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.

Futures Fundamentals:

Futures Fundamentals: Introduction


A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators.



The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions.



While futures are not for the risk averse, they are useful for a wide range of people



Futures Fundamentals: A Brief History

Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed and unpurchased crops were left to rot in the streets! Conversely, when a given commodity - wheat, for instance - was out of season, the goods made from it became very expensive because the crop was no longer available.





In the mid-nineteenth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The latter contracts - forward contracts - were the forerunners to today's futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season.



Today's futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Treasury bonds and securities (securities futures). It's a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas farmer can match a bid from a buyer in Europe



Futures Fundamentals: How The Market Works



The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity.





What Exactly Is a Futures Contract?

Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.



That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.



So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions.



In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.



Profit And Loss - Cash Settlement

The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.



On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.



As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract.







But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.



Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)



Economic Importance of the Futures Market

Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators.



Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.



Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market



Futures Fundamentals: The Players



The players in the futures market fall into two categories: hedgers and speculators.





Hedgers

Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.



The holders of the long position in futures contracts (the buyers of the commodity), are trying to secure as low a price as possible. The short holders of the contract (the sellers of the commodity) will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.



Example:

A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can't be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How?



The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let's say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract.



So that's basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract's expiration the equity price has risen, the investor's contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to hedge against declining stock prices in the future.



A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year.





Speculators

Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits.



In the futures market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future.



Unlike the hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts.

Trader Short Long

The Hedger Secure a price now to protect against future declining prices Secure a price now to protect against future rising prices

The Speculator Secure a price now in anticipation of declining prices Secure a price now in anticipation of rising prices



In a fast-paced market into which information is continuously being fed, speculators and hedgers bounce off of - and benefit from - each other. The closer it gets to the time of the contract's expiration, the more solid the information entering the market will be regarding the commodity in question. Thus, all can expect a more accurate reflection of supply and demand and the corresponding price.







Regulatory Bodies

The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC) an independent agency of the U.S. government. The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.



A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.



In the unfortunate event of conflict or illegal loss, you can look to the NFA for arbitration and appeal to the CFTC for reparations. Know your rights as an investor!











Futures Fundamentals: Characteristics



In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.





When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.



The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.



Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of your account to $400. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000.



Word to the wise: when a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf.



Leverage: The Double-Edged Sword

In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.



Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments.



You already know that the futures market can be extremely risky and,therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or greater losses.



As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost.



If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%!



On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge amount compared to the initial margin deposit made to obtain the contract. This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to the index could result in such a large profit or loss to the investor (sometimes even more than the initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in futures contracts due to low margins and high leverage.







Pricing and Limits

As we mentioned before, contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on).



Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as “ticks.” For example, the minimum sum that a bushel of grain can move upwards or downwards in a day is a quarter of one U.S. cent. For futures investors, it's important to understand how the minimum price movement for each commodity will affect the size of the contract in question. If you had a wheat contract for 5,000 bushels, a minimum of $1,500 per contract (0.30 cents x 5,000) could be gained or lost on that particular contract in one day. In this case, the daily price limit is thirty cents per bushel.



Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day.



Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower boundary would be $4.75. If at any moment during the day the price of futures contracts for silver reaches either boundary, the exchange shuts down all trading of silver futures for the day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until an equilibrium price is found. Because trading shuts down if prices reach their daily limits, there may be occasions when it is NOT possible to liquidate an existing futures position at will.



The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or “spot” month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.



In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.



Futures Fundamentals: Strategies



Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.





Going Long

When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.



For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September.



By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit!



Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.



Going Short

A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.



Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market.



Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.



By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.







Spreads

As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called “spreads.”



Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.



There are many different types of spreads, including:



Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates.



Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies.



Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).



Futures Fundamentals: How To Trade



At the risk of repeating ourselves, it's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment. Talk to your broker and ask questions before opening a futures account.





Unlike traditional equity traders, futures traders are advised to only use funds that have been earmarked as pure "risk capital"- the risks really are that high. Once you've made the initial decision to enter the market, the next question should be “How?” Here are three different approaches to consider:



Do It Yourself - As an investor, you can trade your own account without the aid or advice of a broker. This involves the most risk because you become responsible for managing funds, ordering trades, maintaining margins, acquiring research and coming up with your own analysis of how the market will move in relation to the commodity in which you've invested. It requires time and complete attention to the market.



Open a Managed Account - Another way to participate in the market is by opening a managed account, similar to an equity account. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay an extra management fee.



Join a Commodity Pool - A third way to enter the market, and one that offers the smallest risk, is to join a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which can be invested in. No one person has an individual account; funds are combined with others and traded as one. The profits and losses are directly proportionate to the amount of money invested. By entering a commodity pool, you also gain the opportunity to invest in diverse types of commodities. You are also not subject to margin calls. However, it is essential that the pool be managed by a skilled broker, because the risks of the futures market are still present in the commodity pool.



Futures Fundamentals: Conclusion



Buying and selling in the futures market can seem risky and complicated. As we've already said, futures trading is not for everyone, but it works for a wide range of people. This tutorial has introduced you to the fundamentals of futures. If you want to know more, talk to your broker.





Let's review the basics:



• The futures market is a global marketplace, initially created as a place for farmers and merchants to buy and sell commodities for either spot or future delivery. This was done to lessen the risk of both waste and scarcity.

• Rather than trade in physical commodities, futures markets buy and sell futures contracts, which state the price per unit, type, value, quality and quantity of the commodity in question, as well as the month the contract expires.

• The players in the futures market are hedgers and speculators. A hedger tries to minimize risk by buying or selling now in an effort to avoid rising or declining prices. Conversely, the speculator will try to profit from the risks by buying or selling now in anticipation of rising or declining prices.

• The CFTC and the NFA are the regulatory bodies governing and monitoring futures markets in the U.S. It is important to know your rights.

• Futures accounts are credited or debited daily depending on profits or losses incurred. The futures market is also characterized as being highly leveraged due to its margins; although leverage works as a double-edged sword. It's important to understand the arithmetic of leverage when calculating profit and loss, as well as the minimum price movements and daily price limits at which contracts can trade.

• “Going long,” “going short,” and “spreads” are the most common strategies used when trading on the futures market.

• Once you make the decision to trade in commodities, there are several ways to participate in the futures market. All of them involve risk - some more than others. You can trade your own account, have a managed account or join a commodity pool.

Security Identification

Security Identification

International Securities Identification Number (ISIN)

• An International Securities Identification Number (ISIN) uniquely identifies a security. Its structure is defined in ISO 6166. Securities for which ISINs are issued include bonds, commercial paper, equities and warrants. The ISIN code is a 12-character alpha-numerical code that does not contain information characterizing financial instruments but serves for uniform identification of a security at trading and settlement.

• Securities with which ISINs can be used include debt securities, shares, options, derivatives and futures. The ISIN identifies the security, not the exchange (if any) on which it trades; it is not a ticker symbol. For instance, Daimler AG stock trades on twenty-two different stock exchanges worldwide, and is priced in five different currencies; it has the same ISIN on each, though not the same ticker symbol. ISIN cannot specify a particular trading location in this case, and another identifier, typically MIC(Market Identification Code) or the three-letter exchange code, will have to be specified in addition to the ISIN. The SEDOL board of the London Stock Exchange has revised their own standards to address this issue.

Procedure

• An ISIN consists of three parts: Generally, a two letter country code, a nine character alpha-numeric national security identifier, and a single check digit. The country code is the ISO 3166-1 alpha-2 code for the country of issue, which is not necessarily the country in which the issuing company is domiciled. International securities cleared through Clearstream or Euroclear, which are Europe-wide, use "XS" as the country code.

• The nine-digit security identifier is the National Securities Identifying Number, or NSIN, assigned by governing bodies in each country, known as the national numbering agency (NNA). In North America the NNA is the CUSIP organization, meaning that CUSIPs can easily be converted into ISINs by adding the US or CA country code to the beginning of the existing CUSIP code and adding an additional check digit at the end. In the United Kingdom and Ireland the NNA is the London Stock Exchange and the NSIN is the SEDOL, converted in a similar fashion after padding the SEDOL number out with leading zeros. Most other countries use similar conversions, but if no country NNA exists then regional NNAs are used instead.

• The procedure for calculating ISIN check digits is similar to the "Modulus 10 Double Add Double" technique used in CUSIPs. To calculate the check digit, first convert any letters to numbers by adding their ordinal position in the alphabet to 9, such that A = 10 and M = 22. Starting with the right most digit, every other digit is multiplied by two. (For CUSIP check digits, these two steps are reversed.) The resulting string of digits (numbers greater than 9 becoming two separate digits) are added up. Subtract this sum from the smallest number ending with zero that is greater than or equal to it: this gives the check digit which is also known as the ten's complement of the sum modulo 10. That is, the resulting sum, including the check-digit, is a multiple of 10.





• ISINs are slowly being introduced worldwide. At present, many countries have adopted ISINs as a secondary measure of identifying securities, but as of yet only some of those countries have moved to using ISINs as their primary means of identifying securities.

Example (1)

• Apple Inc.: ISIN US0378331005, expanded from CUSIP 037833100 The main body of the ISIN is the original CUSIP, assigned in the 1970s. The country code "US" has been added on the front, and an additional check digit at the end. The country code indicates the country the issuer is Domiciled. The check digit is calculated in this way...

• Convert any letters to numbers:

• U = 30, S = 28. US037833100 -> 3028037833100.

• Collect odd and even characters:

• 3028037833100 = (3, 2, 0, 7, 3, 1, 0), (0, 8, 3, 8, 3, 0)

• Multiply the group containing the rightmost character (which is the FIRST group) by 2:

• (6, 4, 0, 14, 6, 2, 0)

• Add up the individual digits:

• (6 + 4 + 0 + (1 + 4) + 6 + 2 + 0) + (0 + 8 + 3 + 8 + 3 + 0) = 45

• Take the 10s modulus of the sum:

• 45 mod 10 = 5

• Subtract from 10:

• 10 - 5 = 5

• Take the 10s modulus of the result (this final step is important in the instance where the modulus of the sum is 0, as the resulting check digit would be 10).

• 5 mod 10 = 5

• So the ISIN check digit is five.

Example (2)

• TREASURY CORP VICTORIA 5 3/4% 2005-2016: ISIN AU0000XVGZA3

• Convert any letters to numbers:

• A = 10, G = 16, U = 30, V = 31, X = 33, Z = 35. AU0000XVGZA -> 103000003331163510.

• Collect odd and even characters:

• 103000003331163510 = (1, 3, 0, 0, 3, 3, 1, 3, 1), (0, 0, 0, 0, 3, 1, 6, 5, 0)

• Multiply the group containing the rightmost character (which is the SECOND group) by 2:

• (0, 0, 0, 0, 6, 2, 12, 10, 0)

• Add up the individual digits:

• (1 + 3 + 0 + 0 + 3 + 3 + 1 + 3 + 1) + (0 + 0 + 0 + 0 + 6 + 2 + (1 + 2) + (1 + 0) + 0) = 27

• Take the 10s modulus of the sum:

• 27 mod 10 = 7

• Subtract from 10:

• 10 - 7 = 3

• Take the 10s modulus of the result (this final step is important in the instance where the modulus of the sum is 0, as the resulting check digit would be 10).

• 3 mod 10 = 3

• So the ISIN check digit is three.

Conversion table

________________________________________

Conversion table for characters is :

A = 10 F = 15 K = 20 P = 25 U = 30 Z = 35

B = 11 G = 16 L = 21 Q = 26 V = 31

C = 12 H = 17 M = 22 R = 27 W = 32

D = 13 I = 18 N = 23 S = 28 X = 33

E = 14 J = 19 O = 24 T = 29 Y = 34

________________________________________



BAE Systems: ISIN GB0002634946, expanded from SEDOL 0263494

The main body is the SEDOL, padded on the front with the addition of two zeros. The country code "GB" is then added on the front, and the check digit on the end as in the example above.

CUSIP

• The acronym CUSIP historically refers to the Committee on Uniform Security Identification Procedures, which was founded in 1964, during the paper crunch in Wall Street. This 9-character alphanumeric code identifies any North American security for the purposes of facilitating clearing and settlement of trades. The CUSIP distribution system is owned by the American Bankers Association and is operated by Standard & Poor's. The CUSIP Service Bureau acts as the National Numbering Association (NNA) for North America, and the CUSIP serves as the National Securities Identification Number for products issued from both the United States and Canada.



• In the 1980s there was an attempt to expand the CUSIP system for international securities as well. The resulting CINS (CUSIP International Numbering System) has seen little use as it was introduced at about the same time as the truly international ISIN system. CINS identifiers do appear in the ISIDPlus directory

Procedure

• Description The first six characters are known as the base (or CUSIP-6), and uniquely identify the issuer. Issuer codes are assigned alphabetically from a series that includes deliberate built-in "gaps" for future expansion. The 7th and 8th digit identify the exact issue. The 9th digit is an automatically generated checksum (some clearing bodies ignore or truncate the last digit). The last three characters of the issuer code can be letters, in order to provide more room for expansion.



• Issuer numbers 990 to 999 and 99A to 99Z in each group of 1,000 numbers are reserved for internal use. This permits a user to assign an issuer number to any issuer which might be relevant to his holdings but which does not qualify for coverage under the CUSIP numbering system. Other issuer numbers (990000 to 999999 and 99000A to 99999Z) are also reserved for the user so that they may be assigned to non-security assets or to number miscellaneous internal assets.

• The 7th and 8th digit identify the exact issue, the format being dependent on the type of security. In general, numbers are used for equities and letters are used for fixed income. For commercial paper the first issue character is generated by taking the letter code of the maturity month, the second issue character is the day of the maturity date, with letters used for numbers over 9. The first security issued by any particular issuer is numbered "10". Newer issues are numbered by adding ten to the last used number up to 80, at which point the next issue is "88" and then goes down by tens. The issue number "01" is used to label all options on equities from that issuer.



• Fixed income issues are labeled using a similar fashion, but due to there being so many of them they use letters instead of digits. The first issue is labeled "AA", the next "A2", then "2A" and onto "A3". To avoid confusion, the letters I and O are not used since they might be mistaken for the digits 1 and 0.



• The 9th digit is an automatically generated check digit using the "Modulus 10 Double Add Double" technique. To calculate the check digit every second digit is multiplied by two. Letters are converted to numbers based on their ordinal position in the alphabet.

Code

Check digit pseudocodealgorithm Cusip-Check-Digit(cusip) is

Input: an 8-character CUSIP

Output: the check digit for that CUSIP

sum := 0

for 1 ≤ i ≤ 8 do

c := the ith character of cusip

if c is a digit then

v := numeric value of the digit c

else if c is a letter then

p := ordinal position of c in the alphabet (A=1, B=2...)

v := p + 9

else if c = "*" then

v := 36

else if c = "@" then

v := 37

else if c = "#" then

v := 38

end if

if i is even then

v := v × 2

end if

sum := sum + v div 10 + v mod 10

repeat

return (10 - (sum mod 10)) mod 10

Outlook

• Antitrust Review In November 2009, ten months after launching an investigation, the European Commission formally charged Standard & Poor’s with abusing its position as the sole provider of CUSIP international securities identification codes for U.S. securities by requiring European financial firms and data vendors to pay licensing fees for their use. “This behavior amounts to unfair pricing,” the European Commission said in its statement of objections which lays the groundwork for an adverse finding against S&P. “The (numbers) are indispensable for a number of operations that financial institutions carry out – for instance, reporting to authorities or clearing and settlement – and cannot be substituted.”





• S&P has run the CUSIP Service Bureau, the only ISIN issuer in the US, on behalf of the American Bankers Association. In its formal statement of objections, the European Commission alleges that S&P is abusing this monopoly position by forcing financial services companies and information service providers to pay licence fees for the use of US ISINs. It claims that comparable agencies elsewhere in the world either do not charge fees at all, or do so on the basis of distribution cost, rather than usage.

SEDOL

• SEDOL stands for Stock Exchange Daily Official List, a list of security identifiers used in the United Kingdom and Ireland for clearing purposes. The numbers are assigned by the London Stock Exchange, on request by the security issuer. SEDOLs serve as the National Securities Identifying Number for all securities issued in the United Kingdom and are therefore part of the security's ISIN as well. The SEDOL Masterfile (SMF) provides reference data on millions of global multi-asset securities each uniquely identified at the market level using a universal SEDOL code

Procedure

• SEDOLs are seven characters in length, consisting of two parts: a six-place alphanumeric code and a trailing check digit. SEDOLs issued prior to January 26, 2004 were composed only of numbers. For those older SEDOLs, those from Asia and Africa typically begin with 6, those from the UK and Ireland (until Ireland joined the EU) typically begin with 0 or 3 those from Europe typically began with 4, 5 or 7 and those from the Americas began with 2. After January 26, 2004, SEDOLs were changed to be alpha-numeric and are issued sequentially, beginning with B000009. At each character position numbers precede letters and vowels are never used. All new SEDOLs, therefore, begin with a letter. Ranges beginning with 9 are reserved for end user allocation.

• The check digit for a SEDOL is chosen to make the total weighted sum of all seven characters a multiple of 10. The check digit is computed using a weighted sum of the first six characters. Letters have the value of 9 plus their alphabet position, such that B = 11 and Z = 35. While vowels are never used in SEDOLs, they are not ignored when computing this weighted sum (e.g. H = 17 and J = 19, even though I is not used), simplifying code to compute this sum. The resulting string of numbers is then multiplied by the weighting factor as follows:

First 1

Second 3

Third 1

Fourth 7

Fifth 3

Sixth 9

Seventh 1 (the check digit)

• The character values are multiplied by the weights. The check digit is chosen to make the total sum, including the check digit, a multiple of 10, which can be calculated from the weighted sum of the first six characters as (10 − (weighted sum modulo 10)) modulo 10.



• For British and Irish securities, SEDOLs are converted to ISINs by padding the front with two zeros, then adding the country code on the front and the ISIN check digit at the end.

Code

JavaScript codes for validating SEDOLs Code:



Modified from http://rosettacode.org/wiki/SEDOLs



function checkSedol(text){

var weight = [1, 3, 1, 7, 3, 9, 1];

try{

var input = text.substr(0,6);

var check_digit = sedol_check_digit(input);

if( text == input + check_digit){

return true;

}else{

return false;

}

}catch(e){

return false;

}

return false;



function sedol_check_digit(char6) {

if (char6.search(/^[0-9BCDFGHJKLMNPQRSTVWXYZ]{6}$/) == -1){

throw "Invalid SEDOL number '" + char6 + "'";

}

var chars = char6.split('');

var sum = 0;

for (var i in chars){

sum += weight[i] * char_to_value(chars[i]);

}

var check = (10 - sum%10) % 10;

return check.toString();

}

function char_to_value(ch) {

var val = ch.charCodeAt(0);

if (48 <= val && val <= 57)

return val - 48;

else

return val - 65 + 10;

}

}

BAE System

Exampl eBAE Systems: 0263494



The checksum can be calculated by multiplying the first six digits by their weightings:



(0×1, 2×3, 6×1, 3×7, 4×3, 9×9) = (0, 6, 6, 21, 12, 81)

Then summing up the results:



0 + 6 + 6 + 21 + 12 + 81 = 126

The check digit is then calculated by:

(10 − (126 modulo 10)) = (10 − 6) = 4

Exchange Traded derivative

 

Exchange- traded derivative contract are standardized derivative contract (e.g. Future contracts and options) that are transacted on an organized future exchanges. These contract include futures, call and put. Part of the name of these contract always reflect on which date the contract expire. For example, a future PQR expiring in Sep11 will be called PQRU11. A call option PQR expiring in Sep11 will be called PQRI11C. A Put (P) option of same asset expiring Sep11 will be called PQRU11P.

Table

 

Month	Call	Put	Futures
January	A	M	F
February	B	N	G
March	C	O	H
April	D	P	J
May	E	Q	K
June	F	R	M
July	G	S	N
August	H	T	Q
September	I	U	U
October	J	V	V
November	K	W	X
December	L	X	Z

Pari passu

Pari passu is a Latin phrase that literally means "with an equal step" or "on equal footing." It is sometimes translated as "ranking equally", "hand-in-hand," "with equal force," or "moving together," and by extension, "fairly," "without partiality."



passu is the ablative of the Latin noun passus, "step"

pari is the ablative singular masculine (since it must grammatically agree with passu) of the adjective par, "equal". If it was nominative, "an equal step" it would simply be par passus.

In law, this term is commonly used jargon. Black's Law Dictionary (8th ed., 2004) defines pari passu as "proportionally; at an equal pace; without preference."



In inheritance, an in pari passu distribution can be distinguished from a per stirpes distribution. For example, suppose a testator had two children A and B. A has 2 children, and B has 3. The testator leaves his entire estate to his grandchildren in equal shares in pari passu, each grandchild would inherit one fifth of the estate. If the testator left his entire estate to his grandchildren per stirpes, the children of A would share one half of the estate equally between the two of them, and the children of B would share one half of the estate equally between the three of them. The problem with an in pari passu distribution in the example given is that, let's assume A dies before B. On A's death a distribution could not be made to his or her children: they would have to await the death of B (B may have more children after A's death) before the share of the estate they are to take could be determined.



In finance, this term refers to two or more loans, bonds, classes of shares having equal rights of payment or level of seniority. For asset management firms, the term denotes an equal allotment of trades to strategically identical funds or managed accounts.



This term is also often used in bankruptcy proceedings where creditors are said to be paid pari passu, or each creditor is paid pro rata in accordance with the amount of his claim. Here its meaning is "equally and without preference."



There have been cases where differences in interpretation of what pari passu means.

From Anna's Jan Lokpal

हमें क्यों चाहिए लोकपाल?






मोटे तौर पर, लोकपाल कानून बनवाने के दो मकसद हैं -





पहला मकसद है कि भ्रष्ट लोगों को सज़ा और जेल सुनिश्चित हो। भ्रष्टाचार, चाहे प्रधानमंत्री का हो या न्यायधीश का, सांसद का हो या अफसर का, सबकी जांच निष्पक्ष तरीके से एक साल के अन्दर पूरी हो। और अगर निष्पक्ष जांच में कोई दोषी पाया जाता है तो उस पर मुकदमा चलाकर अधिक से अधिक एक साल में उसे जेल भेजा जाए।





दूसरा मकसद है आम आदमी को रोज़मर्रा के सरकारी कामकाज में रिश्वतखोरी से निजात दिलवाना। क्योंकि यह एक ऐसा भ्रष्टाचार है जिसने गांव में वोटरकार्ड बनवाने से लेकर पासपोर्ट बनवाने तक में लोगों का जीना हराम कर दिया है। इसके चलते ही एक सरकारी कर्मचारी किसी आम आदमी के साथ गुलामों जैसा व्यवहार करता है।



प्रस्तावित जनलोकपाल बिल में इन दोनों उद्देश्यों को ध्यान में रखते हुए सख्त प्रावधान रखे गए हैं। आज किसी भी गली मोहल्ले में आम आदमी से पूछ लीजिए कि उन्हें इन दोनों तरह के भ्रष्टाचार से समाधान चाहिए या नहीं। देश के साथ ज़रा भी संवेदना रखने वाला कोई आदमी मना करेगा? सिवाय उन लोगों के जो व्यवस्था में खामी का फायदा उठा उठाकर देश को दीमक की तरह खोखला बना रहे हैं।



जन्तर मन्तर पर अन्ना हज़ारे के साथ लाखों की संख्या में खड़ी हुई जनता यही मांग बार बार उठा रही थी। देश के कोने कोने से लोगों ने इस आन्दोलन को समर्थन इसलिए नहीं दिया था कि केन्द्र और राज्यों में लालबत्ती की गाड़ियों में सरकारी पैसा फूंकने के लिए कुछ और लोग लाएं जाएं। बल्कि इस सबसे आजिज़ जनता चाहती है कि भ्रष्टाचार का कोई समाधान निकले, रिश्वतखोरी का कोई समाधान निकले। भ्रष्टाचारियों में डर पैदा हो। सबको स्पष्ट हो कि भ्रष्टाचार किया तो अब जेल जाना तय है। रिश्वत मांगी तो नौकरी जाना तय है।

एक अच्छा और सख्त लोकपाल कानून आज देश की ज़रूरत है। लोकपाल कानून शायद देश का पहला ऐसा कानून होगा जो इतने बड़े स्तर पर जन चर्चा और जन समर्थन से बन रहा है। जन्तर मन्तर पर अन्ना हज़ारे के उपवास और उससे खड़े हुए अभियान के चलते लोकपाल कानून बनने से पहले ही लोकप्रिय हो गया है। ऐसा नहीं है कि एक कानून के बनने मात्र से देश में भ्रष्टाचार खत्म हो जाएगा या इसके बाद रामराज आ जाएगा। जिस तरह भ्रष्टाचार के मूल में बहुत से तथ्य काम कर रहे हैं उसी तरह इसके निदान के लिए भी बहुत से कदम उठाने की ज़रूरत होगी और लोकपाल कानून उनमें से एक कदम है।

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