part of the compensation package and can sometimes be between 10-40% of any capital
gains. Performance fees are often structured so that they have a "high-water mark", which
ensures that the manager does not receive this compensation until previous losses by the
fund are made up.
For an investor who purchases an FOF, there are two levels of fees that must be paid. In
addition to management fees, which are charged at the individual hedge fund level, there are
additional fees charged at the FOF level as well. Just like an individual fund, an FOF may
charge a management fee of 1% or more along with a performance fee, although the
performance fees are typically lower to reflect the fact that most of the management is
delegated to the sub-funds themselves.)
FOF Advantages
Hedge funds make up their own asset class, which can be opaque at times. There are
thousands of hedge fund managers making it difficult to weed out the good from the mediocre.
An FOF serves as an investor's proxy, performing professional due diligence, manager
selection and oversight over the hedge funds in its portfolio. The professional management
provided by an FOF can give investors the ability to dip their toes into hedge fund investing
before they tackle the challenge of individual fund investing.
Most FOFs have a formal due-diligence process and will conduct background checks before
selecting new managers. In addition to searching for a disciplinary history within the securities
industry, this work can include researching the backgrounds, verifying the credentials and
checking the references provided by a hedge fund manager who wishes to be chosen for the
fund of funds.
Hedge funds typically have high minimum investment levels, which restricts the ability of
many investors from diversifying their portfolios within the allocated amount for hedge
funds. With an FOF, those investors with limited capital can access a number of fund returns
with one investment, achieving instant diversification. The fund selection process can provide
greater stability (i.e., lower volatility) of returns by spreading assets over a broader range of
strategies. Rather than assuming the risk of selecting one individual manager, the FOF
provides a portfolio of managers with a single investment.
FOF Disadvantages
Overall, fees for funds of funds are typically higher than those of traditional hedge funds
because they include both the management fees charged by the FOF and those of the
underlying funds. This doubling up of fees can be a significant drag on the overall return an
investor receives.
Hedge funds are similar to mutual funds in that they pool investor money and invest the
assets of the fund in a variety of investments. But unlike mutual funds, hedge funds are not
required to register with the SEC and are typically sold in private offerings. This means that
positions within hedge funds don't have to be publicly reported the way mutual fund holdings
must be. However, hedge funds are still subject to the basic fiduciary responsibilities as
registered investment advisors.
The SEC and other securities regulators generally have a limited ability to perform routine
checks on hedge fund activities. This reduces the likelihood that these agencies will ferret out
any wrongdoing early on. And since an FOF buys many hedge funds (which themselves
invest in a number of securities) the fund of funds may end up owning the same stock or other
security through several different funds, thus reducing the potential diversification.
Risks
Hedge fund investing is more complicated and involves higher risk than many traditional
investments.
Gates and Locks-Ups
Some hedge funds have lock-up periods during which investors must commit their money;
these can last several years. Hedge funds typically limit opportunities to redeem, or cash in,
shares, such as only quarterly or annually. This reduces an investor's ability to take cash out
of a fund in times of market turbulence. Gates, or limits on the percentage of capital that can
be withdrawn on a redemption date, also restrict the ability of hedge fund investors to exit a
fund. This feature is increasingly common. Hedge fund managers need gates to reduce
variability in portfolio assets, and anything that protects against a mass exodus of capital
helps this goal. Gates are most likely to be used when markets sour, which is exactly when an
investor may want to redeem shares.
Manager Risks
An FOF depends on the expertise and ability of the fund's manager to select hedge funds that
will perform well. If the FOF does not achieve this goal, its returns are likely to suffer.
Performance fees can motivate hedge fund managers to take greater risks in the hope of
generating a larger return for themselves and their investors. If a manager gets a large cut of
the capital gains of a fund, he may take undue risks in order to profit from the potential returns.
If a hedge fund manager is an active trader, the frequent transactions can result in higher tax
consequences than a buy-and-hold strategy. Higher taxes will reduce the overall return an
investor receives on his or her investment, all else being equal.
Most hedge funds use leverage and short selling to some extent in order to generate returns
or hedge against falling markets. Both of these strategies increase the risks for an investor.
Short positions can lose an unlimited amount of money while leverage can magnify losses
and make quick movements in and out of the markets much more difficult.
Final Thoughts
FOFs can be pain-free entrance into the harsh hedge fund world for investors with limited
funds, or for thos who have limited experience with hedge funds, but this doesn't mean every
FOF will be the perfect fit. An investor should read the fund's marketing and related materials
prior to investing so that the level of risk involved in the fund's investment strategies is
understood. The risks taken should be commensurate with your personal investing goals,
time horizons and risk tolerance. As is true with any investment, the higher the potential
returns, the higher the risks.
could do the research, buy the tools and fix the car yourself (and many people do), but often
it's not only easier, but also safer to let an expert handle the problem. Mechanics and mutual
funds may cost you a little more in fees, but there is nothing inherently wrong with paying
extra for peace of mind. Mutual funds usually allow investors to skip the murky, confusing
world of stock picking, but what if stocks aren't the asset class you're interested in? With their
million-dollar buy-ins and dangerous reputations, hedge funds were once the exclusive
investment vehicles of the rich and powerful, but now there is a way for regular investors to
get in on the action through a fund of funds.
A fund of funds (FOF) is an investment product made up of various hedge funds - basically, a
mutual fund for hedge funds. They are often used by investors who have smaller investable
assets, limited ability to diversify within the hedge fund arena, or who are not that experienced
with this asset class. In this article we will explore the advantages, disadvantages and risks of
a fund of funds.
Fund of Funds Vs. Hedge Funds
Individual hedge funds often focus on a particular strategy or market segment, tying their
returns to those areas. FOFs, on the other hand, pool investor money and buy individual
hedge funds for their portfolio, thereby holding a number of funds with different strategies.
FOFs provide instant diversification for an investor's hedge fund allocation and the
opportunity to reduce the risk of investing with a single fund manager.
Most hedge funds are sold through private placements which means they have restrictions
imposed upon them under Regulation D of the Securities Act. An important restriction is the
limit on investors who are permitted to invest in the fund. Most hedge fund investors must
meet accredited investor requirements meaning that individuals must have a net worth of $1
million or total income exceeding $200,000.
The convergence between the hedge fund and mutual fund industries is being pushed by
demand from investors to beat the market. Hedge funds traditionally catered to the rich, but
with that niche now served by thousands of funds, new investors are being sought and hedge
funds are going down-market, reducing their investment minimums and seeking creative ways
to allow those who are less well off to access these investment products. One way to get
around the traditional limits on unaccredited investors is to register a hedge fund with the
Securities and Exchange Commission (SEC). Registered FOFs can have lower minimum
investments than private hedge funds and can be offered to an unlimited number of investors.
However, unlike registered mutual funds, there is no secondary market available, so you
won't be able to sell your investment readily
Fees and Expenses
Hedge funds typically charge asset-based fixed fees that range between 1-2%, but these fees
can go all the way to 3% or even 4% annually. Incentive or performance fees may also be
part of the compensation package and can sometimes be between 10-40% of any capital
gains. Performance fees are often structured so that they have a "high-water mark", which
ensures that the manager does not receive this compensation until previous losses by the
fund are made up.
For an investor who purchases an FOF, there are two levels of fees that must be paid. In
addition to management fees, which are charged at the individual hedge fund level, there are
additional fees charged at the FOF level as well. Just like an individual fund, an FOF may
charge a management fee of 1% or more along with a performance fee, although the
performance fees are typically lower to reflect the fact that most of the management is
delegated to the sub-funds themselves.)
FOF Advantages
Hedge funds make up their own asset class, which can be opaque at times. There are
thousands of hedge fund managers making it difficult to weed out the good from the mediocre.
An FOF serves as an investor's proxy, performing professional due diligence, manager
selection and oversight over the hedge funds in its portfolio. The professional management
provided by an FOF can give investors the ability to dip their toes into hedge fund investing
before they tackle the challenge of individual fund investing.
Most FOFs have a formal due-diligence process and will conduct background checks before
selecting new managers. In addition to searching for a disciplinary history within the securities
industry, this work can include researching the backgrounds, verifying the credentials and
checking the references provided by a hedge fund manager who wishes to be chosen for the
fund of funds.
Hedge funds typically have high minimum investment levels, which restricts the ability of
many investors from diversifying their portfolios within the allocated amount for hedge
funds. With an FOF, those investors with limited capital can access a number of fund returns
with one investment, achieving instant diversification. The fund selection process can provide
greater stability (i.e., lower volatility) of returns by spreading assets over a broader range of
strategies. Rather than assuming the risk of selecting one individual manager, the FOF
provides a portfolio of managers with a single investment.
FOF Disadvantages
Overall, fees for funds of funds are typically higher than those of traditional hedge funds
because they include both the management fees charged by the FOF and those of the
underlying funds. This doubling up of fees can be a significant drag on the overall return an
investor receives.
Hedge funds are similar to mutual funds in that they pool investor money and invest the
assets of the fund in a variety of investments. But unlike mutual funds, hedge funds are not
required to register with the SEC and are typically sold in private offerings. This means that
positions within hedge funds don't have to be publicly reported the way mutual fund holdings
must be. However, hedge funds are still subject to the basic fiduciary responsibilities as
registered investment advisors.
The SEC and other securities regulators generally have a limited ability to perform routine
checks on hedge fund activities. This reduces the likelihood that these agencies will ferret out
any wrongdoing early on. And since an FOF buys many hedge funds (which themselves
invest in a number of securities) the fund of funds may end up owning the same stock or other
security through several different funds, thus reducing the potential diversification.
Risks
Hedge fund investing is more complicated and involves higher risk than many traditional
investments.
Gates and Locks-Ups
Some hedge funds have lock-up periods during which investors must commit their money;
these can last several years. Hedge funds typically limit opportunities to redeem, or cash in,
shares, such as only quarterly or annually. This reduces an investor's ability to take cash out
of a fund in times of market turbulence. Gates, or limits on the percentage of capital that can
be withdrawn on a redemption date, also restrict the ability of hedge fund investors to exit a
fund. This feature is increasingly common. Hedge fund managers need gates to reduce
variability in portfolio assets, and anything that protects against a mass exodus of capital
helps this goal. Gates are most likely to be used when markets sour, which is exactly when an
investor may want to redeem shares.
Manager Risks
An FOF depends on the expertise and ability of the fund's manager to select hedge funds that
will perform well. If the FOF does not achieve this goal, its returns are likely to suffer.
Performance fees can motivate hedge fund managers to take greater risks in the hope of
generating a larger return for themselves and their investors. If a manager gets a large cut of
the capital gains of a fund, he may take undue risks in order to profit from the potential returns.
If a hedge fund manager is an active trader, the frequent transactions can result in higher tax
consequences than a buy-and-hold strategy. Higher taxes will reduce the overall return an
investor receives on his or her investment, all else being equal.
Most hedge funds use leverage and short selling to some extent in order to generate returns
or hedge against falling markets. Both of these strategies increase the risks for an investor.
Short positions can lose an unlimited amount of money while leverage can magnify losses
and make quick movements in and out of the markets much more difficult.
Final Thoughts
FOFs can be pain-free entrance into the harsh hedge fund world for investors with limited
funds, or for thos who have limited experience with hedge funds, but this doesn't mean every
FOF will be the perfect fit. An investor should read the fund's marketing and related materials
prior to investing so that the level of risk involved in the fund's investment strategies is
understood. The risks taken should be commensurate with your personal investing goals,
time horizons and risk tolerance. As is true with any investment, the higher the potential
returns, the higher the risks.
Accounting of Futures
ACCOUNTING OF INDEX FUTURES TRANSACTIONS
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in
some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock
Index Futures. Stock Index Futures are provided more coverage as these have been
introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting.
The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for
Accounting of Index Futures in December 2000. The guidelines provided here in this Section
below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting
for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be
issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that
is in substance a forward exchange contract to establish the amount of the reporting currency
required or available at the settlement date of transaction. Accounting Standard 11 provides
that the difference between the forward rate and the exchange rate at the date of the
transaction should be recognised as income or expense over the life of the contract. Further
the profit or loss arising on cancellation or renewal of a forward exchange contract should be
recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment
and interest. As on 1st December 1999, it appears to the company that the US $ may be
dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50.
Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The
forward rate may be higher or lower than the spot rate prevailing on the date of the forward
contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as
against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will
pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume
that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract
(US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000
Amount payable had the forward contract not been in place
(US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000
Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the
transaction should be recognised as income or expense over the life of the contract. In the
above example, the difference between the spot rate and forward rate as on 1st December is
Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward
contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of
the forward contract should be apportioned on time basis. In the given example, the time ratio
would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-
2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on
the date of forward contract be accounted. As a result, the benefits or losses accruing due to
the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange
should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $
1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on
cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of
this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future.
Both the Bombay Stock Exchange and the National Stock Exchange have introduced index
futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures
respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will
represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed
Futures upto 3 months expiry. For example, in the month of September 2000, an investor can
buy September Series, October Series and November Series. The September Series will
expire on the last Thursday of September. From the next day (i.e. Friday), the December
Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments
and stock index futures. Fair value is the amount for which an asset could be exchanged
between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction. Simply stated, fair value accounting requires that underlying securities and
associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the
current investments should be carried in the financial statements as lower of cost and fair
value determined either on an individual investment basis or by category of investment.
Current investment is an investment that is by its nature readily realisable and is intended to
be held for not more than one year from the date of investment. Any reduction in the carrying
amount and any reversals of such reductions should be charged or credited to the profit and
loss account.
On the disposal of an investment, the difference between the carrying amount and net
disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value,
size=2 index futures (and other derivative instruments) are also valued at fair value. In
countries where local accounting practices for the underlying are largely dependent on cost
(or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of
Indian accounting practices currently not recognising fair value, it is widely expected that
stock index futures will also be accounted based on prudent accounting conventions. The
Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should
be read in this perspective. The suggestions contained are based on the author’s personal
views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee
and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National
Stock Exchange have set up independent derivatives segments, where select brokermembers
have been permitted to operate. These broker-members are required to satisfy net
worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin.
This margin is generally a percentage of the amount of exposure that the client takes up and
varies from time to time based on the volatility levels in the market. At the point of buying or
selling index futures, the payment made by the client towards Initial Margin would be reflected
as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price
would be compared with the closing price of the previous evening and profit or loss computed
by the exchange. The exchange would collect or pay the difference to the member-brokers on
a daily basis. The broker could further pay the difference to his clients on a daily basis.
Alternatively, the broker could settle with the client on a weekly basis (as daily fund
movements could be difficult especially at the retail level).
Example
Mr. X purchases following two lots of Sensex Futures Contracts on 4th Sept. 2000 :
October 2000 Series 1 Contract @ Rs. 4,500
November 2000 Series 1 Contract @ Rs. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose
the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract
on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050
To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00
Oct. Series
4520
Nov. Series
4850
05/09/00
06/09/00
07/09/00
08/09/00
4510
4480
4500
4490
4800
--
--
--
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to
increase/decrease in daily settlement prices is as below. Please note that one Contract on the
Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series October Series November Series November Series
Receive(RS) Pay(RS) Receive(RS) Pay(RS)
4th September 2000 1,000 - - -
5th September 2000 - 500 - 2,500
6th September 2000 - 1,500 - -
7th September 2000 1,000 - - -
8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Markto-
Market Margin Account’ on a day to day basis. For example, on the 4th of September the
following entry will be passed:
Bank A/c Dr. 1,000
To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series
Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered
a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on
6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on
squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin
Account so that this Account is reduced to zero. The Mark to Margin Account will contain
transactions pertaining to this Futures Series. This component will also be reversed on 6th
Sept 2000.
Bank Account Dr 15,050
Loss on November Series Dr 2,000
Initial Margin 14,550
Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not
permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients
should pay them slightly higher margins than that demanded by the exchange and use this
extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from
his broker, the client would again account for this payment or refund in the Balance Sheet.
The margins paid would get reflected as Assets in the Balance Sheet and refunds would
reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared
up, the exchange would automatically square up all transactions on the day of expiry of the
futures series. For example, an October 2000 future would expire on the last Thursday, i.e.
26th October 2000. On this day, all futures transactions remaining outstanding on the system
would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses
accrue from day to day or do they accrue only at the point of squaring up. It is widely believed
that daily settlement does not mean daily squaring up. The daily settlement system is an
administrative mechanism whereby the stock exchanges maintain a healthy system of
controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be
recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which
particular transaction was squared up, the client could follow the First In First Out method of
accounting. For example, if the October series of SENSEX futures was purchased on 11th
October and again on 12th October and sold on 16th October, it will be understood that the
11th October purchases are sold first. The FIFO would be applied independently for each
series for each stock index future. For example, if November series of NIFTY are also
purchased and sold, these would be tracked separately and not mixed up with the October
series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar
principle would be applied to index futures also. Thus, losses if any would be recognised at
the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures
contracts and compares the cost with the market values as at the financial year end. A total of
such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the
total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the
transaction. This would be accounted net of the provision towards losses (if any) already
effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs
2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs
2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st
March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss
of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit
or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs
2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs
2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st
March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss
of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a
provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been
accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next
financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting
Standard Board, US defines the criteria /attributes which an instrument should have to be
called as derivative and also provides guidance for accounting of derivatives. The Standard is
facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
• A derivative’s cash flows or fair value must fluctuate or vary based on the changes in
an underlying 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
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance
Sheet as assets or liability at fair value and changes in fair value should be recognised in the
year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts.
It is important to understand the purpose of the enterprise while entering into the transaction
relating to the derivative instrument. The derivative instrument could be used as a tool for
hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging
instrument, the gain or loss on the derivative instrument is required to be recognised as profit
or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are
called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off
setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to
hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures
contract would compensate the loss or gain on the portfolio. Both the gains and losses will be
recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will
offset each other and hence will not have any impact on the current earnings. However, if the
hedge is not a perfect hedge, there would be a difference between the gain and the
compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and
liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be
transferred to current earnings of the same period or the periods during which the forecasted
transaction affects the earnings. The remaining gain or loss on the derivative instrument if any
shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency
transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a
hedge transaction, the company should at the inception of the transaction:
• Designate the hedge relationship
• Document such relationship
• Identifying hedge item, hedge instrument and risks being hedged
• Expect hedge to be highly effective
• Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be
reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised
that not all hedging transactions can be perfect. There can be a degree of ineffectiveness
which should be recognized. The Statement requires that the assessment of effectiveness
must be consistent with risk management strategies documented for that particular hedge
relationship. Further the assessment of effectiveness is required whenever financial
statements or earnings are reported.
Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The international
trend is moving towards marking the underlying securities as well as associated derivative
instruments to market. Such a practice would bring into the accounts a clear picture of the
impact of derivatives related operations. Indian accounting is based on traditional prudence
where profits are not recognised till realisation. This practice, though sound in general,
appears to be inconsistent with reality in a highly liquid and vibrant area like derivatives.
TAXATION OF DERIVATIVE TRANSACTIONS IN INDEX FUTURES
This Note seeks to provide information on the taxation aspects of index futures transactions.
The contents of this Note should not be treated as advice or guidance or authoritative
pronouncements. Readers are advised to consult their tax advisors before taking any action
relating to their tax computations or planning. This Note is not intended for any such purpose.
In the absence of special provisions, the current provisions, which are inadequate to handle
the complexities involved are reviewed in this Note. It is expected that the Central Board of
Direct Taxes (CBDT) will shortly provide guidelines for taxation aspects of Derivative
transactions.
Speculation Losses – Cannot be set off
Losses from Speculation business can be set off only against profits of another speculation
business. If speculation profits are insufficient, such losses can be carried forward for eight
years, and will be set off against speculation profits in these future years. (Section 73)
Definition of Speculative Transactions
Section 43(5) defines speculative transactions as those which are periodically or ultimately
settled otherwise than by actual delivery or transfer. By this definition all index futures
transactions will qualify prima facie as speculative transactions, as delivery of such futures is
not possible.
Exceptions are provided to this definition to cover cases where contracts are entered into in
respect of stocks and shares by a dealer or investor to guard against loss in holdings of
stocks and shares through price fluctuations. Another exception is provide for contracts
entered into by a member of a forward market or a stock exchange in the course of any
transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the
ordinary course of his business as such member.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
• Hedging sales can be taken to be genuine only to the extent the total of such
transactions does not exceed the ready stock, the loss arising from excess
transactions should be treated as total stocks of raw material or merchandise in hand.
If forward sales exceed speculative losses.
• Hedging transactions in connected, though not the same, commodities should not be
treated as speculative transactions.
• It cannot be accepted that a dealer or investor in stocks or shares can enter into
hedging transactions outside his holdings. By this interpretation, transactions in index
futures will not be covered under the definition of ‘hedging’.
• Speculation loss, if any carried forward from earlier years, could first be adjusted
against speculation profits of the particular year before allowing any other loss to be
adjusted against those profits.
Deemed Speculation
As per Explanation to Section 73, where any part of the business of a company consists in
the purchase and sale of shares of other companies, such company shall, for the purposes of
this Section, be deemed to be carrying on a speculation business to the extent to which the
business consists of purchase and sale of such shares.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
• Company whose Gross Total Income consists mainly of Income chargeable under the
heads Interest on Securities, Income from House Property, Capital Gains and Income
from Other Sources
• Company whose principal business is Banking
• Company whose principal business is granting of loans and advances
Most brokers and dealers are currently caught within the mischief of this Explanation,
especially after the wave of corporatisation of brokers businesses.
The Explanation however does not cover index futures.
Possibility of ‘Speculation’ treatment
In view of the above provisions, it appears that the possibility of the Income Tax department
treating index futures transactions to be speculative and taxed accordingly, is high as far as
assessees carrying on business are concerned, unless a clarification is issued by the Central
Board of Direct Taxes.
Another possible view (as far as non-business assessees are concerned) could be that gains
and losses from index futures be treated as short term capital gains. This view can gain
support from the fact that such assessees are not covered within the ambit of Sections 43 and
73 referred to above.
Possible Arguments :
It is possible to argue that index futures transactions are not speculative transactions. Some
lines of argument are explored below.
1. Section 43(5) speaks of purchase and sale of any ‘commodity’, including shares and
stocks. Index futures are not ‘commodities’. Further, index futures are also not ‘stocks
and shares’. Hence, section 43(5) does not apply to futures transactions. The
question of examining the provisos (exceptions) does not arise.
2. Exceptions to ‘speculative transactions’ as provided in Section 43(5) also include
hedging transactions undertaken in respect of stocks and shares. Proviso (b) to
Section 43(5) sates – ‘a contract in respect of stocks and shares entered into by a
dealer or investor therein to guard against loss in his holdings of stocks and shares
through price fluctuations’. It however remains to be seen whether index futures can
be covered under ‘stocks and shares’.
To our mind, it appears that if index futures are considered to be part of stocks and
shares as per the wording of Section 43(5), then the proviso will also become
applicable and hence hedging contracts through the mechanism of index futures will
not be considered speculative. On the other hand, if index futures are not part of
stocks and shares, then neither Section 43(5) nor the proviso apply and hence the
entire gamut of index futures transactions will remain out of the purview of speculative
transactions.
3. Explanation to Section 73 speaks of purchase and sale of shares of other companies.
Index futures are not ‘shares’. Hence, this Explanation does not apply to futures
transactions.
It is believed and understood that foreign exchange forward transactions are currently not
being caught within the mischief of Sections 43 and 73. This lends more comfort to the
possibility of index futures also being left out of this net, though only experience will indicate
the stand the Income tax department will take.
Other Possible Controversies:
1. The Income tax department may take a stand that profits and losses accrue on a day
to day basis, in view of the daily settlement procedure. This could be contrary to the
accounting guidelines, which (as it currently appears) may advocate profit (loss)
recognition at the expiry of the contract.
2. It appears currently that accounting guidelines will require recognition of unrealised
losses at financial year end, but not unrealised profits. The Income tax department
may not agree with this conservative treatment
APPENDICES
1. Section 43(5)
2. Section 73
3. Section 28 - Explanation
4. Circular No 23 dated 12th September 1960
APPENDIX 1
INCOME TAX ACT, 1961
Section 43 (5)1
“Speculative transaction” means a transaction in which a contract for the purchase or sale of
any commodity, including stocks and shares, is periodically or ultimately settled otherwise
than by the actual delivery or transfer of the commodity or scrips:
Provided that for the purpose of this clause:
a. a contract in respect of raw materials or merchandise entered into by a person in the
course of his manufacturing or merchanting business to guard loss against loss
through future price fluctuations in respect of his contracts for actual delivery of goods
manufactured by him or merchandise sold by him; or
b. a contract in respect of stocks and shares entered into by a dealer or investor therein
to guard against loss in his holdings of stocks and shares through price fluctuations;
or
c. a contract entered into by a member of a forward market or a stock exchange in the
course of any transaction in the nature of jobbing or arbitrage to guard against loss
which may arise in the ordinary course of his business as such member
APPENDIX 2
INCOME TAX ACT, 1961
SECTION 73 Losses in speculation business
1. Any loss, computed in respect of a speculation business carried on by the assessee,
shall not be set off except against profits and gains, if any, of another speculation
business.
2. Where for any assessment year any loss computed in respect of a speculation
business has not been wholly set off under sub-section (1), so much of the loss as is
not so set off or the whole loss where the assessee had no income from any other
speculation business, shall, subject to the other provisions of this chapter, be carried
forward to the following assessment year,and:
i. it shall be set off against the profit and gains, if any, of any speculation
business carried forward to the following assessment year; and
ii. if the loss cannot be wholly set off, the amount of the loss not so set off shall
be carried forward to the following assessment year and so on.
3. In respect of allowance on account of depreciation or capital expenditure on scientific
research, the provisions of sub-section (2) of section 72 shall apply in relation to
speculation business as they apply in relation to any other business.
4. No loss shall be carried forward under this section for more than eight assessment
years immediately succeeding the assessment year for which the loss was first
computed.
Explanation. – Where any part of the business of a company (other than a company whose
gross total income consists mainly of income which is chargeable under the heads “Interest
on securities”, “Income from house property”, “Capital gains” and “Income from other sources”
or a company the principal business of which is the business of banking or the granting of
loans and advances) consists in the purchase and sale of shares of other companies, such
company shall, for the purposes of this section, be deemed to be carrying on a speculation
business to the extent to which the business consists of the purchase and sale of such
shares.
APPENDIX 3
Section 28
Explanation 2 – Where speculative transactions carried on by an assessee are of such a
nature as to constitute a business, the business (hereinafter referred to as ‘speculation
business’) shall be deemed to be distinct and separate from any other business.
APPENDIX 4
Central Board of Revenue
Circular No. 23(XXXIX) of 1960
Dated 12th September 1960
A number of representations and suggestions have been received by the Board from
associations and chambers of commerce regarding the manner in which the provisions of
section 24 of the Income-tax Act, particularly those of explanation 2 to sub-section (1) thereof,
are being interpreted and applied by the Income-tax officers. The Direct Taxes Administration
Enquiry Committee have also made a few suggestions on this subject in chapter III of their
Report. The board have carefully considered the points involved. Those points and their
decisions thereon are given below :
Point (i) Under clause (a) of the proviso to Explanation 2 to section 24(1) of the Income-tax
Act 1922, the Income-tax Officers exclude from the category of speculative transactions only
a “hedging purchase” transaction entered into with reference to specific contracts for sale of
goods but do not exclude a “hedging sale” transaction made against stocks in hand or against
contracts for purchase of ready goods. The latter type of transactions are also genuine
hedging transactions and should be excluded from the category of speculative transactions so
that any losses sustained therein will be allowed to be set off against other income.
Board’s decision The intention has always been that where bonafide forward sales are
entered into with a view to guarding against the risk of raw materials or merchandise in stock
falling in value, the losses arising as a result of such forward sales should not be treated as
speculation losses. Accordingly, Income-tax Officers should not treat such transactions as
speculative transactions within the meaning of Explanation 2 to Section 24(1). It is to be noted
in this connection that hedging sales can be taken to be genuine only to the extent the total of
such transactions does not exceed the total stocks of raw materials or merchandise in hand. If
the forward sales exceed the ready stock, the loss arising from the excess transactions
should be treated as loss arising from speculative transactions and not from genuine hedging
transactions.
Point (ii) Hedging transactions in connected, though not the same, commodities should not
be treated as speculative transactions
Board’s decision The Board accepted this point. Attention is invited to Board’s letter No.
13(102) IT/53 dated September 8, 1954, in which it was stated that as regards hedging in raw
materials, the Income-tax Officers should not be particular about the quantities and timing so
long as the transactions constitute genuine hedging. Similarly, Income-tax officers should not
treat genuine transactions in connected commodities as speculative transactions though the
transactions may not be in identically the same commodity. Thus, hedging transactions in one
type of cotton against another type of cotton, one variety of oil seed against another, one type
of grain against another, should not be treated as speculative transactions provided the other
conditions of Explanation 2 to section 24 are satisfied. The conditions mentioned in last two
sentences of the decision on point (i) above will apply here also.
Point (iii) Where a transaction contemplating actual delivery is ultimately settled (wholly or
partially) by paying differences and without actual delivery due to any reasons and where
there was no intention to speculate, the transaction should be excluded from the purview of
speculative transactions
Board’s decision The Board are unable to accept this suggestion as a general rule. It is
already provided that if on the facts of any case it can be demonstrated that the forward
transaction has been entered into only for safeguarding against loss through future price
fluctuations, such a transaction should not be treated as a speculative transaction but as a
case of hedging. However, the case of a bonafide ready delivery contract being settled by
delivery to a substantial extent and by payment of difference paid need be treated as a loss
arising in a speculative transaction.
Point (iv) Bonafide hedging transactions by a dealer or investors on shares should be
allowed provided that the hedging transactions are up to the amount of his holdings even
though these transactions may extend to other types of shares not held by him.
Board’s decision The Board are unable to accept this suggestion. It cannot be accepted that a
dealer or investor in stocks or shares can enter into hedging transactions in scrips outside his
holding. The materials words in clause (b) of the proviso to Explanation 2 to section 24(1) are
“to guard against loss in his holdings of stocks and shares through price fluctuations”
Therefore, hedging transactions having reasonable relations to the value and volume of the
dealer’s or the investor’s holdings are expected from the ambit of speculative transactions;
but transactions in scrips outside his holding are not.
Point (v) Speculation loss, if any carried forward from the earlier years or the speculation
loss, if any in a year should first be adjusted against speculation profits of the particular year
before allowing any other loss to be adjusted against those profits.
Board’s decision The suggestion is accepted. For the purpose of set-off under section 10 and
section 24(1) (of the 1922 Act) the speculation loss of any year should be first set-off against
the speculation profits of that year and the remaining amount of speculation profits, if any,
should then be utilised for setting off of any loss of that year from other sources. For the
purpose of section 24(2) (of the 1922 Act) the Income-tax Officer may allow the assessee:
i. (i) either to first set off the speculation losses carried forward from an earlier year
against the speculation profits of the current year and then set off the current year’s
losses from other sources against the remaining part, if any, of the current year’s
speculation profits,
ii. or to first set off the current year’s losses from non-specculation business and other
sources against the current year’s speculation profit and then to set off the carried
forward speculation losses of the earlier year against the remaining part, if any of the
current year’s speculation profit, whichever is advantageous to the assessee.
This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in
some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock
Index Futures. Stock Index Futures are provided more coverage as these have been
introduced recently and would be of immediate benefit to practitioners.
International perspective is also provided with a short discussion on fair value accounting.
The implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for
Accounting of Index Futures in December 2000. The guidelines provided here in this Section
below are in accordance with the contents of this Guidance Note.
INDIAN ACCOUNTING PRACTICES
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting
for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be
issued by the Institute of Chartered Accountants of India.
Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that
is in substance a forward exchange contract to establish the amount of the reporting currency
required or available at the settlement date of transaction. Accounting Standard 11 provides
that the difference between the forward rate and the exchange rate at the date of the
transaction should be recognised as income or expense over the life of the contract. Further
the profit or loss arising on cancellation or renewal of a forward exchange contract should be
recognised as income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment
and interest. As on 1st December 1999, it appears to the company that the US $ may be
dearer as compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50.
Accordingly, XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The
forward rate may be higher or lower than the spot rate prevailing on the date of the forward
contract. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as
against the spot rate of Rs. 43.50. As on the future date, i.e., 1st May 2000, the banker will
pay XYZ Ltd $ 3,00,000 at Rs. 44 irrespective of the spot rate as on that date. Let us assume
that the Spot rate as on that date be US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract
(US $ 3,00,000 * Rs. 44)
Rs 1,32,00,000
Amount payable had the forward contract not been in place
(US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000
Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the
transaction should be recognised as income or expense over the life of the contract. In the
above example, the difference between the spot rate and forward rate as on 1st December is
Rs.0.50 per US $. In other words the total loss was Rs. 1,50,000 as on the date of forward
contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of
the forward contract should be apportioned on time basis. In the given example, the time ratio
would be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-
2000 and the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on
the date of forward contract be accounted. As a result, the benefits or losses accruing due to
the forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange
should recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $
1 Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on
cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of
this loss in the financial year 1999-2000.
Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future.
Both the Bombay Stock Exchange and the National Stock Exchange have introduced index
futures in June 2000 and permit trading on the Sensex Futures and the Nifty Futures
respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will
represent 50 units of the underlying Sensex Futures. Currently, both exchanges have listed
Futures upto 3 months expiry. For example, in the month of September 2000, an investor can
buy September Series, October Series and November Series. The September Series will
expire on the last Thursday of September. From the next day (i.e. Friday), the December
Series will be quoted on the exchange.
Accounting of Index Futures
Internationally, ‘fair value accounting’ plays an important role in accounting for investments
and stock index futures. Fair value is the amount for which an asset could be exchanged
between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length
transaction. Simply stated, fair value accounting requires that underlying securities and
associated derivative instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the
current investments should be carried in the financial statements as lower of cost and fair
value determined either on an individual investment basis or by category of investment.
Current investment is an investment that is by its nature readily realisable and is intended to
be held for not more than one year from the date of investment. Any reduction in the carrying
amount and any reversals of such reductions should be charged or credited to the profit and
loss account.
On the disposal of an investment, the difference between the carrying amount and net
disposal proceeds should be charged or credited to the profit and loss statement.
In countries where local accounting practices require valuation of underlying at fair value,
size=2 index futures (and other derivative instruments) are also valued at fair value. In
countries where local accounting practices for the underlying are largely dependent on cost
(or lower of cost or fair value), accounting for derivatives follows a similar principle. In view of
Indian accounting practices currently not recognising fair value, it is widely expected that
stock index futures will also be accounted based on prudent accounting conventions. The
Institute is finalising a Guidance Note on this area, which is expected to be shortly released.
The accounting suggestions provided in the Indian context in the following paragraphs should
be read in this perspective. The suggestions contained are based on the author’s personal
views on the subject.
Regulatory Framework
The index futures market in India is regulated by the Reports of the Dr L C Gupta Committee
and the Prof J R Verma Committee. Both the Bombay Stock Exchange and the National
Stock Exchange have set up independent derivatives segments, where select brokermembers
have been permitted to operate. These broker-members are required to satisfy net
worth and other criteria as specified by the SEBI Committees.
Each client who buys or sells stock index futures is first required to deposit an Initial Margin.
This margin is generally a percentage of the amount of exposure that the client takes up and
varies from time to time based on the volatility levels in the market. At the point of buying or
selling index futures, the payment made by the client towards Initial Margin would be reflected
as an Asset in the Balance Sheet.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price
would be compared with the closing price of the previous evening and profit or loss computed
by the exchange. The exchange would collect or pay the difference to the member-brokers on
a daily basis. The broker could further pay the difference to his clients on a daily basis.
Alternatively, the broker could settle with the client on a weekly basis (as daily fund
movements could be difficult especially at the retail level).
Example
Mr. X purchases following two lots of Sensex Futures Contracts on 4th Sept. 2000 :
October 2000 Series 1 Contract @ Rs. 4,500
November 2000 Series 1 Contract @ Rs. 4,850
Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose
the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract
on the Bombay Stock Exchange).
The accounting entry will be :
Initial Margin Account Dr 28,050
To Bank 28,050
If the daily settlement prices of the above Sensex Futures were as follows:
Date
04/09/00
Oct. Series
4520
Nov. Series
4850
05/09/00
06/09/00
07/09/00
08/09/00
4510
4480
4500
4490
4800
--
--
--
Let us assume that Mr X he sold the November Series contract at Rs 4,810.
The amount of ‘Mark-to-Market Margin Money’ Sensex receivable/payable due to
increase/decrease in daily settlement prices is as below. Please note that one Contract on the
Bombay Stock Exchange implies 50 underlying Units of the Sensex.
Date October Series October Series November Series November Series
Receive(RS) Pay(RS) Receive(RS) Pay(RS)
4th September 2000 1,000 - - -
5th September 2000 - 500 - 2,500
6th September 2000 - 1,500 - -
7th September 2000 1,000 - - -
8th September 2000 - 500 - -
The amount of ‘Mark-to-Market Margin Money’ received/paid will be credited/debited to ‘Markto-
Market Margin Account’ on a day to day basis. For example, on the 4th of September the
following entry will be passed:
Bank A/c Dr. 1,000
To Mark-to-market Margin A/c 1,000
TOn the 6th of Sept 2000, Mr X will account for the profit or loss on the November Series
Contract. He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered
a loss of Rs 40 per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on
6th Sept. Further, the Initial Margin paid on the November Series will be refunded back on
squaring up of the transaction. This receipt will be accounted by crediting the Initial Margin
Account so that this Account is reduced to zero. The Mark to Margin Account will contain
transactions pertaining to this Futures Series. This component will also be reversed on 6th
Sept 2000.
Bank Account Dr 15,050
Loss on November Series Dr 2,000
Initial Margin 14,550
Mark to Market Margin 2,500
Margins maintained with Brokers
Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not
permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients
should pay them slightly higher margins than that demanded by the exchange and use this
extra collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from
his broker, the client would again account for this payment or refund in the Balance Sheet.
The margins paid would get reflected as Assets in the Balance Sheet and refunds would
reduce these Assets.
The client could square up any of his transactions any time. If transactions are not squared
up, the exchange would automatically square up all transactions on the day of expiry of the
futures series. For example, an October 2000 future would expire on the last Thursday, i.e.
26th October 2000. On this day, all futures transactions remaining outstanding on the system
would be compulsorily squared up.
Recognition of Profit or Loss
A basic issue which arises in the context of daily settlement is whether profits and losses
accrue from day to day or do they accrue only at the point of squaring up. It is widely believed
that daily settlement does not mean daily squaring up. The daily settlement system is an
administrative mechanism whereby the stock exchanges maintain a healthy system of
controls. From an accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be
recognised in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which
particular transaction was squared up, the client could follow the First In First Out method of
accounting. For example, if the October series of SENSEX futures was purchased on 11th
October and again on 12th October and sold on 16th October, it will be understood that the
11th October purchases are sold first. The FIFO would be applied independently for each
series for each stock index future. For example, if November series of NIFTY are also
purchased and sold, these would be tracked separately and not mixed up with the October
series of SENSEX.
Accounting at Financial Year End
In view of the underlying securities being valued at lower of cost or market value, a similar
principle would be applied to index futures also. Thus, losses if any would be recognised at
the year end, while unrealised profits would not be recognised.
A global system could be adopted whereby the client lists down all his stock index futures
contracts and compares the cost with the market values as at the financial year end. A total of
such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the
total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the
transaction. This would be accounted net of the provision towards losses (if any) already
effected in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs
2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs
2,20,000 and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st
March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss
of Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit
or loss in this accounting period.
Alternative Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs
2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs
2,20,000 and Rs 2,15,000 respectively. He has not squared up these transactions as on 31st
March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss
of Rs 35,000 on the Nifty futures. As the net result is a loss of Rs 15,000, he will record a
provision towards losses in his Profit or Loss Account in this accounting period.
In the next year, the Nifty future is actually sold for Rs 2,10,000.
At this point, the total loss on that future is Rs 40,000. However, Rs 15,000 has already been
accounted in the earlier financial year. The balance of Rs 25,000 will be accounted in the next
financial year.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting
Standard Board, US defines the criteria /attributes which an instrument should have to be
called as derivative and also provides guidance for accounting of derivatives. The Standard is
facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
• A derivative’s cash flows or fair value must fluctuate or vary based on the changes in
an underlying 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
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance
Sheet as assets or liability at fair value and changes in fair value should be recognised in the
year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts.
It is important to understand the purpose of the enterprise while entering into the transaction
relating to the derivative instrument. The derivative instrument could be used as a tool for
hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging
instrument, the gain or loss on the derivative instrument is required to be recognised as profit
or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are
called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off
setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to
hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures
contract would compensate the loss or gain on the portfolio. Both the gains and losses will be
recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will
offset each other and hence will not have any impact on the current earnings. However, if the
hedge is not a perfect hedge, there would be a difference between the gain and the
compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and
liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be
transferred to current earnings of the same period or the periods during which the forecasted
transaction affects the earnings. The remaining gain or loss on the derivative instrument if any
shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency
transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a
hedge transaction, the company should at the inception of the transaction:
• Designate the hedge relationship
• Document such relationship
• Identifying hedge item, hedge instrument and risks being hedged
• Expect hedge to be highly effective
• Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be
reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised
that not all hedging transactions can be perfect. There can be a degree of ineffectiveness
which should be recognized. The Statement requires that the assessment of effectiveness
must be consistent with risk management strategies documented for that particular hedge
relationship. Further the assessment of effectiveness is required whenever financial
statements or earnings are reported.
Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The international
trend is moving towards marking the underlying securities as well as associated derivative
instruments to market. Such a practice would bring into the accounts a clear picture of the
impact of derivatives related operations. Indian accounting is based on traditional prudence
where profits are not recognised till realisation. This practice, though sound in general,
appears to be inconsistent with reality in a highly liquid and vibrant area like derivatives.
TAXATION OF DERIVATIVE TRANSACTIONS IN INDEX FUTURES
This Note seeks to provide information on the taxation aspects of index futures transactions.
The contents of this Note should not be treated as advice or guidance or authoritative
pronouncements. Readers are advised to consult their tax advisors before taking any action
relating to their tax computations or planning. This Note is not intended for any such purpose.
In the absence of special provisions, the current provisions, which are inadequate to handle
the complexities involved are reviewed in this Note. It is expected that the Central Board of
Direct Taxes (CBDT) will shortly provide guidelines for taxation aspects of Derivative
transactions.
Speculation Losses – Cannot be set off
Losses from Speculation business can be set off only against profits of another speculation
business. If speculation profits are insufficient, such losses can be carried forward for eight
years, and will be set off against speculation profits in these future years. (Section 73)
Definition of Speculative Transactions
Section 43(5) defines speculative transactions as those which are periodically or ultimately
settled otherwise than by actual delivery or transfer. By this definition all index futures
transactions will qualify prima facie as speculative transactions, as delivery of such futures is
not possible.
Exceptions are provided to this definition to cover cases where contracts are entered into in
respect of stocks and shares by a dealer or investor to guard against loss in holdings of
stocks and shares through price fluctuations. Another exception is provide for contracts
entered into by a member of a forward market or a stock exchange in the course of any
transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the
ordinary course of his business as such member.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
• Hedging sales can be taken to be genuine only to the extent the total of such
transactions does not exceed the ready stock, the loss arising from excess
transactions should be treated as total stocks of raw material or merchandise in hand.
If forward sales exceed speculative losses.
• Hedging transactions in connected, though not the same, commodities should not be
treated as speculative transactions.
• It cannot be accepted that a dealer or investor in stocks or shares can enter into
hedging transactions outside his holdings. By this interpretation, transactions in index
futures will not be covered under the definition of ‘hedging’.
• Speculation loss, if any carried forward from earlier years, could first be adjusted
against speculation profits of the particular year before allowing any other loss to be
adjusted against those profits.
Deemed Speculation
As per Explanation to Section 73, where any part of the business of a company consists in
the purchase and sale of shares of other companies, such company shall, for the purposes of
this Section, be deemed to be carrying on a speculation business to the extent to which the
business consists of purchase and sale of such shares.
The CBDT has issued a Circular No 23 dated 12th September 1960 on this area. The
important provisions of this Circular are summarised below:
• Company whose Gross Total Income consists mainly of Income chargeable under the
heads Interest on Securities, Income from House Property, Capital Gains and Income
from Other Sources
• Company whose principal business is Banking
• Company whose principal business is granting of loans and advances
Most brokers and dealers are currently caught within the mischief of this Explanation,
especially after the wave of corporatisation of brokers businesses.
The Explanation however does not cover index futures.
Possibility of ‘Speculation’ treatment
In view of the above provisions, it appears that the possibility of the Income Tax department
treating index futures transactions to be speculative and taxed accordingly, is high as far as
assessees carrying on business are concerned, unless a clarification is issued by the Central
Board of Direct Taxes.
Another possible view (as far as non-business assessees are concerned) could be that gains
and losses from index futures be treated as short term capital gains. This view can gain
support from the fact that such assessees are not covered within the ambit of Sections 43 and
73 referred to above.
Possible Arguments :
It is possible to argue that index futures transactions are not speculative transactions. Some
lines of argument are explored below.
1. Section 43(5) speaks of purchase and sale of any ‘commodity’, including shares and
stocks. Index futures are not ‘commodities’. Further, index futures are also not ‘stocks
and shares’. Hence, section 43(5) does not apply to futures transactions. The
question of examining the provisos (exceptions) does not arise.
2. Exceptions to ‘speculative transactions’ as provided in Section 43(5) also include
hedging transactions undertaken in respect of stocks and shares. Proviso (b) to
Section 43(5) sates – ‘a contract in respect of stocks and shares entered into by a
dealer or investor therein to guard against loss in his holdings of stocks and shares
through price fluctuations’. It however remains to be seen whether index futures can
be covered under ‘stocks and shares’.
To our mind, it appears that if index futures are considered to be part of stocks and
shares as per the wording of Section 43(5), then the proviso will also become
applicable and hence hedging contracts through the mechanism of index futures will
not be considered speculative. On the other hand, if index futures are not part of
stocks and shares, then neither Section 43(5) nor the proviso apply and hence the
entire gamut of index futures transactions will remain out of the purview of speculative
transactions.
3. Explanation to Section 73 speaks of purchase and sale of shares of other companies.
Index futures are not ‘shares’. Hence, this Explanation does not apply to futures
transactions.
It is believed and understood that foreign exchange forward transactions are currently not
being caught within the mischief of Sections 43 and 73. This lends more comfort to the
possibility of index futures also being left out of this net, though only experience will indicate
the stand the Income tax department will take.
Other Possible Controversies:
1. The Income tax department may take a stand that profits and losses accrue on a day
to day basis, in view of the daily settlement procedure. This could be contrary to the
accounting guidelines, which (as it currently appears) may advocate profit (loss)
recognition at the expiry of the contract.
2. It appears currently that accounting guidelines will require recognition of unrealised
losses at financial year end, but not unrealised profits. The Income tax department
may not agree with this conservative treatment
APPENDICES
1. Section 43(5)
2. Section 73
3. Section 28 - Explanation
4. Circular No 23 dated 12th September 1960
APPENDIX 1
INCOME TAX ACT, 1961
Section 43 (5)1
“Speculative transaction” means a transaction in which a contract for the purchase or sale of
any commodity, including stocks and shares, is periodically or ultimately settled otherwise
than by the actual delivery or transfer of the commodity or scrips:
Provided that for the purpose of this clause:
a. a contract in respect of raw materials or merchandise entered into by a person in the
course of his manufacturing or merchanting business to guard loss against loss
through future price fluctuations in respect of his contracts for actual delivery of goods
manufactured by him or merchandise sold by him; or
b. a contract in respect of stocks and shares entered into by a dealer or investor therein
to guard against loss in his holdings of stocks and shares through price fluctuations;
or
c. a contract entered into by a member of a forward market or a stock exchange in the
course of any transaction in the nature of jobbing or arbitrage to guard against loss
which may arise in the ordinary course of his business as such member
APPENDIX 2
INCOME TAX ACT, 1961
SECTION 73 Losses in speculation business
1. Any loss, computed in respect of a speculation business carried on by the assessee,
shall not be set off except against profits and gains, if any, of another speculation
business.
2. Where for any assessment year any loss computed in respect of a speculation
business has not been wholly set off under sub-section (1), so much of the loss as is
not so set off or the whole loss where the assessee had no income from any other
speculation business, shall, subject to the other provisions of this chapter, be carried
forward to the following assessment year,and:
i. it shall be set off against the profit and gains, if any, of any speculation
business carried forward to the following assessment year; and
ii. if the loss cannot be wholly set off, the amount of the loss not so set off shall
be carried forward to the following assessment year and so on.
3. In respect of allowance on account of depreciation or capital expenditure on scientific
research, the provisions of sub-section (2) of section 72 shall apply in relation to
speculation business as they apply in relation to any other business.
4. No loss shall be carried forward under this section for more than eight assessment
years immediately succeeding the assessment year for which the loss was first
computed.
Explanation. – Where any part of the business of a company (other than a company whose
gross total income consists mainly of income which is chargeable under the heads “Interest
on securities”, “Income from house property”, “Capital gains” and “Income from other sources”
or a company the principal business of which is the business of banking or the granting of
loans and advances) consists in the purchase and sale of shares of other companies, such
company shall, for the purposes of this section, be deemed to be carrying on a speculation
business to the extent to which the business consists of the purchase and sale of such
shares.
APPENDIX 3
Section 28
Explanation 2 – Where speculative transactions carried on by an assessee are of such a
nature as to constitute a business, the business (hereinafter referred to as ‘speculation
business’) shall be deemed to be distinct and separate from any other business.
APPENDIX 4
Central Board of Revenue
Circular No. 23(XXXIX) of 1960
Dated 12th September 1960
A number of representations and suggestions have been received by the Board from
associations and chambers of commerce regarding the manner in which the provisions of
section 24 of the Income-tax Act, particularly those of explanation 2 to sub-section (1) thereof,
are being interpreted and applied by the Income-tax officers. The Direct Taxes Administration
Enquiry Committee have also made a few suggestions on this subject in chapter III of their
Report. The board have carefully considered the points involved. Those points and their
decisions thereon are given below :
Point (i) Under clause (a) of the proviso to Explanation 2 to section 24(1) of the Income-tax
Act 1922, the Income-tax Officers exclude from the category of speculative transactions only
a “hedging purchase” transaction entered into with reference to specific contracts for sale of
goods but do not exclude a “hedging sale” transaction made against stocks in hand or against
contracts for purchase of ready goods. The latter type of transactions are also genuine
hedging transactions and should be excluded from the category of speculative transactions so
that any losses sustained therein will be allowed to be set off against other income.
Board’s decision The intention has always been that where bonafide forward sales are
entered into with a view to guarding against the risk of raw materials or merchandise in stock
falling in value, the losses arising as a result of such forward sales should not be treated as
speculation losses. Accordingly, Income-tax Officers should not treat such transactions as
speculative transactions within the meaning of Explanation 2 to Section 24(1). It is to be noted
in this connection that hedging sales can be taken to be genuine only to the extent the total of
such transactions does not exceed the total stocks of raw materials or merchandise in hand. If
the forward sales exceed the ready stock, the loss arising from the excess transactions
should be treated as loss arising from speculative transactions and not from genuine hedging
transactions.
Point (ii) Hedging transactions in connected, though not the same, commodities should not
be treated as speculative transactions
Board’s decision The Board accepted this point. Attention is invited to Board’s letter No.
13(102) IT/53 dated September 8, 1954, in which it was stated that as regards hedging in raw
materials, the Income-tax Officers should not be particular about the quantities and timing so
long as the transactions constitute genuine hedging. Similarly, Income-tax officers should not
treat genuine transactions in connected commodities as speculative transactions though the
transactions may not be in identically the same commodity. Thus, hedging transactions in one
type of cotton against another type of cotton, one variety of oil seed against another, one type
of grain against another, should not be treated as speculative transactions provided the other
conditions of Explanation 2 to section 24 are satisfied. The conditions mentioned in last two
sentences of the decision on point (i) above will apply here also.
Point (iii) Where a transaction contemplating actual delivery is ultimately settled (wholly or
partially) by paying differences and without actual delivery due to any reasons and where
there was no intention to speculate, the transaction should be excluded from the purview of
speculative transactions
Board’s decision The Board are unable to accept this suggestion as a general rule. It is
already provided that if on the facts of any case it can be demonstrated that the forward
transaction has been entered into only for safeguarding against loss through future price
fluctuations, such a transaction should not be treated as a speculative transaction but as a
case of hedging. However, the case of a bonafide ready delivery contract being settled by
delivery to a substantial extent and by payment of difference paid need be treated as a loss
arising in a speculative transaction.
Point (iv) Bonafide hedging transactions by a dealer or investors on shares should be
allowed provided that the hedging transactions are up to the amount of his holdings even
though these transactions may extend to other types of shares not held by him.
Board’s decision The Board are unable to accept this suggestion. It cannot be accepted that a
dealer or investor in stocks or shares can enter into hedging transactions in scrips outside his
holding. The materials words in clause (b) of the proviso to Explanation 2 to section 24(1) are
“to guard against loss in his holdings of stocks and shares through price fluctuations”
Therefore, hedging transactions having reasonable relations to the value and volume of the
dealer’s or the investor’s holdings are expected from the ambit of speculative transactions;
but transactions in scrips outside his holding are not.
Point (v) Speculation loss, if any carried forward from the earlier years or the speculation
loss, if any in a year should first be adjusted against speculation profits of the particular year
before allowing any other loss to be adjusted against those profits.
Board’s decision The suggestion is accepted. For the purpose of set-off under section 10 and
section 24(1) (of the 1922 Act) the speculation loss of any year should be first set-off against
the speculation profits of that year and the remaining amount of speculation profits, if any,
should then be utilised for setting off of any loss of that year from other sources. For the
purpose of section 24(2) (of the 1922 Act) the Income-tax Officer may allow the assessee:
i. (i) either to first set off the speculation losses carried forward from an earlier year
against the speculation profits of the current year and then set off the current year’s
losses from other sources against the remaining part, if any, of the current year’s
speculation profits,
ii. or to first set off the current year’s losses from non-specculation business and other
sources against the current year’s speculation profit and then to set off the carried
forward speculation losses of the earlier year against the remaining part, if any of the
current year’s speculation profit, whichever is advantageous to the assessee.
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