The Hindu Business Line : Because derivatives are merely contracts, just about anything can be an underlying asset

Derivatives are emerging as a big worry for bankers, alerted H. A. Daruwalla, CMD of Central Bank of India, when speaking in Kolkata a few days ago. She highlighted the need for accounting standards on recognition, measurement and presentation of derivatives. Not long ago, K. C. Chakrabarty, CMD of Indian Bank, had rued the absence of standards for accounting of derivative contracts in the books of accounts.

"At present, banks are disclosing their exposure in derivative transactions as off-balance-sheet items, which include currency and interest rate swaps, rupee options and forward contracts," said Chakrabarty. Alarmingly, "The off-balance-sheet exposure of banks has increased by a huge 60 per cent, standing at 119 per cent of the total liabilities in financial year 2005."

To be fair, though, the ICAI (Institute of Chartered Accountants of India) has a Guidance Note (GN) for the purpose, on `equity index and equity futures and options'. An accounting standard on derivatives is expected by the end of the year. Meanwhile, there is enough and more in the GN for handling derivatives.

The Note defines derivatives as a kind of financial instrument whose values change in response to the change in specified interest rates, security or commodity prices, index of prices or rates, or similar variables. It speaks of examples such as futures and forward contracts, swaps and options.

For the avid, the Web abounds with definitions of derivatives. Please note that the word is used in many contexts, ranging from linguistics to mathematics, from chemistry to finance. `Quickly' is a derivative of `quick', your English teacher would tell you.

And your math lesson could have enlightened you that change of function is a derivative, a key concept of calculus.

To the chemist, chloroform is a derivative of methane. Derivatives are "blood products obtained from liquid or frozen plasma units that have been pooled and then chemically fractionated," reads a chilling definition on www.yourbloodcenter.org.

The first meaning on Encarta reads, "copied from somewhere and not original." Thus, Opal may be said to be a derivative of Sloppy, though accountants may be quick to point out that our standards are but derivatives of foreign material.

The finance-minded may start with www.investopedia.com, which explains thus: "The derivative itself is merely a contract between two or more parties.

Its value is determined by fluctuations in the underlying asset." Because derivatives are just contracts, just about anything can be used as an underlying asset, adds the site. "There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region."

These are rainy days, and Times of Malta has a June 19 alert, "Hurricane season puts spotlight on weather hedging."

Derivative volumes are dizzyingly high (more than $780 trillion or 67 times the US GDP, according to Kyle Pope, cited on www.marketwatch.com) . They are getting excitingly exotic. For instance, a job ad for `Senior Quantitative Analyst — Exotic IR Derivatives' on www.quantfinancejobs.com, offering `£300-600K' notes: "The Exotics Business is still young and has a huge potential to increase revenue flows as they develop a complete range of products to satisfy clients demand. This position offers you opportunities to expand their range of instruments into hybrid and inflation derivatives."

More innovative and less usual derivative products are often called `exotic', explains www.hmrc.gov.uk, the site of the UK taxman. "The term has no precise meaning. Exotic derivatives have been compared to pornography: both are easier to recognise on sight than to define and the definition of both is dependent on time and place," it adds, citing William Margrabe's Derivatives Strategy. For example, "Interest rate and currency swaps were exotic when they first appeared in the 1980s, but are now standard financial tools. Similarly, proprietary products originally developed by merchant banks or other financial institutions to meet the needs of particular clients may in time diffuse more widely into the market."

What's new on the topic is from GASB or the Governmental Accounting Standards Board (www.gasb.org) of the US, a 168-page PV (preliminary views) document `on major issues related to accounting and financial reporting for derivatives'.

FASB or the Financial Accounting Standards Board (www.fasb.org) has Statement No. 133 of 1998, which requires that an entity recognise all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value.

See if you can catch up with `a new 880-page updated edition of Accounting for Derivative Instruments and Hedging Activities,' prepared by the FASB staff. Giddy?

Take lessons from Prof Ian Giddy, New York University, on http://pages.stern.nyu.edu, on how `simplicity is not one of FAS 133's strong suits,' and how DIG is `a special committee to deliberate and explain how to apply FAS 133,' short for the Derivatives Implementation Group. The site www.derivativesindia.com too has inputs of value, while www.india-accounting.com outlines the evolution of derivative standards.

There's help for the baffled, in the form of a 19-page `plain language supplement' from the GASB.

http://AccountSpeak.blogspot.com

D. Murali

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