The Hindu Business Line : Into the exotic land of derivatives

You are not alone if there are umpteen questions you always wanted to ask about derivatives but were afraid of asking. Derivatives are an exotic topic. As if to compound the problems of the confounded, there are exotic derivatives too. A quick help for the worried, therefore.

What is a derivative?

"The derivative of a constant is zero," states en.wikipedia.org, but that may not help those whose understanding is zero about what the word means in finance. Derivative is "a generic term often used to categorise a wide variety of financial instruments whose value `depends on' or is `derived from' the value of an underlying asset, reference rate or index," says www.harperrisk.com, and that's a definition you can depend on, though your comprehension may apparently be constant.

Heard the RBI has said something about derivatives?

True, the central banker has issued draft guidance called `Discussion Paper on Derivative and Hedge Accounting by banks,' dated June 28, and posted on www.rbi.org.in. "The growing complexity, diversity and volume of derivative products have emphasised the urgent need for adoption of uniform principles for recognition, classification, measurement and disclosure of derivatives and their inherent risks in banks' books of accounts and financial statements," it says. Recommended `urgent' read!

I always thought accounting was the hedge!

Accounting has been helpful as a bush, and protective as a hedge, if that's what you mean. But in the matter of accounting for derivatives, we do not have an accounting standard laying down the principles. In the pipeline of the Institute of Chartered Accountants of India (ICAI) is an Accounting Standard on `Financial Instruments: Recognition and Measurement', corresponding to the International Accounting Standard (IAS) 39. "However, the formal introduction of the Accounting Standard for recognition and measurement of financial instruments in India by the ICAI is likely to take some time," frets the Guv.

Can you give me some derivative jargon to impress others with?

Sure! DPL means derivative through profit and loss; derivative through revaluation account' is DRA. Derivatives at cost are DAC. Unrealised gain/ loss is called UGD.

A `forecast transaction' has nothing to do with weather though there are weather derivatives; the phrase means `an uncommitted but anticipated future transaction'. Financial instrument is "any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity of another enterprise." An instrument that cuts both ways, take care!

Is this fair?

Good that you asked. "Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction." Arm's length means `without close contact or an intimate relationship,' says http://encarta.msn.com, lest you throw your arm around. Fair value of a derivative is "the equivalent of the unrealised gain or loss from marking to market the derivative using prevailing market rates or internal valuation technique," explains the RBI. Sure you would never have realised fair could be as tough as it is tough to be fair.

What are embittered derivatives?

Perhaps, you're referring to `embedded'. Such a derivative is "a component of a hybrid (combined) instrument that also includes a non-derivative host contract - with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative." Embittered?

Now, what is a derivative?

Let me run to a hedge... for cover!

SayCheek@TheHindu.co.in

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