Month: July 2020

Every taxpayer must furnish the details of his income to the Income-tax Department. These details are to be furnished by filing up his return of income. Once the return of income is filed up by the taxpayer, the next step is the processing of the return of income by the Income Tax Department. The Income Tax Department examines the return of income for its correctness. The process of examining the return of income by the Income-Tax department is called as “Assessment”. Assessment also includes re-assessment and best judgment assessment under section 144.

Under the Income-tax Law, there are four major assessments given below:

• Assessment under section 143(1), i.e., Summary assessment without calling the assessee.
• Assessment under section 143(3), i.e., Scrutiny assessment.
• Assessment under section 144, i.e., Best judgment assessment.
• Assessment under section 147, i.e., Income escaping assessment.

Assessment under section 143(1)

This is a preliminary assessment and is referred to as summary assessment without calling the assessee (i.e., taxpayer).

Scope of assessment under section 143(1)

Assessment under section 143(1) is like preliminary checking of the return of income. At this stage no detailed scrutiny of the return of income is carried out. At this stage, the total income or loss is computed after making the following adjustments (if any), namely:

(i) any arithmetical error in the return; or

(ii) an incorrect claim (*), if such incorrect claim is apparent from any information in the return.

(iii) disallowance of loss claimed, if return of the previous year for which set-off of loss is claimed was furnished beyond the due date specified under section 139(1); or

(iv) disallowance of expenditure indicated in the audit report but not taken into account in computing the total income in the return; or

(v) disallowance of deduction claimed u/s 10AA, 80IA to 80-IE, if the return is furnished beyond the due date specified under section 139(1); or

(vi) addition of income appearing in Form 26AS or Form 16A or Form 16 which has not been included in computing the total income in the return. However, no such adjustment shall be made in relation to a return furnished for the assessment year 2018-19 and thereafter.

However, no such adjustment shall be made unless an intimation is given to the assessee of such adjustment either in writing or in electronic mode. Further, the response received from the assessee, if any, shall be considered before making any adjustment, and in case where no response is received within 30 days of the issue of such intimation, such adjustments shall be made.

For the above purpose “an incorrect claim apparent from any information in the return” means a claim on the basis of an entry in the return :-

(i) of an item which is inconsistent with another entry of the same or some other item in such return;

(ii) in respect of which the information is required to be furnished under the Act to substantiate such entry and has not been so furnished; or

(iii) in respect of a deduction, where such deduction exceeds specified statutory limit which may have been expressed as monetary amount or percentage or ratio or fraction;

Procedure of assessment under section 143(1)

• After correcting arithmetical error or incorrect claim (if any) as discussed above, the tax and interest and fee*, if any, shall be computed based on the adjusted income.
• Any sum payable by or refund due to the taxpayer shall be intimated to him.
• An intimation shall be prepared or generated and sent to the taxpayer specifying the sum determined to be payable by, or the amount of refund due to the taxpayer. An intimation shall also be sent to the taxpayer in a case where the loss declared in the return of income by the taxpayer is adjusted but no tax or interest is payable by or no refund is due to him.
• The acknowledgement of the return of income shall be deemed to be the intimation in a case where no sum is payable by or refundable to the assessee or where no adjustment is made to the returned income.

*As per section 234F (as inserted by Finance Act, 2017 with effect from Assessment Year 2018-19), a fee shall be levied where the return of income is not filed within the due dates prescribed under section 139(1). The amount of fee is as follows:-

(a) Rs. 5,000, if the return is furnished on or before the 31st day of December of the assessment year;

(b) Rs. 10,000 in any other case:

Provided that if the total income of the person does not exceed Rs. 5,00,000, the amount of fee shall not exceed Rs. 1000.

Time-limit

Assessment under section 143(1) can be made within a period of one year from the end of the financial year in which the return of income is filed.

Assessment under section 143(3)

This is a detailed assessment and is referred to as scrutiny assessment. At this stage a detailed scrutiny of the return of income will be carried out is to confirm the correctness and genuineness of various claims, deductions, etc., made by the taxpayer in the return of income.

Scope of assessment under section 143(3)

The objective of scrutiny assessment is to confirm that the taxpayer has not understated the income or has not computed excessive loss or has not underpaid the tax in any manner.

To confirm the above, the Assessing Officer carries out a detailed scrutiny of the return of income and will satisfy himself regarding various claims, deductions, etc., made by the taxpayer in the return of income.

Procedure of assessment under section 143(3)

• If the Assessing Officer considers it necessary or expedient to ensure that the taxpayer has not understated the income or has not computed excessive loss or has not underpaid the tax in any manner, then he will serve on the taxpayer a notice requiring him to attend his office or to produce or cause to be produced any evidence on which the taxpayer may rely, in support of the return.
• To carry out assessment under section 143(3), the Assessing Officer shall serve such notice in accordance with provisions of section 143(2).
• Notice under section 143(2) should be served within a period of six months from the end of the financial year in which the return is filed.
• The taxpayer or his representative (as the case may be) will appear before the Assessing Officer and will place his arguments, supporting evidences, etc., on various matters/issues as required by the Assessing Officer.
• After hearing/verifying such evidence and taking into account such particulars as the taxpayer may produce and such other evidence as the Assessing Officer may require on specified points and after taking into account all relevant materials which he has gathered, the Assessing Officer shall, by an order in writing, make an assessment of the total income or loss of the taxpayer and determine the sum payable by him or refund of any amount due to him on the basis of such assessment.

Assessment under section 144

This is an assessment carried out as per the best judgment of the Assessing Officer on the basis of all relevant material he has gathered. This assessment is carried out in cases where the taxpayer fails to comply with the requirements specified in section 144.

Scope of assessment under section 144

As per section 144, the Assessing Officer is under an obligation to make an assessment to the best of his judgment in the following cases:

• If the taxpayer fails to file the return required within the due date prescribed under section 139(1) or a belated return under section 139(4) or a revised return under section 139(5).
• If the taxpayer fails to comply with all the terms of a notice issued under section 142(1).

Assessment under section 147

This assessment is carried out if the Assessing Officer has reason to believe that any income chargeable to tax has escaped assessment for any assessment year

Scope of assessment under section 147

• The objective of carrying out assessment under section 147 is to bring under the tax net any income which has escaped assessment in original assessment.
• Original assessment here means an assessment under sections 143(1), 143(3), 144 and 147 (as the case may be).
• In other words, if any income has escaped (*) from being taxed in the original assessment made under section 143(1) or section 143(3) or section 144 or section 147, then the same can be brought under tax net by resorting to assessment under section 147.

* In the following cases, it will be considered as income having escaped assessment:

• Where no return of income has been furnished by the taxpayer, although his total income or the total income of any other person in respect of which he is assessable during the previous year exceeded the maximum amount which is not chargeable to income-tax.
• Where a return of income has been furnished by the taxpayer but no assessment has been made and it is noticed by the Assessing Officer that the taxpayer has understated the income or has claimed excessive loss, deduction, allowance or relief in the return.
• Where the taxpayer has failed to furnish a report in respect of any international transaction which he was required to do under section 92E.
• Where an assessment has been made, but:

1. income chargeable to tax has been under assessed; or
2. income has been assessed at low rate; or
3. income has been made the subject of excessive relief; or

1. excessive loss or depreciation allowance or any other allowance has been computed;

• Where a person is found to have any asset (including financial interest in any entity) located outside India.
• Where a return of income has not been furnished by the assessee and on the basis of information or document received from the prescribed income-tax authority under section 1 33C(2), it is noticed by the Assessing Officer that the income of the assessee exceeds the maximum amount not chargeable to tax.
• Where a return of income has been furnished by the assessee and on the basis of information or document received from the prescribed income-tax authority under section 133C(2), it is noticed by the Assessing Officer that the assessee has understated the income or has claimed excessive loss, deduction, allowance or relief in the return.

Procedure of assessment under section 147

• For making an assessment under section 147, the Assessing Officer has to issue notice under section 148 to the taxpayer and has to give him an opportunity of being heard. The time-limit for issuance of notice under section 148 is discussed in later part.
• If the Assessing Officer has reason to believe that any income chargeable to tax has escaped assessment for any assessment year, then he may assess or reassess such income and also any other income chargeable to tax which has escaped assessment and which comes to his notice subsequently in the course of the proceedings under this section. He is also empowered to re-compute the loss or the depreciation allowance or any other allowance, as the case may be, for the assessment year concerned.
• Items which are the subject matters of any appeal, reference or revision cannot be covered by the Assessing Officer under section 147.

Time-limit for completion of assessment under section 147

As per Section 153, the time limit for making assessment under section 147 is:

1) Within 9 months from the end of the financial year in which the notice under section 148 was served (if notice is served before 01-04-2019).

2) 12 months from the end of the financial year in which notice under section 148 is served (if notice is served on or after 01-04-2019).

Note: If reference is made to TPO, the period available for assessment shall be extended by 12 months.

Time-limit for issuance of notice under section 148

Notice under section 148 can be issued within a period of 4 (*) years from the end of the relevant assessment year. If the escaped income is Rs. 1,00,000 or more and certain other conditions are satisfied, then notice can be issued upto 6 years from the end of the relevant assessment year.

 In case the escaped income relates to any asset (including financial interest in any entity) located outside India, notice can be issued upto 16 years from the end of the relevant assessment year.

Depreciation under the Income Tax Act is a deduction allowed for the reduction in the real value of a tangible or intangible asset used by a taxpayer. The concept of depreciation is used for the purpose of writing off the cost of an asset over its useful life.

Depreciation is a mandatory deduction in the profit and loss statements of an entity and the Act allows deduction either in Straight-Line method or Written Down Value (WDV) method. The calculation for depreciation under the WDV method is widely used except for undertaking engaged in generation or generation and distribution of power. The Act also allows a deduction for additional depreciation in the year of purchase in certain circumstances. To read about additional depreciation visit Additional Depreciation Under the Income Tax Act.

Block of Assets: Concept

Depreciation is calculated on the WDV of a Block of assets. Block of assets is a group of assets falling within a class of assets comprising of:

• Tangible assets, being building, machinery, plant, or furniture,
• Intangible assets, being know how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature

The block of assets is classified further depending on the similar use, life of the asset and nature of the asset.

Conditions for Claiming Depreciation

You can avail deduction for depreciation, only if it satisfies the following conditions.

1. The assets must be owned, wholly or partly, by the assessee.
2. The assets must be in use for the business or profession of the taxpayer. If the assets are not used exclusively for the business, but for other purposes as well, depreciation allowable would be proportionate to the use of business purpose. The Income Tax Officer also has the right to determine the proportionate part of the depreciation under Section 38 of the Act.
3. Co-owners can claim depreciation to the extent of the value of the assets owned by each co-owner.
4. You cannot claim depreciation on the cost of land.
5. Depreciation is mandatory from A.Y. 2002-03 and shall be allowed or deemed to have been allowed as a deduction irrespective of a claim made by a taxpayer in the profit & loss account.

Written Down Value

As per Section 32(1) of the IT Act depreciation should be computed at the prescribed percentage on the WDV of the asset, which in turn is calculated with reference to the actual cost of the assets. In the context of computing depreciation, it is important to understand the meaning of the term ‘WDV’ & ‘Actual Cost’.

WDV under the Income Tax Act means:

1. Where the asset is acquired in the previous year, the actual cost of the asset shall be treated as WDV.
2. Where the asset is acquired in an earlier year, the WDV shall be equal to the actual cost incurred less depreciation actually allowed under the Act.

Depreciation Allowed

• The allowance for depreciation is calculated under the WDV method except for undertaking engaged in generation or generation and distribution of power. The depreciation rates are given in Appendix 1. In the case of undertakings engaged in generation or generation and distribution of power, such undertaking has an option to claim depreciation on WDV method at the rates provided in New Appendix I – if such option is exercised before the due date of filing the return.

In the case of amalgamation or demerger, the aggregate depreciation allowance shall be apportioned between the amalgamating and the amalgamated company, or the demerged and the resulting company. The aggregate depreciation would be computed as if the amalgamation or demerger had not taken place. It shall be apportioned based on the number of days the assets were used by such companies.

In case of a finance lease transaction, the lessee has to capitalise the assets in its books under AS-19 – the Accounting standard on leases. In such cases, the lessee can exercise the rights of the owner in his own right and hence the allowance for depreciation is available to the lessee.

Depreciation Rates as per the Income Tax Act

Part A Tangible Assets:

Part B Intangible Assets:
Patents, know-how, trademarks,franchises,copyrights, licenses or any other commercial or business right of similar nature – 25% is the Depreciation Rate.

Section 80GG: House Rent Paid

Deduction for House Rent Paid Where HRA is not Received

1. Section 80GG deduction is available for rent paid when HRA is not received. The taxpayer, spouse or minor child should not own residential accommodation at the place of employment
2. The taxpayer should not have self-occupied residential property in any other place
3. The taxpayer must be living on rent and paying rent
4. The deduction is available to all individuals

Section 80GGB: Company Contribution

Deduction on contributions given by companies to Political Parties

Section 80GGB deduction can an Indian company for the amount contributed by it to any political party or an electoral trust. Deduction is allowed for contribution done by any way other than cash.  

the deductions U/s 80IA which is coming to end for certain categories of enterprises in respect of certain incomes.

(a) Developing Roads etc.:  The eligible enterprise should commence business between 01.04.1995 and 31.03.2017.  100% of profit for any 10 consecutive assessment years in a block of 20 years commencing from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1995 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(b) Developing Ports etc.: The eligible enterprise should commence business between 01.04.1995 and 31.03.2017.  100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming between 01.04.1995 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(c) Telecommunication Services: The eligible enterprise should commence business between 01.04.1995 and 31.03.2005.  100% of profit for first 5 assessment years and 30% for next five assessment years for any 10 consecutive years in a block of 15 years commencing from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1995 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.  Further, A.Y. 2020-21 is the last year of the block of 15 years after which the deduction will never be available.

(d) Industrial Parks: The industrial park should be notified by the Central Govt. in accordance with the scheme framed between 01.04.1997 and 31.03.2011. 100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1997 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(e) Special Economic Zones: The SEZs should be notified by the Central Govt. in accordance with the scheme framed between 01.04.1997 and 31.03.2005. 100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1997 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21. Further, A.Y. 2020-21 is the last year of the block of 15 years after which the deduction will never be available.

(f) Generation or generation and distribution of Power: The business should commence between 01.04.1993 and 31.03.2017. 100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1993 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(g) Laying a Network: The business should commence between 01.04.1999 and 31.03.2017. 100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.1999 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(h) Substantial Renovation and Modernisation: The business should commence between 01.04.2004 and 31.03.2017. 100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the enterprise starts business. Accordingly, for those enterprises who commenced business & started claiming deduction between 01.04.2004 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

(i) Reconstruction or revival of a power generating plant: The company must be notified before 31.12.2005 by the Central Government. Such undertaking begins to generate or transmit or distribute power before 31.03.2011.  100% of profit for any 10 consecutive assessment years in a block of 15 years starting from the previous year in which the company starts business.  Accordingly, for those companies who commenced business & started claiming deduction between 01.04.2006 and 01.04.2009, the deduction came to end for them w.e.f. A.Y. 2020-21.

Sec – 80-Ib: Deduction In Respect Of Profit And Gains From Industrial Undertakings Other Than Infrastructure Development Undertakings

1. The deduction in case of an assessee whose gross total income includes any profits and gains from any business of an industrial undertaking, shall be of the following amount:

i. In case of an industrial undertaking located in an industrial Backward State:

1. For the initial 5 assessment years: 100% of the profit and gains derived from such undertaking and
2. Thereafter, for the next 5 assessment years: 25% of the profits and gains derived from such industrial undertaking. (30% in case of a company) (25% for 7 assessment years in case of co-operative society)

ii. In case of an industrial undertaking located in an industrial Backward district:

1. For the initial 5 assessment years: 100% of the profit and gains derived from such undertaking and
2. Thereafter, for the next 5 assessment years: 25% of the profits and gains derived from such industrial undertaking. (30% in case of a company) (25% for 7 assessment years in case of co-operative society)

Note: The deduction is available to an Industrial Undertaking, which fulfills all the following conditions:

1. It is not formed by splitting up, or the reconstruction of a business in existence.

Exception: If re-construction takes place in the circumstances and period given in section 33B, then deduction is available.

1. It is not formed by the transfer to a new business of machinery or plant previously used for any purpose. [Note: The deduction under section 80IB shall be available if the new undertaking is started in an old building or if old furniture and fittings are used]

Exception:

1. Imported old Plant & Machinery
2. 20% of total Plant & Machinery can be old.
3. It begins to manufacture or produce articles or things at any time up to 31-03-2004. For Jammu & Kashmir sunset date is 31-03-2012.
4. The undertaking employs ten or more workers in a manufacturing process carried on with the aid of power or employs twenty or more workers in a manufacturing process carried on without the aid of power.
5. The deduction is available to any undertaking which begins commercial production or refining of mineral oil in any part of India. The deduction is 100% of the profits from such business for the 7 consecutive assessment years including the initial assessment year. Initial assessment year means the assessment year relevant to the previous year in which the undertaking commences the commercial production or refining of mineral oil.
6. The deduction under section 80-IB shall be:

• 100% of the profits for a period of 7 consecutive Assessment Years
• Derived from an undertaking which is engaged in commercial production of natural gas in blocks licensed under the New Exploration Licensing Policy (NELP)
• And which begins commercial production of natural gas
• The deduction shall commence from the AY relevant to the previous year in which the undertaking commences commercial production of natural gas.

Explanation: For the purpose of claiming deduction under this section, all blocks licensed under a single contract, which has been awarded under the NELP, shall be treated as a single undertaking. (This explanation is relevant for both mineral oil and natural gas)

3. The amount of deduction in the  case of an undertaking developing and building housing projects approved by a local authority shall be 100% of the profits derived in any previous year from such housing project if:

• such undertaking commences development and construction of the housing project and completes such construction within 5 years, from the end of the financial year in which the housing project is approved by the local authority.

• the project is on the size of a plot of land which has a minimum area of an acre

• the residential unit has a maximum built-up area of 1000 square feet where such residential unit is situated within the city of Delhi or Mumbai or within 25 kilometers from the municipal limits of these cities and 1500 square feet at any other place and

• the built up area of the shops and other commercial establishments included in the housing project does not exceed 3% of the aggregate built-up area of the housing project or five thousand square feet, whichever is higher.

• Not more than one residential unit in the housing project is allotted to any person not being an individual and

• in a case  where a residential unit in the housing project is allotted to a person being an individual, no other residential unit in such housing project is allotted to any of the following persons, namely:

i. The individual or the spouse or the minor children of such individual

ii. The HUF in which such individual is the Karta

iii. The person representing such Individual, the spouse or the minor children of such individual or the HUF in which such individual is the Karta.

The deduction is 100% of the profits derived from the housing project in any previous year. It is possible that the residential units are sold say over a period of 6 years, then the deduction shall be profits derived during these 6 years from the housing project.

Note: Deduction can be claimed on a year to year basis where assessee is showing profit from partial completion of project. If later any of the condition is violated, then deduction allowed in earlier years shall be withdrawn.

4. The amount of deduction in the case of an undertaking deriving profits from the business of operating and maintaining a hospital located anywhere in India, other than the excluded area, shall be 100% of the profits and gains derived from such business for a period of 5 consecutive assessment years, beginning with  the initial assessment year, if:
5. The hospital has at least 100 beds for patients
6. The construction of the hospital is in accordance with the regulations or bye-laws of the local authority.

80IC

Tax subsidy for enterprises in Himachal Pradesh, Sikkim, Uttaranchal and North – Eastern states

For the purpose to set up more industries for overall development of some less developed states in India, this section came into the picture. The major objective of providing tax holiday to specified states is to promote and encourage industrial development in those states.

Deduction under this section is available to undertakings established in specified states. Under this section, eligible assessee will get tax deduction on profits under business head for specified period of time.In this blog, we will discuss the list of states covered who are eligible to claim deduction, conditions and amount of deduction etc. This section was inserted from the assessment year 2004-05.

States covered under section 80-IC

Value at risk (VAR or sometimes VaR) has been called the “new science of risk management,” but you don’t need to be a scientist to use VAR.

Here, in part 1 of this short series on the topic, we look at the idea behind VAR and the three basic methods of calculating it.

alue at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.

For a given portfolio, time horizon, and probability p, the p VaR can be defined informally as the maximum possible loss during that time after we exclude all worse outcomes whose combined probability is at most p. This assumes mark-to-market pricing, and no trading in the portfolio.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, that means that there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one-day period if there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day out of 20 days (because of 5% probability).

More formally, p VaR is defined such that the probability of a loss greater than VaR is (at most) p while the probability of a loss less than VaR is (at least) 1−p. A loss which exceeds the VaR threshold is termed a “VaR breach”.

The Idea Behind VAR

The most popular and traditional measure of risk is volatility. The main problem with volatility, however, is that it does not care about the direction of an investment’s movement: stock can be volatile because it suddenly jumps higher. Of course, investors aren’t distressed by gains.

For investors, the risk is about the odds of losing money, and VAR is based on that common-sense fact. By assuming investors care about the odds of a really big loss, VAR answers the question, “What is my worst-case scenario?” or “How much could I lose in a really bad month?”

Now let’s get specific. A VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the question that VAR answers:

• What is the most I can – with a 95% or 99% level of confidence – expect to lose in dollars over the next month?
• What is the maximum percentage I can – with 95% or 99% confidence – expect to lose over the next year?

You can see how the “VAR question” has three elements: a relatively high level of confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in dollar or percentage terms).

Methods of Calculating VAR

Institutional investors use VAR to evaluate portfolio risk, but in this introduction, we will use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which is traded through the Invesco QQQ Trust. The QQQ is a very popular index of the largest non-financial stocks that trade on the Nasdaq exchange.

There are three methods of calculating VAR: the historical method, the variance-covariance method, and the Monte Carlo simulation.

1. Historical Method

The historical method is the simplest method for calculating Value at Risk. Market data for the last 250 days is taken to calculate the percentage change for each risk factor on each day. Each percentage change is then calculated with current market values to present 250 scenarios for future value. For each of the scenarios, the portfolio is valued using full, non-linear pricing models. The third worst day selected is assumed to be 99% VaR.

Where:

• v_i is number of variables on day i
• m is the number of days from which historical data is taken

2. Parametric Method

The parametric method is also known as the variance-covariance method. This method assumes a normal distribution in returns. Two factors are to be estimated – an expected return and a standard deviation. This method is best suited to risk measurement problems where the distributions are known and reliably estimated. The method is unreliable when the sample size is very small.

Let loss be ‘l’ for a portfolio ‘p’ with ‘n’ number of instruments.

3. Monte Carlo Method

Under the Monte Carlo method, Value at Risk is calculated by randomly creating a number of scenarios for future rates using non-linear pricing models to estimate the change in value for each scenario, and then calculating the VaR according to the worst losses. This method is suitable for a great range of risk measurement problems, especially when dealing with complicated factors. It assumes that there is a known probability distribution for risk factors.

Advantages of Value at Risk (VaR)

1. Easy to understand

Value at Risk is a single number that indicates the extent of risk in a given portfolio. Value at Risk is measured in either price units or as a percentage. This makes the interpretation and understanding of VaR relatively simple.

2. Applicability

Value at Risk is applicable to all types of assets bonds, shares, derivatives, currencies, etc. Thus, VaR can be easily used by different banks and financial institutions to assess the profitability and risk of different investments, and allocate risk based on VaR.

3. Universal

The Value at Risk figure is widely used, so it is an accepted standard in buying, selling, or recommending assets.

Limitations of Value at Risk

1. Large portfolios

Calculation of Value at Risk for a portfolio not only requires one to calculate the risk and return of each asset but also the correlations between them. Thus, the greater the number or diversity of assets in a portfolio, the more difficult it is to calculate VaR.

2. Difference in methods

Different approaches to calculating VaR can lead to different results for the same portfolio. 3. Assumptions

Calculation of VaR requires one to make some assumptions and use them as inputs. If the assumptions are not valid, then neither is the VaR figure.

Key Elements of Value at Risk

• Specified amount of loss in value or percentage
• Time period over which the risk is assessed
• Confidence interval

Swaps are used to manage risk in a couple ways. First, you can use swaps to ensure favorable cash flows, either through timing (as with the coupons on bonds) or through the types of assets being exchanged (as with foreign exchange swaps that ensure a corporation has the right type of currency). The exact nature of the risk being managed depends on the type of swap being used.

Four types of swaps are interest rate, currency, equity, and commodity swaps.

• Interest rate swaps typically involve one side paying at a floating interest rate and the other paying at a fixed interest rate. In some cases both sides pay at a floating rate, but the floating rates are different.
• Currency swaps are essentially interest rate swaps in which one set of payments is in one currency and the other is in another currency. The payments are in the form of interest payments; either set of payments can be fixed or floating, or both can be fixed or floating. With currency swaps, a source of uncertainty is the exchange rate so the payments can be fixed and still have uncertain value.
• In equity swaps, at least one set of payments is determined by the course of a stock price or stock index.
• In commodity swaps at least one set of payments is determined by the course of a commodity price, such as the price of oil or gold.

The easiest way to see how companies can use swaps to manage risks is to follow a simple example using interest-rate swaps, the most common form of swaps.

1. Company A owns $1,000,000 in fixed rate bonds earning 5 percent annually, which is $50,000 in cash flows each year.
2. Company A thinks interest rates will rise to 10 percent, which will yield $100,000 in annual cash flows ($50,000 more per year than their current bond holdings), but exchanging all $1,000,000 for bonds that will yield the higher rate would be too costly.
3. Company A goes to a swap broker and exchanges not the bonds themselves but the company’s right to the future cash flows.

Company A agrees to give the swap broker the $50,000 in fixed rate annual cash flows, and in return, the swap broker gives the company the cash flows from variable rate bonds worth $1,000,000.

4. Company A and the swap broker continue to exchange these cash flows over the life of the swap, which ends on a date determined at the time the contract is signed.

Revenue generation and swap derivatives

When pursuing opportunities to generate revenue through swaps, the process is no different, but the motivation behind the swap is to take advantage of differentials in the spot and anticipated future values related to the swap. To see how revenue generation works with swaps, consider the following example, which involves foreign exchange swaps, a simpler but less common form of swap (in the example, USD = U.S. dollar):

1. Company A has USD 1,000 and believes that the Chinese Yuan (CNY) is set to increase in value compared to the USD.
2. Company A gets in touch with Company B in China, which just happens to need USD for a short time to fund a capital investment in computers coming from the U.S.
3. The two companies agree to swap currency at the current market exchange rate, which for this example, is USD 1 = CNY 1.

They swap USD 1,000 for CNY 1,000. The swap agreement states that they’ll exchange currencies back in one year at the forward rate (also USD 1 = CNY 1; it’s a very stable market in Example-World).

In the example, Company B needs the currency but doesn’t want to pay the transaction fees, while Company A is speculating on the change in exchange rate. If the CNY were to increase by 1 percent compared to the USD, then Company A would make a profit on the swap.

If the CNY were to decrease in value by 1 percent, then Company A would lose money on the swap. This potential for loss is why using derivatives to generate income is called speculating. (Did you know the term speculate means “to come by way of very loose interpretation” or “to guess”?)

Valuation of swap derivatives

The value of a swap isn’t very difficult to measure. Simply put, you start with the value of what you’re receiving plus any added value that results from changes in rates or returns and then subtract the value of what you’re giving away plus any increases in value associated with interest earned or changes in rates.

Of course, as with all known valuations, this is a hindsight calculation. When you’re estimating future value, the calculations involve the time value of money and the probabilities of event occurrences, both of which should be treated in the same manner as estimating the value of futures. Remember that a swap is nothing more than a combination of a spot rate exchange and a futures exchange in a single contract.

Many investors mistakenly believe that options are always riskier investments than stocks because they may not fully understand what options are exactly and how they work. Options, in fact, can be used to hedge positions and reduce risk, such as with a protective put. Options can also be used to bet on a stock going up or down, but with relatively less risk than owning or shorting the actual equivalent in the underlying stock. This latter use of options to minimize risk in making directional bets will be the focus of this article. Read on to learn how to calculate the potential risk of options positions and how the power of leverage can work in your favor.

Here are five ways to effectively manage risk as an option trader:

• The first step in managing risk as an option trader is position sizing. When buying options the amount of capital you spend buying an option contract long is the most you can lose if your option expires worthless before expiration. The best way to avoid the risk of ruin when trading options is to never put on a position size greater than 1% to 2% of your total trading capital. If you have a $50,000 option trading account your maximum option trade should be $500.
• When selling option contracts to open your risk can be theoretically unlimited unless you buy a farther out option as a hedge. Using fix loss option plays is important so you cap the amount of your losses if a strong trend moves against your short option. You should buy your hedge at the location of price you want to cap losses at.
• If you sell a covered call your risk is in the stock. You can set a stop loss for your stock position where you will cut your losses short and buy to cover your short call.
• If you sell a married put your risk is in the short stock. You can set a stop loss for your short stock position where you will cut your losses short and buy to cover your short stock and buy to close your short put option.
• Do not put on option plays with open risk or undefined risk. It is very dangerous to expose yourself to uncapped and unlimited risk selling options short, the odds are that eventually you will be ruined on one outsized move. Always have an exit strategy when you sell option contracts. Option hedges are insurance that will pay for their self over the long term.
• Options and Leverage

Let us first consider the concept of leverage, and how it applies to options. Leverage has two basic definitions applicable to options trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into the most trouble. A dollar invested in a stock, and the same dollar invested in an option does not equate to the same risk.

The second definition characterizes leverage as maintaining the same sized position but spending less money doing so. This is the definition of leverage that a consistently successful trader or investor incorporates into his or her frame of reference.

• Options contracts can be used to minimize risk through hedging strategies that increase in value when the investments you are protecting fall.
• Options can also be used to leverage directional plays with less potential loss than owning the outright stock position.
• This is because long options can only lose a maximum of the premium paid for the option, but have potentially unlimited profit potential.