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Double Taxation Avoidance Agreement (DTAA)

What is double taxation?
Double taxation can be defined as the levy of taxes on income / capital in the hands of the same tax payer in more than one country, in respect of the same income or capital for the same period. Double taxation may arise when the jurisdictional connections, used by different countries, overlap or the taxpayer may have connections with more than one country.

What are the different jurisdictional connections used by countries?
Broadly, there are three groups of countries:
Status Jurisdiction- Anglo-Saxon System: Status of the taxpayer is the jurisdictional test. E.g. Citizenship in USA. An American citizen pays US tax on his global income. In the case of India, residence in the country is the jurisdictional test. I.e., if a taxpayer is a resident of India, he will pay tax in India on his world income. In the case of estate duty, the jurisdictional test is domicile. Features of Status jurisdiction:
Jurisdictional connection is the personal status of the taxpayer--rather than the source of his income;
In the case of companies, fiscal domicile (location of the seat of management) and not legal domicile (place of incorporation) is the jurisdictional test;
Tax is paid on global income, i.e., income from domestic and foreign sources are taxed (global in character);
Tax rates are applied on the total global income (canon of equity);
Economically advanced countries like US, UK, Germany, Sweden, and Netherlands follow this system.
Source Jurisdiction: European countries follow source jurisdiction. Income, arising or accruing from a source within the country, is subject to taxation. Features of Source Jurisdiction:
The jurisdictional connection is the source of income;
Only income from domestic sources is taxed (territorial rule of jurisdiction);
A schedular system is followed i.e., income from each source in the country is computed and taxed, separately;
France, Latin American countries and some Middle East countries follow this system.
Both Status and Source Jurisdiction: India follows both the methods. However, unlike source jurisdiction countries, income from each source is not taxed separately, though it is computed under each source. The aggregate income from all sources is taxed, applying the principle of progressive taxation, thus satisfying the canon of equity. However, it results in double taxation in many ways. E.g. ‘A’, an American citizen gets income from his investment in India and pays tax in India since his source of income is in India. He also has to pay tax on this income in the US, since he is an American citizen and, thus, is liable to pay tax on his global income.

What is the need for Double Taxation Avoidance Agreements?
Due to the phenomenal growth in international trade and commerce and increasing interaction among nations, citizens, residents and businesses of one country extend their sphere of activity and business operations to other countries, where income is earned. It is in the interest of all countries to ensure that an undue tax burden is not cast on persons who earn an income, by taxing them twice; once in the country of residence and again, in the country where the income is derived. At the same time, sufficient precautions are also needed to guard against tax evasion and to facilitate tax recoveries.
To avoid hardship to individuals and also with a view to seeing that national economic growth does not suffer, the Central Government, under Section 90 of the Income Tax Act, has entered into double tax avoidance agreements with other countries.
These Tax Treaties serve the following purposes:
Provide protection to tax-payers against double taxation and thus, prevent any discouragement which the double taxation may otherwise create in the free flow of international trade, international investment and international transfer of technology;
Prevent discrimination between the tax-payers in the international field;.
Provide a reasonable element of legal and fiscal certainty within a legal framework;
They also contain provisions for mutual exchange of information and for reducing litigation by providing for mutual assistance procedure.
The Government of India has entered into Double Tax Avoidance Agreement agreements with several countries, including Australia, Austria, Bangladesh, Belgium, Brazil, Bulgaria, Canada, China, Cyprus, (erstwhile) Czechoslovakia, Denmark, Egypt, Finland, France, Germany, Greece, Hungary, Indonesia, Israel, Italy, Japan, Kenya, Korea (South), New Zealand, Norway, Philippines, Poland, Romania, Singapore, Sri Lanka, Sweden, Switzerland, Syria, Tanzania, Thailand, Turkey, U.A.E., United Kingdom, United States of America, U.S.S.R. (Russian Federation) Vietnam and Zambia.

What are the different models for DTA Agreements?
These are essentially the UN (United Nations) and the OECD (Organisation of Economic Co-operation and Development) Models for DTA Agreements. The UN Model for a DTA Agreement takes into consideration the requirements of and the prevailing conditions in the developing countries and safeguards their interests, while the OECD Model is biased in favour of the developed countries. India’s DTA Agreements are mostly based on the UN Model. The US has its own model which issued for DTAs with United States.

Who is covered by a DTA Agreement between India and another country?
A typical DTA Agreement between India and another country usually covers persons who are residents of India or the other contracting country, which has entered into the agreement with India. A person, who is not resident either of India or of the other contracting country, would not be entitled to benefits under DTA Agreements.

How is the term ‘resident’ defined in a DTA Agreement?A resident: The definition of the term, ‘resident,’ is central to the application of a treaty because treaties often assign the taxing authority to the state of residence. Each contracting state defines ‘residence’ for individuals and companies under its domestic law. However, the definition of residence under a DTAA may be the same as that under the regular tax laws of a contracting state, i.e. based on the number of days’ stay in that country or other such criterion, or on the basis of whether he has a permanent home in both states, or where his personal and economic relations (center of vital interest are greater. If the center of the vital interests cannot be determined, then the ‘habitual abode’ test is applied. In the absence of habitual abode, citizenship may be the determining factor. If the person is a citizen of both/ states or neither, some DTAAs specify that it will be the phase of effective management which is determinative.

If a provision under the domestic Income-tax Act is more beneficial than a corresponding provision in the DTA Agreement, then which will apply?A situation may arise when, originally, the tax provision in the other contracting state gave concessional treatment compared to India at a particular time. However, Indian laws were subsequently amended to bring incidence of tax to a level, lower than the tax rate, existing in the other contracting state. Since the tax treaties are meant to be beneficial and not intended to put tax payers of a contracting state to a disadvantage, it is provided in Sec. 90 (2) that beneficial provisions, under the Income Tax Act of India will not be denied to residents of a contracting state, merely because the corresponding provision in a tax treaty are less beneficial. Thus, whichever is more beneficial, betweenthe treaty and (Indian) Income-tax Act provisions, will apply.

What is meant by the term ‘permanent establishment’?One important term that occurs in all the Double Taxation Avoidance Agreements is the term 'Permanent Establishment' (PE), which has not been defined in the Income- tax Act. There is a consensus that the host country can tax income of foreign companies only if it maintains a PE. Normally, a PE includes the following:
a place of management;
a branch;
an office;
a factory.
Thus, a PE takes the form of a facility, a construction site or an agency relationship, all of which require a measure of permanence. India’s approach has been to enlarge the definition of PE, so as to get maximum tax revenue. In general terms, a business connection is deemed to exist if there is any continuous relationship between a business carried on in India and, a non-resident person who derives income through this connection. There must be a continuity of transactions so as to establish a business connection. Normally, the time period to constitute a PE in the host country is six months. Another issue is the scope of income earned by a PE in a country, i.e., what is the portion of the income of PE earned in India that can be taxed. Under the ‘Attribution Rule’, only those profits are taxable which are attributable to the PE, computed on the basis of a hypothesis that the establishment in a country is completely independent of the head office in another country. The profits, which such an independent enterprise might be expected to derive on the amount so ascertained, are taken into account in the computation of the business income of the PE. Under the “force of an attraction rule”, the income, arising from all sources in a country, where a foreign enterprise maintains a PE is subject to tax in that country. This means that in addition to the profits attribution to the PE, those attributable to the sale of goods or merchandise and activities, similar to those carried on through the PE in another country are also taxable in the source country. Thus, in keeping with India’s stand that the country of source has a greater right to tax the profits of all enterprises of the country as compared to what it had in the treaties, based on the OECD model. As an alternative, all income in the source country which is not covered by the PE may be subject to the withholding tax if under the domestic law of the country, the income in question is taxable.
What is meant by the term ‘business income’?As a general rule, each country will tax a non-resident enterprise, engaged in the active pursuit of business in its territory, with a certain degree of intensity and regularity. Historically, the treatment of business income of a taxpayer is governed by a tax convention, which is tied to the ‘permanent establishment’ concept. A business enterprise or undertaking is subject to income tax on its industrial and commercial profits on parity with local enterprises in a treaty country, but only when it is engaged in trade or business in the country through a permanent establishment.
How is income from Air and Shipping Transport, taxed under a DTA agreement?Income, derived from the operation of Air transport in international traffic by an enterprise of one contracting state, will not normally be taxed in the other contracting state. An air transport company will be liable to tax only in the treaty country in which it is incorporated. However, this does not apply to aircraft companies, engaged in domestic traffic. In respect of an enterprise of one contracting state, income earned in the other contracting state from the operation of ships in international traffic, will be taxed in that contracting state, wherein the place of effective management of enterprise is situated. However, some DTA agreements contains provisions to tax the income in the other contracting state also, although, at a reduced rate. These provisions do not apply to coastal traffic.
How are associated enterprises taxed under DTA Agreements?In order to plug loop holes for tax evasion, there is generally a separate article in DTA agreement, which provides for taxing the notional income, deemed to arise on account of an enterprise of one contracting state, participating directly/indirectly in the management of another enterprise in the other contracting state or, where some persons participate directly or indirectly in both the enterprises, under conditions different from those existing between the independent enterprises
How is dividend income taxed under a DTA Agreement?Dividend paid out by a company in country A to a resident of country B could e taxed in both countries. Prior to 1st June 1997, a dividend, received by a shareholder from an Indian company was taxable in India. However, the DTAAs provide for a concessional rate of tax, e.g. 5% or 10%, as against the normal rate of tax of 25% under section 115A of the Income-tax Act. A resident of another contracting State, entitled to the receipts of a DTAA, was therefore entitled to opt for the lower rate of tax to be applied to him in the paying country. In India, with effect from 1st June 1997 to 31st March 2002 a tax on distribution of dividends is to be paid by the Company on distributing the dividends. No tax is levied by India on the recipient of the dividend. However, by virtue of the Finance Act 2002, dividend is again taxable in the hands of the recipient with effect from AY: 2003-2004 and therefore the taxability of dividend under the DTAA assumes significance.
How is interest income taxed under a DTA Agreement?Taxation of Interest Income under DTA agreement: Interest, paid in a Contracting State to a resident of the other Contracting State is chargeable in both the States. Usually, the following are the common features in all DTA Agreements, regarding the taxation of income from interest:
If the payee is the Government or the Central Bank of the Government or a Government agency, the interest would usually be exempt from tax in the country in which the payment is made.
Penalty charges for late payment e.g. for defaults in clearance of dues for purchases will not constitute interest nor will any item be treated as dividend, though styled as dividend by the taxpayer or the person with whom he has the relevant transaction.
There will be no deduction of tax at source if the payee has a permanent establishment in the country from which the payment is made, or if he is engaged in professional services there. In this case, the income will be covered by his assessment to tax in that country in the ordinary course.
Interest will be deemed to arise in that State in which the payer resides.
How is income from royalties taxed under a DTA Agreement? Regarding Royalties, arising in a Contracting State, that are paid to a resident of the other Contracting State:-
Some DTA agreements provide for taxation in the other Contracting State.
Some agreements provide for taxation in the contracting State.
Some agreements provide for taxation in both the States.
How is income from capital gains taxed under a DTA Agreement?Capital Gains will usually be taxed in the state where the capital asset is situated at the time of sale. However, some DTAAs-- e.g. India’s agreements with Mauritius and with Cyprus provide that there will be no Capital gains tax on the sale of shares in one contracting state by a resident of the other Contracting State.
How is income from professional services taxed under a DTA Agreement?Income will be taxed in the state where the person is resident and practicing his profession. However, if he has a fixed base in the other Contracting State, the income, attributable to the fixed base, will be taxed in the other contracting state. Some treaties also specify that a professional will be liable to tax if he stays in another country for more than a specified number of days, (183 days for most treaties but 90 for the US) and derives income in that country, even if he does not have a ‘fixed base’ there.
How are disputes, regarding the interpretation of a DTA Agreement, resolved?If there are any disputes in the interpretation or implementation of the terms of DTA Agreements, normal remedies of appeal, provided in the Income-tax Act, are available to the aggrieved party. The DTA Agreements also contain mutual agreement procedures. The aggrieved party may approach the Competent Authority of the Contracting State wherein he is a resident, who, if he is unable to resolve the dispute by himself, will approach the competent Authority of the other Contracting State to arrive at a solution after mutual discussion. The (Indian) Income-Tax Act also contains a special provision, which is offered to those Non- residents who would like to have advance ruling on a matter of law or fact, in relation to a transaction undertaken or proposed to be undertaken by them. The facilities, available in such provision, can be availed of by Non-residents in the matters regarding Double Taxation of income, also.
What is meant by the term ‘other income’?Any income, not specifically covered in the treaties, is usually subject to tax in the State in which the income arises
What is meant by withholding rate of tax?Usually, taxation of income of an enterprise in any State is on net basis, i.e., after allowing all relatable expenses. However, in case of non-resident recipients, who have no organisation of funds in the country of source, it becomes difficult for the source country to arrive at the taxable income using normal methods. Such income usually relates to dividends, interest, royalties and fees for technical services, shipping profits and aircraft profits. In order to remove uncertainties for both sides, the usual practice now is to specify in domestic laws, the rates of tax on gross basis. This tax is to be charged on dividends, interest and royalties or fees for services, which would be deducted at source from the payments, before they are remitted out of the country. Such retention of tax is termed as ‘withholding tax’.
What is meant by ‘treaty shopping’?In the present age of economic globalization, both individuals and corporates are ever anxious to find ways and means of minimizing their tax burden. One way to do so is by moving to a tax haven, i.e., a tax jurisdiction, where the tax incidence is very small, sometimes even nil. Another way of doing this is to take the benefit of the double taxation avoidance agreements, entered into by one country with one or more other countries. This amounts to treaty shopping, which is a method of using or misusing the tax treaties by taking advantage by investing in low tax countries. In effect, there may be a situation where a person, resident in a third State, seeks to obtain the benefit of a double tax treaty between two other countries. MNCs shop for DTA Agreements, signed by countries to obtain fiscal advantages. It is used by investors for the following purposes:
to reduce the source country taxation;
to pay a low or zero effective rate of tax in the payee treaty country; and,
to pay a low or zero tax rate on payments from the payee treaty country to the tax-payer.
What is a tax haven?The Organization for Economic Co-operation & Development (OECD) has laid down four determinants for a tax haven. These include the following:
Lack of effective exchange of information;
Lack of transparency;
Attracting business with no substantial activities.
What is a harmful preferential tax regime?
The OECD defines a harmful preferential tax regime as one that:
imposes a low or zero effective tax rate on the relevant income;
the regime is ring-fenced (that is, it does not offer its domestic tax-payers the same incentives for the same activity as are offered to foreigners);
operation of the regime is non-transparent and there is no effective exchange of information with other countries.
What are the salient features of the Indo-Mauritius DTA Agreement?
The DTA Agreement between India and Mauritius was entered into in 1982. Some of the salient features of this treaty are as follows:
Article 4 of the Indo-Mauritius DTA Agreement defines a ‘resident’ of one State to mean "any person, who under the laws of that State is liable to taxation therein by reasons of his domicile, residence, place of management or any other criterion of a similar nature". Many Foreign Institutional Investors and other investment funds, etc., operating in India are incorporated in Mauritius. These entities are’ liable to tax’ under the Mauritius tax law and are, therefore, to be considered as residents of Mauritius in accordance with the DTA Agreement between these two countries. However, it may be noted that a recent ruling Delhi Court quashed the Circular No 789 dated 13th April, 2000 issued by CBDT according to which the production of these residency certificate from authorities in Mauritius were sufficient proof for authorities in India for the residential status in India. Therefore it is now open for assessing officers to determine the residential status after a detailed summary and merely production of tax residency certificate from the Mauritius tax authority is not a sufficient proof to establish the residential status and the beneficial ownership of an entity setup in Mauritius.
Capital gains, derived by a Mauritius shareholder on the sale of his shares in an Indian company, are not taxable in India. However, it is taxable in Mauritius under the Indo-Mauritius treaty and, the Mauritius tax laws do not levy any capital gains tax at present.
Prior to 1st June, 1997, dividends, distributed by domestic companies, were taxable in the hands of the shareholder and tax was deductible at source under the Indian Income Tax Act, 1961, at the rates, specified under S.115A. Under the DTA Agreement, tax was deductible at source on the gross dividend, paid out at the rate of 5% or 15 %, depending upon the extent of the shareholding of the Mauritius resident. India has abolished the withholding of tax on dividend income in the hands of all shareholders (including foreign shareholders). A Mauritius resident company holding portfolio investments in Indian companies will pay only 1.5 per cent on its Indian dividend income.
The normal rate of tax, 30% on royalty income is halved to 15% under the treaty.
Profits, earned by a Mauritian company through a "permanent establishment" in India, are taxable in India. The rates are those applicable under the Indian law.
An offshore entity in Mauritius, now defined as a tax incentive company, which is incorporated after June 30, 1998, is liable to income-tax at 15 per cent. The Income Tax (Foreign Tax credit) Regulation,1996,(of Mauritius) permits such companies to claim credit for actual foreign taxes that are paid. Where proof is not provided, a 'deemed' tax credit of 90 per cent of the Mauritius tax payable, leaving Mauritius tax liability at 1.5 per cent. But in June 2000, the Mauritius Finance Bill proposed to change its ‘deemed tax credit’ to 80%, thus leaving a residual tax liability of 3%. The concept of deemed tax credit mitigates the need of furnishing proof of foreign tax paid and thereby saves time and effort. It also ensures that where a source country gives certain tax exemptions as an incentive for investments into it, such an incentive is preserved in Mauritius. On the other hand, offshore companies, existing prior to June 30, 1998, were given the option to continue with the sliding rate of nil to 35 per cent.
No anti-treaty shopping provision exists in the case of Indo Mauritius Double Taxation Avoidance Agreement.
What needs to be done for Mauritius to avail of the advantages under the Indo-Mauritius DTA Agreement?
To benefit from the treaty concession, a special certificate must be obtained from the Mauritius Offshore Business Authority (MOBA) to that effect.
How is the Indo-Mauritius DTA used for tax avoidance?
Many non-Mauritius companies, investing in the fast growing markets of India, have often structured their deals through a holding company in Mauritius, to take advantage of the India-Mauritius Double Tax Avoidance Agreement (DTAA).
It also may be pointed out that India has entered into several treaties with other countries. In such treaties, there are special provisions for anti-treaty shopping (e.g. Article 24 of Indo-US Double Taxation Avoidance Agreement).

posted by PV

WHAT ARE DERIVATIVES

For a trade to take place, what you need is two people- one with some goods to sell and the other to buy it. The process of the trade will consist of both these parties expressing their individual interests- one to buy and the other to sell – and then they get into an auction process so as to decide the price. Once there is an agreement on the price, the two shake hands and a transaction is complete. Where multiple buyers and sellers congregate and multiple trades begin to occur, is called a market. There are two ways that a trade can take place. One, the goods are physically exchanged for money (like in a retail shop) or Two, there could be a transaction in a “promise” to deliver the goods at a future point of time for a price agreed upon in the present. This kind of transaction was the norm where the goods were expected to arrive or be ready for shipment after a while – such as in Crops or commodities that were imported or exported from other lands. The people dealing in such items would be either the producer of it or a consumer of it. For example, a wheat farmer would be quite interested in ensuring that he gets a good price for his crop – when he is ready with it – from the bread manufacturer (who is the consumer of his product).
In the same fashion, the bread manufacturer is equally interested in tying up good and consistent supply of wheat so that he can produce his goods (i.e. bread) uninterrupted. This need of both parties is met by the formation of the “Forward Market” or a market that deals in the present for value to be settled at some point of time in the future.
Such Forward markets have existed ever since trade began. They had some imperfections within them and this led the traders to form what came to be known subsequently as the Futures markets.

Background of Indian Financial Markets
Financial markets in India have been largely synonymous with the Stock markets. There were several reasons for this. Being a largely agrarian based economy, the farming community was a completely protected one and the socialistic policies followed by successive governments led to the image that trading in commodities was something that was almost “un-Indian”. Therefore, commodity-trading exchanges were never ever encouraged. To this day, the vast majority of the trading taking place in the different commodity markets in the country is all dominated by forward contracts between actual producers and wholesalers/exporters etc. Further, the Indian economy being a closed one, foreign exchange trading was something entirely, well, foreign. We also had some kind of protectionism in the Gold and Silver markets and there was a ban, until recently, on any kind of export or import of these metals. Therefore, this market too could not develop like their counterparts in the other parts of the world. This left only the Stock Markets as an arena where man could express one of his natural instincts to trade. The rapid industrialization and the continued socialistic policies of the seventies led to the Fera dilution which was the major impetus to this market, led to greatly increased public interest in the markets. The era of the IPO (initial public offering) was born and the stock market became the place for investment.

As the markets grew, slowly, a need for some kind of a hedging mechanism was felt by the players of the stock markets, now that the game had gotten a lot bigger than it ever was. The BSE Index during this period had risen from the sedate 200-300 ranges of the early eighties to 4500 in the mid nineties. This was a huge rise and the decline that set in from there was also much, much larger than what had been experienced by the players until then. By then the Mutual Fund industry had also got established in the Indian markets.

The only known hedging mechanism in the market was a system known as “badla”. This system functioned well when stocks had to be sent for transfer and the financier was protected from any adverse stock price moves by taking a position in the budla market. This system was imperfect but served the purposes of most traders and financiers. But since mutual funds were not allowed to participate in this market, it remained the fiefdom of brokers and traders. This led to periodic abuses of the system by different brokers and market operators, the most recent one being the manipulation of the budla market at the CSE by Ketan Parekh and his coterie.

SEBI, which had come into existence by 1993, was slowly flexing its muscles over the years, trying to bring some kind of discipline into the market and relaxing the stranglehold that the brokers and operators had over the stock markets. With every passing year, SEBI gathered more and more teeth and finally, in the year 2000, they managed to get the exchanges to start a Futures and Options segment. The markets started trading in Futures in 2000 and in 2001, the options market also began. This was a landmark event in the evolvement of our financial markets to world standards.

The Need for Derivative Markets

The word derivative means “derived from” or an “offshoot of” some other item. The need for derivative products arose out of the basic need to hedge or control risks in financial trades. The futures markets evolved out of business people’s need to transfer the risk of carrying inventory to the speculators who were willing to bear that risk, hoping to profit by a gain in the value of the commodity or stock. Before proceeding further, therefore, it is necessary to understand the nature of risk. In the stock markets, there are two kinds of risks:
The stock related risk – that which relates to the performance of the company, its industry, and
The market related risk – that which is connected with factors other than the company but which impact the market as a whole.
While it is agreed that most of the stocks purchased by investors and mutual funds would be (or should be) as a result of adequate research into the fundamentals of the stock and its industry, it would be very difficult to account for all the factors that go to affect the market as a whole. The numbers of variables, which affect the market as a whole, are too numerous even to list! Hence, any stock positions carries with it an element of the market as, being a part of the market, it would represent the entire market as a microcosm. If one wanted to have a situation where the outcome of the stock’s price was a function of its individual performance within that industry alone, then it is obvious that there has to be some way of eliminating the risks associated with the market as a whole. This was done through the use of financial futures and options.
Hence, the concept of a derivative product on the stocks and indices (and in the rest of the world, commodities and currencies) arose with an idea of shifting the risk to people who were willing to accept them. Every market needs an element of speculation. It is undeniable that speculation intrinsic of man’s nature. But it plays a very useful function in the markets by increasing or providing the much needed liquidity, without which, most markets would become quite volatile and price stability a mirage. Hence, in order to encourage the flow of volumes, financial re-engineering in the form of Futures and Options on stocks and indices were invented.
Futures and Option Contract Details
The Index futures commenced trading in June 2000. The exchanges commenced Options trading in June 2001 with options on Index and in July 2001 with options on individual stocks. The sensex and nifty are the two designated indices for Futures and Options trading. 31 leading stocks have been designated for options trading. These have been selected on the basis of some stringent conditions and parameters laid down by Sebi.

The Sensex futures contract trades with a 50 multiple while the Nifty contract has a 200 multiple. Translated, this means that one futures contract of the Sensex would mean 50 Sensex while one Nifty contract would get you 200 Nifty. Hence every point move in the sensex would mean a 50-point change in the value of the contract and 200 in the nifty contract. Or, in other words, if one is long index futures, for every one point move of the sensex, one would get a profit or loss of Rs.50 and it would be Rs.200 for the nifty.

It should be realized that derivative products have a short life. They are designated by the time when they are said to “expire”. That is, the date of expiry is the last day of trading. After that date, a new contract has to be entered into. The exchanges have standardized the life of the contracts on both futures and options to three months. We have therefore futures and options on indices as well as stocks for the current month and the next two months. In the jargon, they are referred to as the Near month, the mid month and the far month contracts. Hence we would have July Nifty future, August Nifty and September Nifty (or Sensex) at the moment as the three contract months trading.

The Index option gives the right (without the obligation) to the buyer to either buy or sell the index at a certain price and at a certain time. The contracts are designated by the month and the price. The price here is referred to as the “Strike” price. So when we say “July 1060” what it means is Index option for July at a price of 1060. One can have several strike prices for the same month. So for July we have July1020 or July 1080 or July1100 etc each of which designates the month and the price. In the Nifty options, the strike rates change at an interval of 20 points while in the Sensex, they change at an interval of 50 points (July3500, July3550, August3500, August3450 etc). Stocks are also designated similarly and the change in the strike prices would depend upon the price of the underlying stock. For example, Infosys options have strikes which are 100 points apart i.e. July3500, July3600 etc while Reliance strikes move at 20 points and Digital strikes are spaced 30 points apart. The strikes are decided by the Exchanges and as prices move, new strikes are introduced for trading. It must be understood that each strike is a distinct trading instrument in itself. In other words, July320 for Reliance is a separate instrument for trading, as is July340 or July300. The exchanges have decided that at any given point of time, there would be a minimum of 5 strikes traded.
Types of Players
The market is composed of all types of players with all kinds of strategies and desire for the end outcome. While everyone is engaged in either buying or selling, it is motive or the strategy behind the buying or selling that differentiates the players. Accordingly, we can make the following classifications
Traders or Speculators have a definite view about the directionality of the market for the future. Hence they take up positions that will benefit them from the movement of the underlying. In the futures markets, traders would take up long positions or buy the futures at current rates with an expectation that it would move up in the coming days and give them profits before the contract expires. If their view were bearish, then they would sell the futures contract at current prices and expect it to decline as the market goes lower and then would buy it back and make a profit out of the difference. This process is called short selling. In the options markets, speculators would buy Call options (the right to buy) if they felt the market would rise or buy Put options (the right to sell) if they felt the market would decline. They can then either hold the position until expiry or they could square off the deal if some profits are available before the expiry date. The difference between the purchase and sale price of the future or the option contract would determine the profit or loss in the transaction.
For example, if one is bullish on the market, one can buy an August Future which, say, is currently quoting at 1065 (current index level is 1060) if one expects that the index would be moving up by August. If this supposition is correct and the index moves up to, say, 1100, the August futures would be salable around 1105 or s. Thus the buyer of the future contract would net a gain of about 40 points less the transaction costs. Since each point move on the nifty index is equal to Rs.200, this would be a profit of Rs.8000 on every contract of nifty that is purchased. If one is bearish on the nifty and thinks that the level of nifty in September would be 1000, then one can sell the September future contract currently trading at 1070. If the view is correct and the nifty level in September is indeed 1000, then the September future contract by that time would also have declined to around 1005 or so. One can then buy back what is sold and net a gain of 65 points amounting to Rs.13000 per contract. Of course, if one is wrong in the view and the market rises, say to 1120 by September, then the contract would be trading around 1125 and one would then incur a loss of 55 points or about Rs.11000 per contract.

Hedgers: This is one of the most common usages of the futures and options contracts. This is done by players who hold stocks, like Mutual Funds, and who would like to protect the value of the portfolio during the times when the market is bearish. Typically, they would look to participate in the futures-options markets during bearish times. If the market were expected to fall, then a mutual fund manager would seek to sell the Index future of a value equivalent to his portfolio. Why should one do this? Because the law relating to mutual funds requires that the money raised should be deployed in equities up to a certain minimum percentage. Thus, a fund would always remain invested to that extent and only the balance portion would be held in non-equity instruments. If the market falls, the fund would then take a hit in the values of its holding. By selling index futures and buying them back at a later, lower price, the fund has recouped its losses on the equity side with a profit made on the futures trade. Thus the value of the fund is saved (to a large extent) from eroding. This protects the Net Asset Value (NAV) of the fund and thereby the investor in that mutual fund (people like you and me) are also protected from erosion of their own net worth.
Alternatively, the fund manager can also buy Puts on the index or the individual stocks that he holds and thereby participate in the decline of the market without selling out his holding. Again, the loss in equities value is made up by the profits in the Put options.
It is to be noted here that Hedging does not make profits. It only contains the losses.

Arbitragers: These are set of players who try to take advantage of mispricing that periodically occur in the market due to different sets of reasons. There could be a difference in pricing between the underlying asset and what is known as the “fair value” of the future instrument (either Futures or Options). There could be a mispricing between different futures instruments themselves owing to changes in volatility of the market or temporary supply-demand changes. There are multiple reasons why mispricing will occur. Arbitragers keep a keen watch on the prices and take advantage of the situation by buying and selling the two instruments simultaneously to lock in the difference. For example, if the current index level is 1060 and the fair value of July Nifty is 1080 but it is currently quoting at 1090, then an arbitrager would quickly sell the future contract at 1090 and buy the cash index at 1060. This is because he sees that the correct spread between the two should be 20 points while currently it has expanded to 30 for some reason. He will then square off the transaction when the nifty returns to the “normal” spread of 20 points and thereby net a profit of 10 points. Similarly, one can also spot the mis pricing in option contracts and seek to profit from this. The trading of this kind is almost a risk free venture but requires a keen eye and quick action. Arbitragers impart a great amount of liquidity to the system.

Economic Relevance of Futures Markets

The most important role that the futures markets perform is in aiding the process of proper price discovery. Since several different types of players are engaged in trading the futures markets with different intentions, it leads to a correct pricing of the asset. This has important fall out, especially in the commodity and currency markets. It prevents incorrect extension of trends that would be harmful to the general public and thereby leads to a greater market efficiency. The presence of a larger number of tradable instruments also leads to a more complete market, one where every type of player can have the maximum number of features which will permit him to participate to the fullest extent in the markets. The proper design of the futures products and the framework of trading help to contain the risks in investments for different players. This leads to a more reliable and longer lasting system.

Summary
The advent of the futures and options markets in India is a welcome addition to the number of instruments that is currently available to the individual trader and investor as well as the institutional players. One need no longer bemoan the lack of hedging facilities in the market and this is one of the most bullish developments for the long term. The Indian stock markets can now begin attracting entirely newer set of players who were hitherto hesitant to enter the stock markets because of the absence of risk containing measures. The world over, the experience has been that the cash market has multiplied several fold with the introduction of the Futures markets, particularly, options. The same may be expected to happen in India too. We are therefore set for very exciting times ahead of us in the markets. The entire face of the stock markets as we knew it, is set to change. Truly, we are now about to catch up with the rest of the world.

Suggested Reading and Surfing
1.Futures-Options and the Investor by Dr.CK.Narayan
2.Introduction to Futures and Options Markets by John Hull
3. Complete guide to Futures markets by Jack Schwaeger.
www.cboe.com
www.numa.com
www.optionetics.com
Sources:http://www.chartadvise.com

SWAPS AS THEY ARE KNOWN

What is an interest rate swap?

(i) An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.
Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a basis or money market swap.

(ii) Pricing Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced. This must be literally true: no one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months time or 18 months time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time.
In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value.
It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve. The classic example of a par coupon yield curve is the US Treasury yield curve. A different kind of security to a government security or similar interest bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount which is then repaid representing compounded or "rolled-up" interest. A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve.
Finally, at any time the market is prepared to quote an investor forward interest rates. If, for example, an investor wishes to place a sum of money on deposit for six months and then reinvest that deposit once it has matured for a further six months, then the market will quote today a rate at which the investor can re-invest his deposit in six months time. This is not an exercise in "crystal ball gazing" by the market. On the contrary, the six month forward deposit rate is a mathematically derived rate which reflects an arbitrage relationship between current (or spot) interest rates and forward interest rates. In other words, the six month forward interest rate will always be the precise rate of interest which eliminates any arbitrage profit. The forward interest rate will leave the investor indifferent as to whether he invests for six months and then re-invests for a further six months at the six month forward interest rate or whether he invests for a twelve month period at today's twelve month deposit rate.
The graphical relationship of forward interest rates is known as the forward yield curve. One must conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market does possess a great deal of information concerning the yield generated by existing instruments over future periods of time and it does have the ability to calculate forward interest rates which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this relates to the fact that the net present value of the aggregate set of cashflows due under any swap is -- at inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course, that the loan has been priced according to prevailing market terms. This must be true, since otherwise it would be possible to make money simply by borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The net present value of both the fixed rate stream of payments and the floating rate stream of payments in a fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it involves the exchange of one zero net present value stream of payments for a second net present value stream of payments.

The pricing picture is now complete. Since the floating rate payments due under the swap can be calculated as explained above, the fixed rate payments will be of such an amount that when they are deducted from the floating rate payments and the net cash flow for each period is discounted at the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It might also be noted that the actual fixed rate produced by the above calculation represents the par coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond valuation techniques.

(iii) Financial Benefits Created By Swap Transactions

Consider the following statements:

(a) A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, which it will be convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity.

(b) The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant.

(c) Companies have been able to lower their nominal funding costs by using swaps in conjunction with credit quality spreads.

These statements are, I submit, fully consistent with the objective data provided by swap transactions and they help to explain the "too good to be true" feeling that is sometimes expressed regarding swaps. Can it really be true, outside of "Alice in Wonderland", that everyone can be a winner and that no one is a loser? If so, why does this happy state of affairs exist?

(a) The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most likely to meet from both market participants and commentators alike is that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied. The AAA company therefore raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market.
The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. This argument is an attractive one because of its relative simplicity and because it is fully consistent with data provided by the swap market itself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out: The United States has a comparative advantage in wheat because the United States has wheat producing acreage not available in Japan. If land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage would disappear. The international capital markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and this rationale for the creation of the swap transactions would be eliminated over time leading to the disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued and expanding existence of the swap market.
It would seem, therefore, that even if the theory of comparative advantage does retain some force -- not withstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole explanation for the value created by swap transactions. The source of that value may lie in part in at least two other areas.

(b) Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist with certain information asymmetries. Four authors from a major US money centre bank have argued that a company will -- and should -- choose to issue short term floating rate debt and swap this debt into fixed rate funding as compared with its other financing options if:

(1) It had information -- not available to the market generally -- which would suggest that its own credit quality spread (the difference, you will recall, between the cost of fixed and floating rate debt) would be lower in the future than the market expectation.

(2) It anticipates higher risk- free interest rates in the future than does the market and is more sensitive (i.e. averse) to such changes than the market generally.
In this situation a company is able to exploit its information asymmetry by issuing short term floating rate debt and to protect itself against future interest rate risk by swapping such floating rate debt into fixed rate debt.

(c) Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call provision. In substance this right is no more and no less than a put option on interest rates and a right which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not contain a prepayment option. The early termination of a swap contract will involve the payment, in some form or other, of the value of the remaining contract period to maturity.
Returning, therefore, to our initial question as to why an interest rate swap can produce apparent financial benefits for both counterparties the true explanation is, I would suggest, a more complicated one than can be provided by the concept of comparative advantage alone. Information asymmetries may well be a factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he has no early termination right -- is not paying a premium for the implicit interest rate option embedded within a fixed rate loan that does contain a pre-payment rights. This saving is divided between both counterparties to the swap.

(iv) Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate cashflows that comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the reason for this being that the shape of the yield curves used to price the swap initially will change over time. Assume, for example, that shortly after an interest rate swap has been completed there is an increase in forward interest rates: the forward yield curve steepens. Since the fixed rate payments due under the swap are, by definition, fixed, this change in the prevailing interest rate environment will affect future floating rate payments only: current market expectations are that the future floating rate payments due under the swap will be higher than those originally expected when the swap was priced. This benefit will accrue to the fixed rate payer under the swap and will represent a cost to the floating rate payer. If the new net cashflows due under the swap are computed and if these are discounted at the appropriate new zero coupon rate for each future period (i.e. reflecting the current zero coupon yield curve and not the original zero coupon yield curve), the positive net present value result reflects how the value of the swap to the fixed rate payer has risen from zero at inception. Correspondingly, it demonstrates how the value of the swap to the floating rate payer has declined from zero to a negative amount.
What we have done in the above example is mark the interest rate swap to market. If, having done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement, then the positive net present value figure we have calculated represents the termination payment that will have to be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the swap by entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net present value figure represents the payment that the floating rate payer will have to make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the original swap.

(v) Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cashflows, a degree of credit risk must be implicit in the swap. Note however, that because a swap is a notional principal contract, no credit risk arises in respect of an amount of principal advanced by a lender to a borrower which would be the case with a loan. Further, because the cashflows to be exchanged under an interest rate swap on each settlement date are typically "netted" (or offset) what is paid or received represents simply the difference between fixed and floating rates of interest. Contrast this again with a loan where what is due is an absolute amount of interest representing either a fixed or a floating rate of interest applied to the outstanding principal balance. The periodic cashflows under a swap will, by definition, be smaller therefore than the periodic cashflows due under a comparable loan.
An interest rate swap is in essence a series of forward contracts on interest rates.. In distinction to a forward contract, the periodic exchange of payment flows provided for under an interest rate swap does provide for a partial periodic settlement of the contract but it is important to appreciate that the net present value of the swap does not reduce to zero once a periodic exchange has taken place. This will not be the case because -- as discussed in the context of reversing or terminating interest rate swaps -- the shape of the yield curve used to price the swap initially will change over time giving the swap a positive net present value for either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange of payments is being made.

(vi) Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:
1. To obtain lower cost funding
2. To hedge interest rate exposure
3. To obtain higher yielding investment assets
4. To create types of investment asset not otherwise obtainable
5. To implement overall asset or liability management strategies
6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.
2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.
3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.
4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.
Typical transactions would certainly include the following, although the range of possible permutations is almost endless.

(a) Reduce Funding Costs. A US industrial corporation with a single A credit rating wants to raise US$100 million of seven year fixed rate debt that would be callable at par after three years. In order to reduce its funding cost it actually issues six month commercial paper and simultaneously enters into a seven year, nonamortising swap under which it receives a six month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap payments. The cost saving is 110 basis points.

(b) Liability Management. A company actually issues seven year fixed rate debt which is callable after three years and which carries a coupon of 7%. It enters into a fixed- to- floating interest rate swap for three years only under the terms of which it pays a floating rate of Libor + 185 bps and receives a fixed rate of 7%. At the end of three years the company has the flexibility of calling its fixed rate loan -- in which case it will have actually borrowed on a synthetic floating rate basis for three years -- or it can keep its loan obligation outstanding and pay a 7% fixed rate for a further four years. As a further variation, the company's fixed- to- floating interest rate swap could be an "arrears reset swap" in which -- unlike a conventional swap -- the swap rate is set at the end and not at the beginning of each period. This effectively extends the company's exposure to Libor by one additional interest period which will improve the economics of the transaction.

(c) Speculative Position. The same company described in (b) above may be willing to take a position on short term interest rates and lower its cost of borrowing even further (provided that its judgment as to the level of future interest rates is correct). The company enters into a three year "yield curve arbitrage swap" in which the floating rate payments it makes under the swap are calculated by reference to a formula. For each basis point that Libor rises, the company's floating rate swap payments rise by two basis points. The company's spread over Libor, however, falls from 185 bps to 144 bps. In exchange, therefore, for significantly increasing its exposure to short term rates, the company can generate powerful savings.

(d) Hedging Interest Rate Exposure. A financial institution providing fixed rate mortgages is exposed in a period of falling interest rates if homeowners choose to pre- pay their mortgages and re- finance at a lower rate. It protects against this risk by entering into an "index-amortising rate swap" with, for example, a US regional bank. Under the terms of this swap the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank accepts that the notional principal amount of the swap will amortize as rates fall and that the faster rates fall, the faster the notional principal will be amortized.
A less aggressive version of the same structure is the "indexed principal swap". Here the notional principal amount continually amortizes in line with a mortgage pre- payment index such as PSA but the amortization rate increases when interest rates fall and the rate decreases when interest rates rise.

(e) Creation of New Investment Assets. A UK corporate treasurer whose company has substantial business in Spain feels that the current short term yield curves for sterling and the peseta which show absolute interest rates converging in the two countries is exaggerated. Consequently he takes cash currently invested in the short term sterling money markets and invests this cash in a "differential swap". A differential swap is a swap under which the UK company will pay a floating rate of interest in sterling (6 mth. Libor) and receive, also in sterling, a stream of floating rate payments reflecting Spanish interest rates plus or minus a spread. The flows might be: UK corporation pays six month sterling Libor flat and receives six month Peseta Mibor less 210 bps paid in sterling. Assuming a two year transaction and assuming sterling interest rates remained at their initial level of 5.25%, peseta Mibor would have to fall by 80 bps every six months in order for the treasurer to earn a lower return on his investment than would have been received from a conventional sterling money market deposit.

(f) Asset Management. A German based fund manager has a view that the sterling yield curve will steepen (i.e. rates will increase) in the range two to five years during the next three years he enters into a "yield curve swap "with a German bank whereby the fund manager pays semi- annual fixed rate payments in DM based on the two year sterling swap rate plus 50 bps. Every six months the rate is re- set to reflect the new two year sterling swap rate. He receives six monthly fixed rate payments calculated by reference to the five year sterling swap rate and re- priced every six months. The fund manager will profit if the yield curve steepens more than 50 bps between two and five years.
To repeat: the possibilities are almost endless but the above examples do give some general indication of how interest rate swaps can be and are being used.

HOW MUCH WE KNOW ABOUT CRUDE

Pricing Differences Among Various Types of Crude Oil

According to The International Crude Oil Market Handbook, 2001-2002,1 published by the Energy Intelligence Group, there are about 161 different internationally traded crude oils. They vary in terms of characteristics, quality, and market penetration. Two crude oils which are either traded themselves or whose prices are reflected in other types of crude oil include West Texas Intermediate and Brent. Comparing these two crude oils with EIA's Imported Refiner Acquisition Cost (IRAC), the OPEC Basket, and NYMEX futures is important to understand the differences among the various types of crude oil that are often referred to in the press and by analysts. Generally, differences in the prices of these various crude oils are related to quality differences, but other factors can also influence the price relationships between each other.

West Texas Intermediate:

West Texas Intermediate (WTI) crude oil is of very high quality and is excellent for refining a larger portion of gasoline. Its API gravity is 39.6 degrees (making it a “light” crude oil), and it contains only about 0.24 percent of sulfur (making a “sweet” crude oil). This combination of characteristics, combined with its location, makes it an ideal crude oil to be refined in the United States, the largest gasoline consuming country in the world. Most WTI crude oil gets refined in the Midwest region of the country, with some more refined within the Gulf Coast region. Although the production of WTI crude oil is on the decline, it still is the major benchmark of crude oil in the Americas. WTI is generally priced at about a $2-per-barrel premium to the OPEC Basket price and about $1-per-barrel premium to Brent, although on a daily basis the pricing relationships between these can vary greatly.

Brent:

Brent Blend is actually a combination of crude oil from 15 different oil fields in the Brent and Ninian systems located in the North Sea. Its API gravity is 38.3 degrees (making it a “light” crude oil, but not quite as “light” as WTI), while it contains about 0.37 percent of sulfur (making it a “sweet” crude oil, but again slightly less “sweet” than WTI). Brent blend is ideal for making gasoline and middle distillates, both of which are consumed in large quantities in Northwest Europe, where Brent blend crude oil is typically refined. However, if the arbitrage between Brent and other crude oils, including WTI, is favorable for export, Brent has been known to be refined in the United States (typically the East Coast or the Gulf Coast) or the Mediterranean region. Brent blend, like WTI, production is also on the decline, but it remains the major benchmark for other crude oils in Europe or Africa. For example, prices for other crude oils in these two continents are often priced as a differential to Brent, i.e., Brent minus $0.50. Brent blend is generally priced at about a $1-per-barrel premium to the OPEC Basket price or about a $1-per-barrel discount to WTI, although on a daily basis the pricing relationships can vary greatly.

NYMEX Futures:

The NYMEX futures price for crude oil, which is reported in almost every major newspaper in the United States, represents (on a per-barrel basis) the market-determined value of a futures contract to either buy or sell 1,000 barrels of WTI or some other light, sweet crude oil at a specified time. Relatively few NYMEX crude oil contracts are actually executed for physical delivery. The NYMEX market, however, provides important price information to buyers and sellers of crude oil in the United States (and around the world), making WTI the benchmark for many different crude oils, especially in the Americas. Typically, the NYMEX futures prices tracks within pennies of the WTI spot price described above, although since the NYMEX futures contract for a given month expires 3 days before WTI spot trading for the same month ceases, there may be a few days in which the difference between the NYMEX futures price and the WTI spot price widens noticeably.

OPEC:

OPEC Basket Price For a discussion of crude oil pricing in general, and of the OPEC Basket price in particular, see EIA's OPEC Fact Sheet. OPEC collects pricing data on a "basket" of seven crude oils, including: Algeria's Saharan Blend, Indonesia's Minas, Nigeria's Bonny Light, Saudi Arabia's Arab Light, Dubai's Fateh, Venezuela's Tia Juana Light, and Mexico's Isthmus (a non-OPEC crude oil). OPEC uses the price of this basket to monitor world oil market conditions. As mentioned above, because WTI crude oil is a very light, sweet (low sulfur content) crude, it is generally more expensive than the OPEC basket, which is an average of light sweet crude oils such as Algeria's Saharan Blend and heavier sour crude oils (with high sulfur content) such as Dubai's Fateh. Brent is also lighter, sweeter, and more expensive than the OPEC basket, although less so than WTI. Since OPEC has (at least informally) tied its production management activity to the goal of maintaining the OPEC Basket price between $22 and $28 per barrel, market watchers now pay close attention to this oil price indicator.

Imported Refiner Acquisition Cost :

The Imported Refiner Acquisition Cost (IRAC) is a volume-weighted average price of all crude oils imported into the United States over a specified period. Because the United States imports more types of crude oil than any other country, it may represent the truest “world oil price” among all published crude oil prices. The IRAC is also usually similar to the OPEC Basket price, so it too is typically about $2 per barrel less than the WTI spot price and about $1 per barrel less than the Brent price. However, because the IRAC is not reported by EIA until nearly 2 months after the end of the month in question, i.e., the August IRAC average price would be reported sometime in late October, the IRAC is not a particularly timely measure of a “world oil price”. Although EIA is generally the only organization that uses the IRAC, it is used by EIA as the “world oil price” in all of its forecast publications, including the Short-Term Energy Outlook, released monthly, as well as the Annual Energy Outlook and International Energy Outlook, both of which are released annually and provide an annual forecast looking out approximately 20 years in the future.

1Energy Intelligence Group, The International Crude Oil Market Handbook, 2001-2002 (October 2001), pp. E1, E289 and E315.

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