Accounting for Derivatives Comprehensive Guide

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you to the topic today for the day is accounting for derivative Comprehensive Guide it's gonna be let's understand this in a detailed format accounting for
derivatives now in the regular course of the business operations organizations
are exposed to risks market risk such as like you know the interest rate risk you
have FX risk that is the foreign exchange risk then you have the
commodity pricing risk so this risk gives rise to the income volatility and
as a result the organization often will take some action to mitigate or
economically what we say Hedged against such exposure using the derivative financial
instruments like forwards futures options it swaps in addition some of the
organizations may enter into the derivative contract for speculative or
trading purpose now in this tutorial we are going to see how we account for the
derivative transactions in the books of accounts let's understand the derivative
see there is the first one that is the forward contract what exactly happens in
forward contracts see a forward contract is simply a contract between the two
parties to buy or to sell an asset at a specific future time at a price agreed
today like say let's say there is a company a that contracts with Company B let's say on October 1st of October 2016 for the purchase of let's say 10,000
tata steel shares at $440 share price on 1st January 2017 so in this case the
irrespective the price that is gonna be on 1st January the stockbroker has to
sell 10,000 shares of Tata steel at $440 on 1st of January then the company if
the company a will be at the profit otherwise the stock refer will be at B
will be at a profit the second is the futures contract on a simple sense
futures and forwards are essentially the same except that the future contracts
happens on a future exchange and which acts as a mark list between the buyer
and the sellers the contracts are negotiated at the future exchanges which
as a marketplace between the buyers and the sellers what we say the buyer of the
contract is said to belong belong to the position holder and the selling party is
said to be the short position here it's the long position here it's a short
position as both the party risk their counterparty walking away if the price
goes against them and the contract may involve both the parties lodging a
margin of value Margin a value of the contract with a mutually trusted third
party like for example continuing the above example if the contract has to
purchase the steal of tata steel is entering on a future exchange that is a
clearinghouse and both the parties have to deposit in this particular scenario
an amount for honoring the contract and the contract is the futures your futures
are nothing but the forward contract except that the third party here is
there between to avoid the risk of any denying of honoring the contract so it
gives a future even if the price of the tata steel on the first or for January
2017 went up to let's say $600 then also the stockbroker
in that scenario will have to sell the 10,000 shares to the company a add of 40 and the risk of denying by B is eliminated as the clearing agent or the
Clearing House exchange is there between the margin amount as the margin amount
is actually been deposited just to cover that Third is the option contracts in
option contract which gives the buyer these right which is the who is the
actually the owner of the option the right but not the obligation to buy or
sell on a specified date depending on the of the option like for example
continuing the same example in case of the option company purchase such as is
an option to buy a call option that's at the tata steel the same example at 440 k
per share from the stock broker B at an option price over here let's include the
option price over here as $20 here in this case the denial by B is not
possible as company a bought the right but not an obligation to buy the share
let's say on the first of January 2017 if tata steel's shares are operating at
let's say $300 then company a is not at all obliged to buy
the shares from b at 4:44 share so the option will actually lapse so in this
case the maximum loss for company a here is the amount of the premium that yep
that they are paying $20 per share and profit of company a is unlimited and the
loss for stock a stock broker B is unlimited that's the difference now the
accounting part C basically let's take an example only to understand how to
calculate the profit and loss some derivative or transactions in the in
this example let's take the exercise price I will take up the next sheet and
let's take the example let's take over here the exercise price as 100 call
option premium as $10 per share and the lot size is let's say 200 equity shares
now we will find out a payoff and profit and loss of the buyer and seller option
if the settlement price is less than 90 105 ,110 and 120 so the call
option in the equity share of the profit and loss for both option seller and
buyer will will go something like this this is going to be the scenario in this
particular in in the case of 90 105,110 and 120 this is how the
whole table that will be formed for all the scenarios so in the same case or
entries the journal entry that will go will be something like this it will
start with the call option we have we have all the details that needs to be
operated here we can start with what we call as the solution part which goes as
the bank account the first debit the first entry is the bank account debit to
the call option obligation account credit and the amount will be over here
5000 and 5000 second entry on 1st February the entry for
the same will go as he call obligation account debit the fair value gain
account would be credited to the extent of 1000 in both the scenarios
then on 31st December the final date the call option obligation to bank account
that will be 2000 and 2000 on the exercise date the cast
settlement is going to be is equal to 5,000 -2000- 1000 here instead of this
yeah so this is of your settlement settlement on the settlement date things
are gonna be the case now in case the transaction is settled on 31st of
December your entry will go something like this your call option obligation
account will be debited shares of X limited will be credited that you are
buying or that our limited share whichever you want to 2000 2000 the
things the calculation is gonna remain the same is equal to 5,000 less 2000
less 1000 now the gross shares in in case of the gross entry the entry
is going to be the bank account debit to the call option to the extent of 5000 there'll be no entry on the 31st March but on the 31st December it's
going to be banks accounts to shares to the X limited shares to the extent of
102000 so in this fashion the entries are going to be recorded for the call
option in the similar vein in the food option also the same entries the same
sort of entries will be recorded and you just need to reverse this example does
the the example that we have taken just reverse the case and you will get the
answer so this is it for the accounting for derivatives I've got I think you
have got a clear idea regarding all the situations out there so that's it for
this particular topic if you have learned and enjoyed watching this video
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