Meaning of Derivatives: Derivative is an instrument that does not have a value of its own, rather it “derives” its value/price on the basis of some other instrument, hence the name Derivative.
For eg, Cheese, curd, ice-cream etc. can be termed as “derivatives” of milk products. Their price is dependent on the price of milk, which, in turn will depend on the demand and supply of milk.
Have you not wondered how do Mutual Fund units tend to change daily? On what basis does that value change? Don’t they derive the value from the value of individual securities in the portfolio of the schemes? Are they derivatives then? And what about the ADR/GDR of Satyam/Infosys which are traded on USA/England stock exchanges? Do they have their own value? Or even they derive their value from the shares in India? So, now I guess you get the point.
Definition of Derivatives: Derivatives are financial instruments/contracts that derive their value from some other underlying/underlying asset.
When it comes to derivatives, the gain of one is the loss of other.
Main Aim: Transfer of risk from one party to another (in other words, insurance). Though, it must be noted that some people make use of derivatives solely for profit making. This leads to understanding of different operators in the Derivatives Market.
There are basically three kinds of operators in this market: Hedgers, Speculators and Arbitragers.
Example: Raj wants to purchase a car, which costs Rs 8,000 but does not have enough cash to buy it outright. He will be able to purchase it only 3 months hence. He, however, fears that prices of cars will rise 3 months down the line. Hence, in order to protect himself from the rise in prices Raj enters into a contract now with a car dealer that he will purchase the car three months from now for Rs 8,000. What Raj is doing is that he is locking the current price of a car for a forward contract. The forward contract will be settled at maturity. The dealer will deliver the car to Raj at the end of three months and Raj in turn will pay cash equivalent to the car price on delivery. So, in future if the car prices move in an unfavorable direction, i.e. happen to rise (in this case) then too Raj can buy the car at Rs. 8000.
It is very important for exporters/importers, traders, dealers, etc. to protect themselves against unfavorable price conditions.
Speculators: They are traders who don’t mind taking risks in order to make profits, by taking advantage of the favorable movement of the underlying lmnp. They bet on the direction of markets, if they would go up or come down and try to generate profits from it.
Arbitrageurs: Arbitrage means to take advantage of a lower current market price in comparison with the future value of the asset. Aim: Risk-less profit making is the prime goal of arbitrageurs. They are adept in buying and selling in different markets at the same time and profit by the difference in prices between the two markets.
As we just mentioned about hedging and risk management, can we term Derivatives as Insurance?
One purchases a life insurance policy and thereby pays a premium to the insurance agent as per policy terms for a fixed duration. If you are alive, then you are glad and the insurance company is glad. If you happen to pass away, your relatives are glad as the insurance company will have to pay them the amount for which you are insured.
Insurance, in simple terms, can be termed as “transfer of risk”. An insurance company essentially is selling to you a “risk cover” and buying “your risk” and you are selling “your risk” and buying a “risk cover.” The risk in case of in life insurance is the demise of the policyholder. The insurance company bet on one’s being alive and thereby agree to sell a risk cover for certain amount of premium.
The risk transfer occurs in turn of a financial cost which is “premium”. Considering that, a derivative instrument is comparable to insurance, as it involves a risk transfer at a financial cost.
Derivatives play a significant role across the global markets as instruments of risk management. They are extensively used for minimizing risks and transferring to those who are essentially willing to take risks. Derivatives grant market participants an easy/less expensive way in which one can build their desired portfolio with minimum level of risk. They are risk management and portfolio restructuring tools. Considering that, one might wonder why derivatives are risky.
This in simple terms means that one could take position in the markets in multiples of the resources one possessed. You just have to pay a small amount of margin in order to take a position, so it involves high leverage. As a result, participants tend to take positions that are much higher than their risk taking capabilities and if the market moves in unfavorable directions, they suffer with extremely high losses. At the end of it, this can be perceived as a problem of the participants in the market and not of derivatives.
Basically, derivatives had been introduced in order to hedge against the price risk (risk of price of asset owned going in an unfavorable direction). It enabled transfer of risk from those who were not willing to take it (hedgers) to those who were intentionally willing to assume it (speculators). Besides hedging, they perform some very significant functions discussed below.
Advantages/ Benefits/Merits/Functions of Derivatives:
Enable Price Discovery: In the first place, derivatives encourage more and more people with objectives of hedging, speculation, arbitrage to take part in the market and hence increase competition. Hence there are more and more people who keep track of prices and trade on slightest of reasons. Individuals with better information and judgment are inclined to participate in the markets to take advantage of such situation. A small change in price and it attracts some action on the part of speculators. Active participation in the market in large no.s of both buyers and sellers ensures a fair price. The increased no. of participants, more trades, more volumes, and greater sensitivity to smallest of price changes facilitates correct and efficient price discovery of assets.
Facilitates Transfer of Risk: By their very nature, the derivatives instruments do not involve risk. Instead, they redistribute risk between the various market participants. In this sense, derivatives can be compared to insurance: provides means to hedge against unfavorable market movements in return for a premium, and provides opportunities to those who are willing to take risks and make profits in the process.
Provide Leveraging: In order to take position in derivatives, you require very small initial outlay of capital in comparison to taking position in the spot market. Assume that Mr. A believes that price of rice shall be Rs. 50/kg in 3 months from now and that a farmer has agreed to sell it at Rs. 49/kg. To take this benefit, Mr. A has to pay full amount of Rs. 49/kg today and he will realize Rs. 50/kg 3 months later. Instead, if there is a way through which he can escape making a full payment, he shall be really glad to enter into such contract and Derivatives provide those exit routes by letting one enter into a contract and can neutralize their position by booking opposite position on a future date.
Completion of Market/Efficient Market: A market is efficient or said to be complete market (theoretically possible) when the available instruments can by itself or jointly provide cover against any possible adverse outcomes. It is a theoretical concept, which is not seen in practice. Though with the presence of derivatives, there is a greater degree of market completeness.
Lower Transaction costs: It translates into low transaction costs due to the high no. of participants that take part in the market.
Derivatives behave like a two edged sword. If put to use wisely they work very effectively but when used recklessly can cause you severe agonies. Sadly there is no realistic way in which one could demarcate between the two. There is a very thin line that distinguishes gambling with a calculated taken risk.
Below mentioned are disadvantages/ demerits of Derivatives:
Raises Volatility: As a large no. of market participants can take part in derivatives with a small initial capital due to leveraging derivatives provide, it leads to speculation and raises volatility in the markets.
Higher no. of Bankruptcies: Due to leveraged nature of derivatives, participants assume positions which do not match their financial capabilities and eventually lead to bankruptcies.
Increased need of regulation: Large no. of participants take positions in derivatives and take speculative positions. It is necessary to stop these activities and prevent people from getting bankrupt and to stop the chain of defaults.
In my previous article, I discussed about what exactly are money markets, objectives of money markets and features/drawbacks of money markets: What are Money Markets?
Now, we shall discuss about the structure/constituents of Money Markets in India. Basically, Money Market in India is comprised of two sectors: Organised Money Market and Unorganised Money Market.
The RBI is the apex institution which controls and monitors all the organizations in the organised sector. The commercial banks can operate as lenders and operators. The FIs like IDBI, ICICI, and others operate as lenders. The organised sector of Indian money market is fairly developed and organised, but it is not comparable to the money markets of developed countries like USA, UK and Japan.
Main constituents/components of Organised Money Market:
The Call Money: It is also known as Interbank Call Money Market. Here, lending and borrowing transactions are carried out for one day. These one day loans may or may not be renewed the next day. The demand for call money comes from commercial banks that need to meet requirements of CRR and SLR, whereas supply comes from commercial banks with excess funds, and FIs like IDBI, etc.
The Treasury Bill Market: It deals in Treasury Bills of short term duration: 14 days, 91 days, 182 days and 364 days. They are issued by Government and largely held by RBI. The treasury bills facilitate the financing of Central Government temporary deficits. From May 2001, the auction of 14 days and 182 days treasury bills has been discontinued. At present, there are 91 days and 364 days treasury bills. The rate of interest for treasury bills is determined by the market, depending on the demand and supply of funds in the money market.
The Commercial Bill Market: It deals in bills of exchange. A seller draws a bill of exchange on the buyer to make payment within a certain period of time. The bills can be domestic bills or foreign bills of exchange. The commercial bills are purchased and discounted by commercial banks, and are rediscounted by FIs like EXIM Bank, SIDBI, IDBI, etc.
The Certificate of Deposit Market: The scheme of Certificate of Deposit (CD) was introduced by RBI in 1989. The main purpose of CD is to enable the commercial banks to raise funds from the market. The CDs maturity period ranges from 7 days to 1 year (in case of FIs minimum 1 year and maximum 3 years). The CDs are issued at a discount to its face value. The CDs are issued in denomination of Rs. 1 lakh and thereafter, multiples of Rs. 1 lakh. The holder is entitled to receive a fixed rate of interest and have no lock-in period.
The Commercial Paper Market: The scheme of Commercial Paper (CP) was introduced in 1990. Blue chip companies for short term financing issue CPs. As per RBI guidelines, CPs can be issued on the following conditions:
The minimum tangible net worth of the company to be at least Rs. 4 crores. The CP receives a minimum rating of A-2 or such other rating from recognized rating agencies like CRISIL, CARE, ICRA, Fitch Ratings, etc. The company has been sanctioned working capital limit by bank/s or all-India FIs. The CPs maturity period ranges from 7 days to 1 year. They can be issued in multiples of Rs. 5 lakhs and in multiples thereof. They are sold at a discount to its face value and redeemed at its face value.
The unorganised money market mostly finances short term financial needs of farmers and small businessmen. The main constituents of unorganised Money market are:
Indigenous Bankers (IBs): The IBs are individuals or private firms who receive deposits and give loans and thereby they operate as banks. Unlike moneylenders who only lend money, IBs accept deposits as well as lend money. They operate mostly in urban areas, especially in western and southern regions of the country. Over the years, IBs faced stiff competition from cooperative banks and commercial banks. Borrowers are small manufacturers and traders, who may not be able to obtain funds from the organised banking sector, may be due to lack of security or some other reason.
Money Lenders (MLs): MLs are important participants in unorganised money markets in India. There are professional as well as non professional MLs. They lend money in rural areas as well as urban areas. They normally charge an invariably high rate of interest ranging between 15% p.a. to 50% p.a. and even more. The borrowers are mostly poor farmers, artisans, petty traders, manual workers and others who require short term funds and do not get the same from organised sector.
Chit Funds and Nidhis: They collect funds from the members for the purpose of lending to members (who are in need of funds) for personal or other purposes. The chit funds lend money to its members by draw of chits or lots, whereas Nidhis lend money to its members and others.
Finance Brokers: They act as middlemen between lenders and borrowers. They charge commission for their services. They are found mostly in urban markets, especially in cloth markets and commodity markets.
Finance Companies: They operate throughout the country. They borrow or accept deposits and lend them to others. They provide funds to small traders and others. They operate like indigenous bankers.
Accounting Cycle: In the accounting process, the accounting activities rotate in a similar way or follows the same procedure in each year .The sequence or process is maintained by the accounting activities can be entailed as ‘accounting cycle’.
Step in account cycle:
The following steps are followed in the accounting cycle:
Source document collection and recording in Journal. Classified posting into ‘general ledger’ Proving periodic arithmetical accuracy into ‘trial balance’. Adjusting ‘general ledger and preparation of work sheet. Preparation of Final Financial Statement. In every transaction the above-mentioned steps are followed. First the transactions are recorded in Journal book and classified them and posting into the ledger account. The third step is to provide the arithmetical accuracy through Trial Balance. In the fourth stage, adjusting entries are incorporated with the Trial Balance accounts and worksheet is prepared. And finally, various financial statements are prepared i.e. Income Statement, Cash Flow Statement, Retained Earnings Statements, and Balance Sheet etc. This entire process is called as the ‘Accounting cycle’.
Step 1: Identification and recording of transaction and other events- Journal.
The first step in the Accounting cycle is to record the transactions in the books of accounts. This process is called ‘to record’ into the journal books. The books are also called ‘Book of original Entry’ as transactions occur they are recorded first in the journal.
Simply Journal can be defined as recordings of transactions in a set of books in a systematic way according to days.
Before starting to record the transactions into the journal book, we will discuss about the ‘Accounts.’
Accounts: An account is simply a place where similar transactions and events, which occur during a particular period, are summarized and accumulated.
Classification of Accounts:
Personal account: Any person or organizations. Example: Mr. X’s a/c, Beximco co. ltd. a/c. Real a/c: any assets i.e. cash, bank, machinery, motorcar etc. Nominal a/c: Nominal accounts are of two types: (a) Expense a/c: Any expenses i.e. salary paid, commission paid etc.
(b) Income a/c: Any earnings or revenues i.e. interest earned, commission earned etc.
Debit & Credit:
The term ‘Debit’ & ‘Credit’ gives an accounting explanation of the mathematical changes in the individual accounts. There must be always equal increases and decreases so that equality of the two sides of the accounting equation is maintained.
Example: Mr. Hasan gives Rs. 100 to Mr. Jaman.
Here Mr. Hasan and Mr. Jaman both are personal a/c and Jaman is the receiver. So Jaman’s a/c will be debited. On the other hand Hasan is the donor and his a/c will be credited.
Journal entry: Mr. Jaman’s A/C Dr 100
Mr. Hasan’s A/c Cr 100
Example: Equipment purchased at a cost of Rs. 1, 00,000.
Equipment is an asset for the organization. So it will be debited. On the other hand cash is also an asset for the organization. It will be decreased and will be credited.
Journal entry: Equipment A/c Dr 1, 00,000
Cash A/c Cr 1, 00,000
(a) Expense a/c: Expenses increases—-Dr
Expenses decreases ——Cr
(b) Income or revenue a/c: Income decreases—–Dr
Example 1: salaries paid Rs. 10,000.
Salaries are an expense for the organization and it will be debited. On the other hand salary is been paid in cash. Cash is an asset and it decreases so will be credited.
Journal would be: Salaries a/c Dr. 10,000
Cash a/c Cr. 10,000
Example 2: Interest income Rs. 5000
Interest is an income for the organization and will be credited. On the other hand income is earned in cash. So it will be debited.
Journal entry: Cash a/c Dr. 5000
Interest income Cr. 5000
Any increase —–Cr
Example: Mr. Hasan invested Rs.100, 000 in the business. Here cash is increased and on the other hand Capital is increased (Anything given by the owner’s to the business is the considered as the Capital of the business). So it will be credited.
Journal entry: Cash a/c Dr.100, 000
Capital a/c Cr.100, 000
The specimen form of a General Journal is giver below:
Date Particulars Ledger Folio Debit Rs. Credit Rs.
Journal problem: 1
Ann Evans, CPA, completed the following transactions during August of this current year:
Aug. 1: Begin a public accounting practice by investing $1500 in cash and office
equipment having a $ 1200 fair value.
Aug. 1: Purchased office supplies $75 and office equipment $250, from Sierra Company on credit.
Aug. 1: Paid three months rent in advance on suitable office space, $900.
Aug. 5: Completed accounting work for a client and collected $ 60 cash there for.
Aug. 11: Paid Sierra Co. $ 125 of the amount owed for the items purchased on August 1.
Aug. 12: Paid the premium on insurance policy, $375.
Aug. 15: Completed accounting work for Nevada Co. on credit, $ 350.
Aug. 20: Ann Evans withdrew $100 from the Accounting practice for personal expenses.
Aug. 23: Completed Accounting work for Donner co. on credit, $200.
Aug. 25: Received $ 350 from Nevada co. for the work completed on August 15.
Aug. 31: Paid the utility bills, $ 35
Ann Evans, CPA
Solve the following problems.
Problem no 1:
Dr. Wali Asahraf completed the following transactions in the practice of his profession during May of the current year:
May 1. Paid office rent for May Rs. 1400
Purchased X –ray film and other supplies on account Rs. 680
Received cash on account from patient’s Rs.8476
Purchased equipment on account Rs.5100
Paid cash to creditors on account Rs. 4810
Sold X-ray film to another doctor at cost, as an accommodation, receiving cash Rs. 120
Paid invoice for laboratory analysis Rs.280
Paid cash for renewal of property insurance policy Rs. 560
Out of the items of equipment purchased on May 6 one was defective. It was returned with the permission of the supplier who agreed to reduce the account for the amount charged for the item Rs. 800
Paid cash from business bank account for personal and family expenses Rs. 3500
Recorded the cash received in payment of services (on a cash basis) to patients during May Rs.8350
Recorded fees charged to patients on account for May Rs. 10,000
Problem no 2:
Journalize the following entries:
Mr. Hasan starts his business. He invests RS. 10,00,000; a motorcar of Rs. 5,00,000; a machinery of Rs. 1,00,000 and Rs. 2,00,000 in the Standard Chartered Bank to operate the business.
Purchase goods at a cost of Rs. 30,000
Purchase office equipment of Rs. 50,000
Purchase goods from Beximco ltd. co on account at Rs. 15,000
Sold goods for cash Rs. 1, 00,000
Sold goods on credit to Mr. Rafiq at Rs. 50.000
Goods returned to Beximco ltd. co Rs. 1000
Goods returned from Rafiq at Rs. 2000
Deposited cash into the Bank Rs. 2, 00,000
Paid carriage on sales of goods Rs. 500
Salary paid by cheque Rs. 20,000
Purchase of 10% Government Defense Certificate Rs. 5, 00,000
Bank charges Rs. 100 for services. On the other hand we earned interest Rs. 200 from them.
Insurance prepaid Rs. 2500
Wages outstanding Rs. 2000
In my previous article: Accounting cycle, I discussed Step 1: Identification and recording of transaction and other events- Journal.
Here, I shall discuss about:
Posting to the ledger
Proving periodic arithmetical accuracy into ‘Trial balance’.
Step 2: Classified posting into ‘general ledger’
Ledger: The individual accounts are normally maintained in a book referred to as “Ledger”. It is the most important book of accounts, because it includes all the summaries of transactions. Therefore, it is called the ‘principal book’ of the books of accounts. It provides a permanent record of the financial transactions of a firm.
Practical problem: 2
Based on the mentioned journals in the problem no.1 in my previous article of accounting cycle, now we will open the following accounts.
Open the following accounts: (1) Cash; (2) Accounts Receivable, (3) Prepaid rent; (4) Prepaid insurance; (5) Office supplies; (6) Office Equipment, (7) Accounts payable; (8)Ann Evans Capital; (9) Withdrawals; (10) Accounting Revenue; and (11) Utilities expenses.
Solve the following problems:
Problem no 1:
Based on the journals in the problems of Dr. Wali Asahraf in the lecture no. 6 Prepare ‘T’ from ledger accounts and make posting of all the transactions.
Problem no 2:
Based on the journals in the problems of Mr. Hasan in the lecture no. 6 post to the appropriate ledger accounts.
Step 3: Proving periodic arithmetical accuracy into ‘Trial balance’:
Under double entry system, for every debit entry there is a corresponding credit entry of the same amount. Consequently, the total amount of all the debit entries should be equal to the total of all credit entries. In order to verify, whether the two totals are equal, a statement is prepared periodically showing the debit items in one column and the credit items in another. This statement is called the “Trial Balance”.
There are two methods of preparing a trial balance- (1) Trial Balance prepared with the gross totals of the debit and credit sides of each ledger account, and (2) Trial Balance prepared with the balance of each account. When both gross amounts and balances of the accounts are shown in the trial balance it becomes a third method and it is called a mixed Trial Balance. In actual practice, the first and the third methods are used very rarely while the second method is used generally.
Different classes of errors that may exist in spite of the agreement of the Trial Balance are discussed below:
(a) Errors of omission: Such an error arises when any transaction is either wholly or partially unrecorded in the in the books. In the former case, the trial balance will not be affected, and thus the error will be more difficult to detect. Where only one aspect of a transaction is recorded, the omission will throw the Trial Balance out of agreement.
(b) Errors of commission: Errors of commission arise when transactions are incorrectly recorded, either wholly or partially. In the former case the Trial Balance will not the trial balance out of agreement to that extent.
(c) Clerical errors: A clerical error is a form of error of commission. It may consist of an incorrect posting, or a mistake in casting, or the transposition of figures, or posting to the wrong account. Unless the error affects the debit and credit equally, the incorrect posting and mistakes in casting will cause the trial balance to be out of the agreement. Posting to the wrong account but on correct side, however, will not affect the agreement of the Trial Balance.
(d) Errors of Principle: An error of principle arises by reason of a transaction being recorded in a fundamentally incorrect manner. Certain errors of principle may not affect the ultimate profit, but it may cause a revenue item being posted to wrong revenue account. Major errors of principle directly affect profit. They may be caused by treating revenue item as an asset or liability, or vice versa. These errors will not throw the trial balance out of agreement.
(e) Compensating errors: A compensating error is one, which is counter balanced by another error or errors of the same amount either in the same account or other accounts. Such error will not cause the Trial Balance to disagree.
From the above discussion it is clear that, a Trial Balance may agree in spite of the presence of many errors mentioned above. Hence an agreed Trial Balance cannot be regarded as a conclusive evidence of the correctness of the books of accounts, rather it may be regarded as a prima facie proof that the posting are arithmetically correct.
Rules regarding the Trial Balance:
All assets are recorded in the Debit side
.All the expenses are recorded in the Debit side
All revenues are recorded in the Credit side
Capital, liabilities and Reserves are recorded in the Credit side
From the following balances of accounts prepare a Trial Balance as at 31st July2000:
Accounts Rs Capital Drawings
Cash in hand
Wages and Salaries
Lighting and Heating
Provision for Bad Debts
Rent, Rates and Insurance
Answer: Total of the Debit and Credit are Rs 55,232.
Stock (1.7.1999) is the Opening Stock
‘Provision for Bad Debts’ is a liability
Discount Allowed is an expense
Discount Received is a revenue
Problem no.: 2
The accounts in the ledger of Asbury Park Inc. as of August 31 of the current year are listed in alphabetical order as follows. All accounts have normal balances. The balance of the cash account has been intentionally omitted.
Accounts Payable Rs 18,750
Accounts Receivable Rs 20,500
Capital Stock Rs 50,000
Dividends Rs 20,000
Fees earned Rs 3, 15,000
Insurance Expense Rs 5,000
Land Rs 1, 25,000
Miscellaneous Expense Rs 9,900
Notes Payable Rs 35,000
Prepaid Insurance Rs 3150
Rent Expense Rs 58,000
Retained Earnings Rs 60,290
Supplies Rs 4,100
Supplies Expense Rs 5,900
Unearned Rent Rs 6,000
Utilities Expense Rs 41,500
Wages Expense Rs1, 75,000
Prepare a Trial balance, listing the accounts in their proper order and inserting the missing figure for cash.
Gold has become one of the significant asset classes in anyone’s portfolio due to its capability to grow along with inflation and defend the portfolio from volatility produced by major financial crisis. Gold, not being correlated along with financial markets normally shares an inverse relation with the U.S. dollar. That is one reason that gold managed to reach its all time highs in spite of the financial difficulty in across the globe. Regardless of one’s age and risk-appetite, one must allocate around 10% of their investments to gold. Gold being a precious metal shall always be in short supply. In case you want to invest in gold and are hunting for the best possible ways, I shall discuss here some of the alternative ways of investment.
Here I have mentioned about the various option available to invest in gold: Investing in Gold
It is now known to all that physical gold is appropriate in case of jewellery and does not suit investment needs. Nowadays, gold is treated as an investment asset rather than consumption asset, and hence it is better to hold gold electronically rather than holding physical gold. The chosen way to invest is by means of Gold ETFs and Gold Mutual Funds. Investing in these funds relieves investors from the time, pains and charges associated with storing, safety, making charges etc. which are common when it comes to buying physical gold.
Let me first mention that both the products, Gold ETFs and Gold Funds are provided by Mutual Funds, difference being in the method of purchasing. The latter are nothing but fund of funds. By Fund of Funds (FoF), I mean to say that they invest in their own fund house ETF. For instance, Reliance Gold Fund invests in Reliance Gold ETF.
Let us inspect the advantages and disadvantages of investing in gold funds vs. gold ETFs.
If you are a small investor, Gold Funds/Gold Saving Funds/ Gold FoF are a good alternative as you can buy in a simple SIP way, which has lower costs.
If you are an active trader and have the ability to negotiate with your broker to reduce brokerage costs and want to invest in large amounts, Gold ETF is a better option.