Investors in India trade in futures to earn profit. BSE and NSE are the exchanges where futures contracts are traded by participants who are interested in buying or selling. This article provides the basic understanding about trading in futures and also about various aspects related to it.
**PURPOSE OF THIS ARTICLE**
This article will cover various aspects related to trading in futures – governing laws and regulations, valuation and pricing of futures, its accounting treatment in books of trader, Tax Audit and return filing provisions and GST applicability. Let’s first understand meaning of few terms before we begin discussing upon the above aspects.
**MEANING OF VARIOUS TERMS**
The meaning of few terms which have been used in this article are explained below with suitable examples-
It refers to simultaneous purchase and sale of asset in different markets to take the benefit minor differences (due to market inefficiencies, like- pricing errors) and to earn profit. The arbitrage traders buys the asset in one market and sells it in the other market and earns profit= differences between two prices.
A stock is trading at R500 on BSE while at the same moment it is trading at Rs501 on NSE. The trader can buy the stock on BSE and sell the same on NSE, thus earning a profit of Rs1/share.
Futures are derivative financial contracts where the transactions take place at a predetermined future price (irrespective of market price at expiry date) and date.
Futures can be used for speculation or hedging purposes
A trader willing to speculate on the price of wheat enters into futures contract in April.
The July wheat futures are trading at $ 70. Wheat is traded at 1000 quintals.
The investor’s position is $70*1000Quintals = $70,000.
In July, price rose to $80, and trader sells the contract to square off the position. The investor gains ($80-$70)*1000quintals = $10,000.
In July, price falls to $65 and trader sells the contract. The investor loses ($70-$65)*1000quintals=$50,000
It is a % of purchase price of a security that must be paid by cash while using a margin account. The rules for margin calculation are framed with stock exchanges
An investor buys wheat futures contract to buy for Rs15000. Initial margin requirement is 20%. Here, investor will pay an initial margin of 15000*20%=Rs3000
MARKED TO MARKET MARGIN (MTMM)
It is an accounting practice where the asset value is adjusted to reflect the current market value. (Rather than book value)
An investor buys 1 lot of 100 shares of futures on 10.05.2021, when the price was Rs2000. Next day on 11.05.2021, share price rose to Rs2500, then the investor has made a profit of =Rs50000 [(2500-2000)*100shares]. This gain will be credited to the marked-to-market margin (MTMM A/C) account of investor. The position will start from Rs2500 from the next day.
If on next day i.e, 12.05.2020 the price falls to Rs2300, then the loss being Rs20000 [(2500-2300)*100shares] will be debited to MTMM A/C.
The A/c balance will be Rs2300*100shares = Rs230000
It refers to a financial transaction which involves substantial risk, with the expectation to make high profits based on the market price fluctuations.
If a speculator believes that a stock is under-priced, then he/she will purchase the stock (long position) and wait for price to increase. When the price increases he/she will sell the stock and earn profit.
It is a term associated with trading where the trader reverses/closing the existing position to earn profit
MrsA person buys 50 shares of Infosys @Rs100. Next day she sells shares @Rs150 and pays brokerage of Rs5. Net profit earned = (150-100)*50shares=Rs2500. In the given case, position is reversed on the next day – i.e, this is called squaring off a transaction
**LAWS AND REGULATIONS**
As per section 2(ac) of Securities Contract (Regulation) Act, 1956 [SCRA] ,
- a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security
- a contract which derives its value from the prices, or index of prices, of underlying securities
- commodity derivatives; and
- such other instruments as may be declared by the Central Government to be derivatives
The most common derivative instruments are futures, options, forwards and swaps
As per section 18A of SCRA, 1956,
Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are
- traded on a recognised stock exchange;
- settled on the clearing house of the recognised stock exchange,
- in accordance with the rules and bye-laws of such stock exchange.
Thus, futures (being derivatives) are not settled through recognised stock exchange will be invalid.
REGULATORY ENVIRONMENT - SEBI,1992 AND FEMA,1999
As a capital market regulator, SEBI is the primary regulator governing derivatives in India. SEBI protects the interests of the investors and prohibits unethical and illegal practices.
As a foreign exchange regulator in India, RBI issued Foreign Exchange Management Regulations in which provide detailed guidelines about eligible derivative products, exposures that can be covered, permissions, limitations related to foreign exchange derivative contracts.
Prior approval of RBI is required to enter into any derivative contract unless it is expressly permitted in FEMA regulation.
**PRICING OF FUTURES**
The value of futures prices is determined by cost of carry model which is as follows:
Future price= Spot price + carrying cost –returns
Here, carrying costs refers to storage cost, interest cost to acquire and hold the asset, etc.
And returns includes dividend, bonus, etc.
Spot price of stock on 31.01.2021 = 500
Future price for April 2021 = 525
Face value of stock = 10
Time to expiration = 3 months
Borrowing rate = 20%
Annual Dividend payable before April = 30%
Analysis: In the given Q, spot price = Rs500
Carrying cost (interest cost) = Rs10(FV of stock)*20%(rate)*3/12months = Rs25
And dividend = Rs10*30%=Rs3
Future price will be calculated as follows
= Spot price + interest - dividend
As per COC model, futures price is Rs522 which is less than actual price of Rs525. Thus, there exists arbitrage opportunity and trader can take benefit of it.
The trader will buy stock @Rs500 by borrowing @20% for 3months and sell futures. On April dividend of Rs3 will be received.
On expiry date, stock will be delivered to trader against futures sales.
Thus, arbitrager earns profit of Rs3 by taking the advantage of difference in pricing of futures.
On 01.01.2021, MrA purchases futures contract 1000 quintals of wheat @$100. Margin requirement=10%. On 01.01.2021 $1=Rs70. Suppose on 31.03.2021 $1=Rs75.
Pass the appropriate journal entries
Initial margin to be deposited= 1000Q*$100_Rs70_10% = Rs7,00,000
Purchase amount = 1000Q*$100*Rs70 = Rs70,00,000
Loss as on 31.03.2021 = $75-$70 = $5_100Q_$100= Rs50,000
**TAX AUDIT AND RETURN FILING**
There is a specific exclusion in section 43(5) of Income Tax Act of transactions in futures from being treated as speculative. Hence, transactions in futures will be treated as non-speculative and will be taxed as normal business income.
All expenses incurred for business purpose can be claimed against such income.
Example- telephone bills, brokerage, commission, internet costs, consultancy charges, salary. Personal expenditure are not allowable.
Normal provisions of Income Tax Act would be applicable. Normal books of accounts would require to be maintained in accordance with section 44AA provisions.
Tax Audit would be required if turnover exceeds limit as prescribed under section 44AB.
COMPUTATION OF TURNOVER
The transactions in futures are completed without taking the actual delivery of securities. The transactions are squared up (on or before expiry date) by payment of differences and the journal entries in books of accounts are made for such differences.
The total of favourable and unfavourable differences would be considered as turnover
Mr.A has undertaken into 2 transactions-
(i) Purchases lot of futures of Infosys Ltd worth Rs10Lakh and sells it for Rs12Lakh. Profit= 12-10=Rs200000
(ii) Purchases lot of futures of RIL worth Rs7Lakh and sells it for Rs6.5Lakh. Loss=4-7=Rs50000
Total profit= 200000-50000=Rs150000.
However, Turnover for purpose of Tax Audit= 200000+50000= Rs250000
TREATMENT OF LOSS
Since transactions in futures are considered as normal business income (non-speculative), the loss arising can be set off against all incomes except salary income
If the loss is not set off in same financial year, then such loss can be carried forward upto 8 years (and can be set off against future income which can be set off only against non –speculative income) only if return is filed on or before due date.
If transactions are based on actual delivery, then the same will be treated as capital gain and provisions of capital gain would apply accordingly.
Since future contracts are considered as financial derivatives they qualify as securities.
According to section 2(52) of CGST Act, “goods” means every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply.
According to section 2(102) of CGST Act, “Services” means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged
Thus, securities are excluded from definition of goods as well as services. Since securities are neither treated as supply of goods or services, they are outside the scope of supply.
Hence, futures contracts are not liable to GST.
However, if any brokerage or service charges or documentation fees associated with it are levied, then the same would be considered as supply of services and will be chargeable to GST.
If future contracts are settled by way of actual delivery of underlying commodity/currency, then they would be treated as normal supply of goods or services and will be liable to GST.
Futures are effective instruments to earn income from price changes in the underlying stocks, commodities, currencies, indices, etc. Futures have become popular in India and provide opportunities to maximize the returns.