derivatives in gcc

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Kuwait Financial Centre S.A.K. MarkazR E S E A R C H

Derivatives Market in GCCCutting a (very) long market short

In spite of having an advanced trading infrastructure, most of the GCCcapital markets (except Kuwait) havent yet started the process ofintroducing derivatives products. Our previous research (Managing GCC

Volatility) has established the fact that GCC stock markets are the mostvolatile in the world. Given the growing size and volatility of GCC capitalmarkets, the road ahead is clearly to have a complete market structure thatwill enable stakeholders cost-effectively raise capital and manage risk. A keymissing link in this process is the derivatives segment. GCC stocks marketshave remained a long-only market for a very long time.

Across the globe derivatives, especially Options and Futures, has played avery crucial role in capital market development. Equity Derivatives markethas now reached a size of $114.1 trillion (Appendix 1). The presence ofstrong equity culture along with limitations of GCC capital markets providesa compelling platform for introduction of derivatives market in the GCCregion. Strategic investors can unlock their potential without diluting theirstake. Institutional investors would welcome this as they are familiar withusing such instruments for fixed income and other instruments.

From a regulators point of view, there are questions such as:

To what extent derivatives destabilize the financial system, and howshould these risks be addressed?

What is the impact of derivatives upon market efficiency andliquidity of the cash market?

Can we borrow the experience of developed markets to developingmarkets?

We propose to address some of these concerns in this paper through adiscussion of the following:

A. Limitations of GCC capital marketsB. Application AreasC. Current Status in GCC &D. Suggested Road Map

March 2007Research Highlights:

Examining the need for theintroduction & growth ofderivativesmarket in GCC.

M.R. RaghuCFA, FRMHead of Research+965 224 [email protected]

Hussein A. ZeineddineManager- Equity Derivatives+965 [email protected]

Kuwait Financial Centre S.A.K.Markaz

P. O. Box 23444, Safat 13095,KuwaitTel: +965 224 8000

Fax: +965 242 5828www.markaz.com


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R E S E A R C HMarch 2007

Kuwait Financial Centre S.A.K. Markaz2

A. Limitations of GCC Capital MarketsThe case for derivatives basically stems from the various limitations thatbeset the GCC capital markets. Hence, it is worth recounting some of them.

a. Incomplete Market Structure

Complete market structure is brought about by the presence of equitymarket, debt market and derivatives market. While GCC markets havescored on equity markets, they are yet to score on the other two importantsegments. Islamic bond markets are gaining ground through the issuance ofsukuks and other instruments. Lack of secondary market is hampering itspricing and growth. Due to under supply of such instruments, institutionstend to hold them to maturity thus providing no liquidity. Except for Kuwait,derivatives market is absent in other GCC countries.

b. Lack of Depth and BreadthBreadth is indicated by the number of companies listed in the stock marketwhile depth is indicated by the active contribution of these companies. GCCstock markets do not score well on both counts.

Table 1: Market Breadth

No of companies2002 2005 2006

Saudi Arabia 67 77 81

UAE 47 89 93

Kuwait 88 160 165

Bahrain 42 46 42Oman 96 128 131

Qatar 23 32 36

Total 363 532 548

Market Cap (USD b) 160.9 1157 778Market cap per company(USD b) 0.44 2.17 1.42

Source: Markaz Analysis

GCC market structure is stillincomplete with inadequategrowth of debt market andabsence of derivatives

market.

GCC markets lack bothbreadth and depth of themarket.

EquityMarket

DebtMarket

GCCCapitalMarkets

DerivativesMarket


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In terms of number of companies, GCC region hosts about 550 companiesas at the end of year 2006. When measured against the size of the market(market capitalization), it can be seen that the growth in the number ofcompanies is muted relative to the growth in market size. While in 2002,the average market cap per company was USD 0.44 billion, the ratio shot

up to 1.55 by 2006 as during this period markets grew by 5 times, whilenumber of companies grew only by 1.5 times. (Table 1)

Table 2: Market Depth

2006Market Cap

(USD b)No of

Companies Av Market cap (USD b)

Saudi Arabia 326 81 4.03

UAE 168 93 1.81

Kuwait 147 165 0.89

Bahrain 64 42 1.52

Oman 13 131 0.10

Qatar 60 36 1.68

Egypt 208 290 0.72

Malaysia 236 1,025 0.23

Australia 1096 1,829 0.60

India 819 4,796 0.17

Korea 834 1,689 0.49

China 918 842 1.09

Source: World Federation of exchanges & Markaz Analysis

In terms of market depth, it can be seen that relative to the size of some ofthe GCC markets (Saudi Arabia and UAE, especially), the number ofcompanies are relatively small. The average market cap ratio for Saudi

Arabia 4.03 is significantly higher than say Indias 0.17 or Malaysias 0.23.

c. Skewed Liquidity & High SpeculationThe GCC markets are classified as long only markets where tradingstrategies are limited to buying when market is expected to go up andliquidating when it is expected to fall down. In fact, the absence of theshort-sale activities in such markets does not allow investors to enhancetheir returns during the down trend. Thus investors are left with no choicebut to liquidate their positions which on one hand will exacerbate the effectof the downfall while on the other hand will adversely affect the liquidity ofthe market. The size of the decrease in the liquidity levels is driven to agreat extent by the size of the corresponding downfall. Thus if the downfall

is very sharp the liquidity could be completely drained- out.

Kuwaiti market during the period 2005 to 2006 can be offered as a goodexample. Although the Kuwaiti market is characterized by the presence of awide diversity of sectors with a major presence for the blue chip companiessuch as NBK, MTC, and PWCetc, the market was not able to sustainliquidity during the correction movement in February 06. Investors as wellas fund managers, in the lack of the hedging tools such as the put options,were desperately trying to liquidate their positions while the market washeading down and draining out the liquidity with it. This results in aDomino effect. (Figure 4)

Given the size of the GCCmarkets, the number ofcompanies listed is very small.

GCC markets are long-onlymarkets limiting the possibletrading strategies and hencegrowth.


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Figure 4: Kuwaiti General Market Index

4,0005,0006,0007,0008,0009,000

10,00011,000

12,00013,000

Feb-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Sep-06

0

50,000,000

100,000,000

150,000,000

200,000,000

250,000,000

300,000,000

350,000,000

400,000,000

Value Traded (KD) Price Index

Most of the GCC stock markets are speculative as well, though in varyingdegrees. While volumes are concentrated in few stocks, even these areamong penny stocks. To present an example (Table 3), we can see in Saudi

Arabia the most active shares constitute nearly 30% of total volume whilethey account only for 6% of market capitalization. The second highesttraded stock in Saudi Arabia (Al Mawashi Al Mukarish) is a penny stock with0.19% share in the market cap.

Table 3: Saudi Most Active Shares 2006

2004 2005 2006

Share in volume traded

Saudi Electricity 15% 11% 10%

Al Mawashi Al Mukarish 13% 8% 8%

National Shipping 7% 4% 2%

Arriyadh Dev 4% 4% 3%

Saudi Industrial Development 4% 3% 2%

Gassim Agriculture 3% 5% 2%

Saudi Public Transport co 3% 5% 3%

Saudi Automotive Services 2% 1% 3%

52% 41% 32%

Share in Market Cap

Saudi Electricity 9.70% 4.98% 4.42%

Al Mawashi Al Mukarish 0.18% 0.11% 0.19%

National Shipping 0.73% 0.80% 0.58% Arriyadh Dev 0.22% 0.35% 0.16%

Saudi Industrial Development 0.11% 0.14% 0.08%

Gassim Agriculture 0.08% 0.16% 0.09%

Saudi Public Transport co 0.22% 0.27% 0.18%

Saudi Automotive Services 0.07% 0.15% 0.10%

11% 7% 6%

Source: Markaz Analysis


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The downturn of GCC stock markets during 2006 was accompanied bydrying up of market liquidity (Figure 1). Fall in liquidity (value traded) iscuriously accompanied by growth in volumes (Figure 2) signifying that midand small cap stocks are being increasingly pursued for speculative reasonsat the cost of large cap blue chips.

Figure 1: Liquidity Squeeze*

-80%

-60%

-40%

-20%

0%

20%

40%

Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07

Saudi Arabia

Kuwait

Dubai

Qatar

*% change in value traded to the corresponding period one year before

Figure 2: Liquidity Squeeze*

-100%

0%

100%

200%

300%

400%

500%

Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07

Saudi

Arabia

Kuwait

Dubai

Qatar

*% change in volume traded to the corresponding period one year before

Liquidity is the heart of a market. While GCC markets have grown during thepast few years in size, it has failed to mature in terms of market breadth.Narrow market structure leads to price spikes resulting in increasedvolatility.

d. High Volatility

GCC countries experienced relatively very high risk compared to otherinternational indices. Among GCC, Saudi Arabia, Dubai, Abu Dhabi andQatar exhibited high levels of risk while Kuwait, Oman and Bahrain hasbeen at levels comparable to other international markets. The increase inrisk for Saudi Arabia has been remarkable from 24% to 49% literallydoubling. (Figure 3)

Fall in liquidity isaccompanied by growth involumes.

GCC markets experiencedvery high volatility in thepast.


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Figure 3: Volatility (Standard Deviation)

49.4

6%

38.4

0%

24.4

0%

26.9

9%

16.8

8%

12.1

7%

9.9

8%

10.0

2% 1

4.1

6%

15.4

2%

18.0

7%

19.7

3%

25.6

8%

24.1

2%

35.2

4%

28.6

8%

30.8

9%

12.4

9%

15.0

9%

11.4

8%

10.2

8%

12.5

1%

15.4

2%

11.9

6%

13.3

8%

17.1

0%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

SaudiA

rabia

Dubai

ADSM Qatar

Kuwai

t

Oman Bahrain

S&P50

0

Nasdaq BRIC

Emergin

gMkt

Nikk

ei225

Sensex

(India

)

2006 2005

e.Lack of Institutional InvestmentParticipation of institutions in the capital market lends stability andcredibility as institutional investors are considered to be more rational andlong-term oriented than individual investors. Though a difficult thing tomeasure, a broad proxy would be the mutual fund segment. It isunderstood that other categories of institutions in the GCC like pensionfunds, central banks, etc prefer to invest through mutual funds. Table 4provides statistics pertaining to mutual funds. Except Saudi Arabia and

Kuwait, all other markets have very meager institutional participation.Curiously enough, in spite of a respectable figure, Saudi Arabia continues tobe the most volatile and speculative market in the GCC.

Table 4:Institutional Participation

Mutual Fund Assets Market Cap

Saudi Arabia 22452 326000 6.89%

UAE 1612 160000 1.01%

Kuwait 5200 143000 3.64%

Oman 37 16150 0.23%

Bahrain 16 12170 0.13%

Qatar 68 60940 0.11%

Source: Markaz Analysis, Data as of Dec 2006 in USD Million

The representation ofinstitutions in the GCC marketis sparse.


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B. Application Areas

In this section, we highlight some application areas for derivatives withinthe context of GCC capital markets.

Short Selling Options strategies Trading Volatility & Structured Products

a. Short SellingIt is interesting to note that historical stock market speculative excesseshave been committed not only on the bull side but on the bear side as well.While speculation per se is good for the market, excesses are not. Bothover-valuation and under-valuation of stocks reflect market inefficiencies.

A short sale is a sale of securities which the seller does not own at the time

of effecting a sale. The theoretical pinning to this is very simple. In ascenario where a particular stock is under valued, market participants willidentify this and buy up the stock with the result that the stock price tendsto rise eliminating under-valuation. In this case, the market participantmakes a profit and the markets pricing efficiency will also improve. Thesame logic can be applied to over-valued stocks. Similar to earlier logic,market participants will now sell over-valued stocks which will reduce themarket price and improve pricing efficiency. Hence, there is nothingimmoral about this. However, short-selling strategy is not as straightforward as the strategy of buying under-valued stocks. In the case of short-selling, the short seller has to borrow the stocks sold short during the entireprocess till he returns the borrowed stock.

While there is nothing undesirable about short-selling, history is replete withabuses on short-selling making the need to regulate this more than what isnecessary. This is because short-selling could result in a loss that can beindefinite. In a long-only strategy, the maximum loss could be at best100%. In a short-sale, the potential loss can be much higher because thereis no limit to price rise. Short-selling in a context where floating stock issmall (as is the case with many stocks in GCC) may lead to manipulativepractices viz., short squeeze. A short squeeze arises when bulls are able tocorner the supply of stock and bid up the price artificially.

Existence of short-selling is not a precondition for improved marketefficiently, provided the market is blessed with active and well-informed

investors. However, in the absence of active and well-informed investors,encouraging short-selling with appropriate regulatory checks and balanceswill certainly improve market pricing efficiency. This, in turn, will lead toefficient resource allocation.

Also, short-selling is much more beneficial if applied in a portfolio contextthan in individual stock context. If there is a rise in market prices, theinvestors will incur loss on their portfolios of short-sales but would becompensated by the gains on their actual investment holdings.

In short, short selling promotes more active search for over-valued stocksand more speedy adjustment of market prices to company performance.

Short-selling refers to sellinga stock that is not owned.Shorting (selling high andbuying low) is not allowed inGCC.


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1) Historical Volatility: It is statistical measure to quantify historicalvolatility. It is generally measured with the use of standarddeviation (dispersion around the mean) expressed in percentagesfor different time periods. For example you can compute a 20 day,

40 day or 120 days of volatility.2) Implied Volatility: As described by its name, it shows what the

market predicts as the volatility of the underlying instrument to beover its life. For instance, the implied volatility of an option contractcan be derived by plugging in its market price in an option pricingmodel such as the Black-Scholes.

Trading OptionsRecall that investors need to have a tool in order to trade volatility. In thisreport we will use the options as an illustrative tool to show how volatilitycan be traded. There are essentially two types of trading strategies that areused by the option traders

1) Strategies that are based on taking a speculation on the direction ofthe price movement of the underlying equity or "directionaltrading".

2) Strategies that are based on taking a bet on the market volatility ofthe option contract or "volatility trading".

Directional TradingTraders who rely on directional trading to make profits have first to take aguess on the movement of the underlying equity price and then establishthe corresponding position in the option market. It is advantageous toimplement this strategy using options than direct equity exposure as

options provide many benefits. (Appendix 3).

Volatility TradingSimilar to the fundamental equity trading approach where traders seek toidentify overvalued and undervalued stocks based on a comparison betweenthe equity market price and its intrinsic value, the volatility traders willcompare the implied volatility of an option contract with the historicalvolatility. Trading actions can be summarized as follows:

Scenario Trading Action

Implied Volatility > Historical Volatility Sell Volatility

Implied Volatility < Historical Volatility Buy Volatility

Thus if the implied volatility is higher than the historical volatility, then thiswould be an indication that the option contract is overpriced, andconsequently, "selling volatility" is recommended and vice-versa. This isillustrated by using the implied volatility vs. historical volatility chart of theIntel Corporation stock. (Figure 4)

One sells volatility when thehistorical volatility is lowerthan the implied volatility.


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The chart demonstrates the fact that implied volatility exhibit a meanreverting characteristics i.e., if the implied volatility of the stock shoots up or

down in response to a major event that is expected by the market, it willeventually move back "revert" towards its mean.

Historical Volatility ConesVolatility Cones initially proposed by Burghart and Lane (1990) are oftenused by option traders to figure out whether the implied volatilities tradedin the market are cheap or expensive. The volatility cone chart is a veryuseful tool to predict the future volatility of the stock as it presentsimportant characteristics of the volatility of a particular stock. It is alsouseful in comparing the predicted future volatility of a stock with its actualrealized volatility. To illustrate we'll use the volatility cone chart of the IntelCorporation Stock.

Historical Volatility Cone

Intel Co. Mar 05 to Feb 07

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0 30 60 90 120 150 180 210 240 270

Days to ExpiryMin Mean Max Last

Source: Markaz

The mean reverting behavior of volatility is evident in the above cone chartwhich shows the distribution of the Intel stock volatility over differentperiods for a 2-year range of data. Starting from the extreme left on the X-axis, we can see that over 30 days period, the volatility has rangedapproximately from 13% to 39%. Over 120 days period during the last 2years the volatility has ranged from approximately 19% to 28%. The meanvolatility has ranged from 23% to 25%. As one moves further out in timethe lines converge towards the mean, and the mean becomes stable. Thus

the volatility is indeed "mean reverting". Another implication that can be

Intel Corporation

Source: IVolatility.com

Sell

SellSell

Buy

Bu

Buy

IV HV

Figure 4

Historically Volatility, liketock prices, is mean-everting.

Structured products aredesigned to meet specificnvestor needs.


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observed from the volatility cone chart is that the range (max min) of theshorter periods (30 days) volatilities is wider than that of the longer periods(120 days) which indicates that the shorter the period the more the variationof the volatility around its mean. Kindly referAppendix 4 for volatility conecharts for the GCC region.

It is worth noting that in order to make the volatility trading processeffective, traders should maintain a delta neutral position which can beachieved through dynamic hedging techniques where the underlying marketprice risk can be eliminated.

c. Structured Products A structured product is a financial instrument that mostly combines aconventional asset class such as equity or a fixed income security with aderivative instrument. Structured products are usually designed to meet theinvestors' specific needs taking into consideration the existing marketconditions.

There are many advantages for investing in the structured products whichincludes:

Capital Protection Enhanced Returns Controlling risk (volatility) Portfolio Diversification Utilize Current Market Trend

Each structured product is unique by itself. Among the many types ofstructured products the most popular is the capital protected equityproducts or "the capital guaranteed notes". It provides to some extent a risk

free ownership of the underlying asset (stock, index, a basket of stocks).

Capital Guaranteed NotesA capital guaranteed note is a note which guarantees the investor a certainpercentage of capital while giving a chance to participate in the upsidemovement of the value of an underlying stock or basket or index. Thepercentage of the capital guaranteed (C %) and the upside participation rate(R %) can be structured based on investor preference. The higher thepercentage of capital guaranteed (C %), the lower the participation rate (R%) as illustrated below:

StructuredProducts

Single StockBasket of StocksEquity IndexBondsMutual FundsHedge FundsCommoditiesETFs, etc

Call OptionsPut OptionsExotic OptionsSwapsFutures, etc

Derivatives find extensiveapplication in capitalguaranteed notes.


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CapitalGuarantee

Normal Upside Participation Rate Range

90% 85% 100%

100% 40% 55%

105% 5% 15%

If the performance of the underlying asset that the note is linked to isdenoted by (P %), then the Payoff of the note at maturity would be:

Payoff = Initial Investment * C% + Initial Investment *R%*P%

(ReferAppendix: 2 for Illustration)

Dynamic Strategies (CPPI)Constant Proportion Portfolio Insurance (CPPI) is an investment strategywhereby funds are allocated dynamically between two types of assets, a

risky growth asset such as equities and non-risky asset like bonds, cash etc.The allocation is determined by a prescribed formula and designed topreserve capital at a future date. CPPI has played a crucial role in thestructured equity markets. CPPI provides capital protection by reducingequity exposure in declining markets and increasing it in rising markets. Atmaturity the investor gets the capital guaranteed plus appreciation in thedynamic basket invested both in risky and risk free asset.(ReferAppendix: 2 for Illustration)

C. Current Status (GCC)In this section, we trace the growth and development of derivatives marketin the GCC region. As noted earlier, only Kuwait has some form of

derivatives in the form of options and futures/forward market. The genesisand workings of this is presented below.

a. Options MarketWith rapid growth worldwide, trading options did not exist in the MiddleEast Stock Exchanges or in the Arab Stock Exchanges until Kuwait FinancialCentre S.A.K. Markaz initiated a proposal to provide the options service inKuwait Stock Exchange in year 2002. Markaz suggested establishing asystem for trading in options through a Fund viz., Forsa Fund to work as amarket maker for options trading in the first stage. After analyzing thecharacteristics of the Kuwait Stock Exchange (KSE), its nature of risks anddetermining the needs of investors, Markaz suggested a complete

mechanism for option trading at KSE after taking into account the currentmechanism in international markets. Many trials and simulations werecarried out using historical data for system compatibility with the KSE andmeasuring the risks resulting from option trading in markets. Testing andmeasurements were made continuously till March 2005 when KSE allowedCall options to be traded by Forsa Fund. Trading on the first day (March 28,2005) was on 13 stocks and 75 contracts with a total strike value of KD2,378,150.000. Options value and volume traded fell during year 2006compared to year 2005 mainly on the back of weak market sentiment.(Figure 5). This reduced the total net premium (Net Premium=Premiumreceived-amount paid back to investor in case he sells the option backbefore expiry) generated from this activity. (Figure 6)

Markaz initiated a proposalto provide the options

services in Kuwait.


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Figure 5: Options Value & Volume Traded

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

Mar-

05

May-0

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Ju

l-05

Sep-0

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06

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6

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l-06

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lue

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de

d

0

20,000,000

40,000,000

60,000,00080,000,000

100,000,000

120,000,000

Vo

lume

Tra

de

d

Volume Traded Value Traded

Figure 6: Net Premium Received

(1,000,000)

(500,000)

0

500,000

1,000,000

1,500,000

2,000,000

Mar-05

May-05

Jul-05

Sep-05

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Jan-06

Mar-06

May-06

Jul-06

Sep-06

Nov-06

KD

How it worksForsa option contracts are currently traded in the secondary market on 45listed stocks in the Kuwait Stock Exchange. The contracts are between theMarket Maker (Forsa Fund) and the Option Buyer (trader). By this contract,Forsa Fund confers the option buyer the right but not the obligation to buy(in the case of call options) or sell (in the case of put options) a specificnumber of stocks at a specific price called the strike price before or at aspecific date called the expiration date. In return, the option buyer will payForsa Fund the price of the option contract or the option premium.Therefore, the option buyer during the term of the contract, may exercisehis right to buy (in the case of call options) the underlying stocks fromForsa Fund at the strike price, or exercise his right to sell (in the case of put

options) the underlying stocks to Forsa Fund at the strike price. If theinvestor does not exercise the option during the term of the contract, thevalidity of the contract will expire at the expiration date. It should be notedthat KSE presently permits only call options. Any statement above on theput option is purely for explanatory purposes only and does not imply itsexistence.

In order to provide the necessary liquidity to the market, the Forsa Fundwill daily quote bid and ask prices to all the option contracts it writes with apurpose of creating a trading environment that confers the trader theopportunity to sell or exercise the contract.

(ReferAppendix: 2 for Illustration)

Forsa fund provides dailyiquidity through quoting bid

and ask prices for all optionontracts.


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Mechanism of option TradingForsa Options are traded at the trading floor of the Kuwait Stock Exchange(KSE) after the close of the spot market from 12:45 PM till 1:15 PM. TheFund as a market maker will provide the investors with the bid and askprices for all the existing option contracts. Investor who wishes to trade in

Forsa options should be a registered trader at KSE. He has to route hisorders through the brokers in KSE. After the execution of the deal, thebroker provides the investor with a contract showing the details of theoption trade.

The investor has three ways in which he can settle the Option Contract.

He can sell the contract back to the buyer i.e. Forsa Fund. ForsaFund is obliged to provide bid price for all the Option it sold and beready to buyback the Option from the buyer of the Option.

He can exercise his right to buy, in case of Call Option and right tosell, in case of put option. Forsa Fund is obliged to perform the

contract. If the investor wishes to sell or exercise his contract back,it should be done through the same broker who executed theoriginal trade. &

Take no action and let the Option expire where if the Option is inthe money, the contract will be automatically cash settled. Thesettlement cycle of the option contracts is the same as that of thespot and the forward markets. The brokerage and commissioncharges will be applied as per the KSE Rules.

Major PlayersAt the moment, only Kuwait Financial Center S.A.K Markaz through theForsa Fund can make market in call options.

Brokerage and Commission ChargesThe brokerage, clearing and settlement fees charged for option trading inKuwait Stock Exchange are charged to both the option buyer and themarket maker. The total fees for each of the option buyer and the marketmaker is 5.5% of the contract value and this is actually reflected in thelarge Ask-Bid spread (around 10.5%).

Brokerage Fees: 1.25% (one leg)Clearing and settlement Fees: 1.5% (one leg)

To illustrate, in the NBK call option example presented previously the optionbuyer and the market maker has each to pay KD 70 (2,550 * 2.75%) at the

time the contract is initiated and KD 79.2 (2,880 * 2.75%) at the time thecontract is settled. Statistics regarding Kuwait options market is presentedinAppendix-5

b. Forwards & FuturesForwards Market

According to the rules and regulations for trading forward contracts at theKuwait Stock Exchange, a forward contract represents an agreementbetween the forward buyer (trader) and the forward seller (market maker)in which the buyer agrees to buy a certain number of shares from the sellerfor a fixed price (equity spot price) during a future period of time.

Forward contract representsan agreement between thebuyer and seller in which thebuyer agrees to buy a certain

number of shares from theseller for a fixed price duringa future period of time.

Nearly 75% to 80% ofinvestors offset theircontracts in spot market.


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At the inception of the forward contact, the forward buyer will pay anupfront premium (price of the forward contract) to the market maker plus40% of the equity spot price as an initial margin. In return, the seller willdeposit the shares with the Kuwait Clearing Company (KCC) that willpreserve them to the buyer who should settle the remaining 60% of the

value of the equity specified in the forward contract to the market makerbefore the maturity of the forward contract. If the buyer decides not to paythe remaining 60% (incase the price of the underlying stock decreased),then at maturity the ownership of the shares will return back to the marketmaker leaving the buyer with a loss of the premium paid as well as the 40%initial margin.

Any corporate actions related to the shares under the forward contract arepreserved with KCC to be submitted to the buyer once he settles theremaining 60% balance. In case the forward contract expires withoutsettling the remaining 60% balance the dividends are returned to the selleralong with the underlying shares.

In order to reduce the market makers credit risk in case the spot price ofthe underlying declines significantly a 40% decline would wipe out thebuyers down payment margin the buyer has to pay a 10% margin callminimum to keep the contract active or can voluntarily close the contract.Failing to do either of the above results in the contract being terminatedand the stock and dividends etc. returned to the seller, who retains theoriginal margins. If the stock cannot be liquidated promptly, in this case,the seller could lose money on the liquidation.

Currently the forward market offers contracts for 3, 6, 9 and 12 monthperiods and operates after the spot trading session (12:45PM to 01:15PM).This market is very suitable to the KSE trading environment where the

majority of the speculators buy forward contracts to gain financial leverage,and if they make money they sell the shares out in the spot market therebysettling the balance payment before maturity of the contract.

Based on historical figures and KSE trading atmosphere, 75% - 85%investors offsets/early settle their contracts in spot market. The Portfolio willreceive the final payment balance before maturity of contracts. This enablesthe portfolio to reinvest the capital before its maturity date. There is a gainin time value of period where final payment is received in advance.

During periods of decline, 60% of the investors whose contracts have fallenbelow the coverage level prefer to pay the margin calls. The reason being

that the investors psyche does not allow him to let go of a contract inwhich he has invested the upfront payment of 40%. The buyer receives theMargin Calls and thereby minimizes his risk further by 10% (minimum). Agraphical presentation on the workings of the forward market is presentedinAppendix: 6

Futures Market

The futures market operates in a completely similar manner as the forwardmarket except that the future market operates during the spot tradingsession (9:30AM to 12:15PM). Because forwards are traded after the closeof the spot market, the manager has to maintain a minimum inventoryholding and be able to find the liquidity to cover it, whereas in the case of

the futures market, traders would first request for the shares, whereby themarket maker would make the direct purchase of shares from the spot

Futures market operates veryimilar to forward market.

There are 17 players in theutures/forward market as

against 1 in options.


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market and pass them on to the trader through the future contract afteradding the premium and commissions. Thus there will be no need toaccumulate stocks unlike the forward market.

Market Players

Unlike options market where there is only one market maker, the futuresand forward market enjoys many players. An indicative list of players isprovided in Appendix: 7. Statistics regarding Kuwait futures market ispresented inAppendix-6

D. Road MapA major motivation for introduction and growth of derivatives in the GCCregion is that it can enable transfer of risk between individuals and firms inthe economy. More simply, it is like buying and selling insurance. While therisk-averse investor buys insurance, a risk-seeking investor sells theinsurance. Past researches have produced very encouraging findings, someof which are summarized below.

Introduction of derivatives do not destabilize the underlying market.On the contrary, it improves liquidity and reduces informationalimbalances in the market.

Derivatives play a very important role in terms of price discoveryand in completing the market.

They provide a solid basis for institutional investors and mutualfund managers for risk management. This role as a riskmanagement tool clearly assumes that derivatives trading do notincrease market volatility and risk. For e.g., put options will reducethe volatility in the market as irrational exuberance would becorrected much before it becomes a bubble and affects the socio

economic set up/ordinary investors. Put options will help the marketreach its true level faster and help prevent manipulative practices. Availability of derivatives (especially equity derivatives) has enabled

traders to transact large volumes at much lower transaction costsrelative to the cash market. This, in turn, will increase market depthand volatility, two major limitations of GCC markets.

Studies also point to the fact that introduction of options seemed tohave helped stabilize trading in the underlying stocks. It is observedthat volumes in the underlying stocks increase after the introductionof stock options.

Studies have also found that after the introduction of options, pricestend to reflect new information more quickly leading to narrowingof bid-ask spreads.

The Road Map

In terms of an action plan for GCC regulators, we suggest the following:

1. Set up a Derivatives Exchange: Exchange-Traded Derivatives canbe a solid basis to start the process than OTC. Derivatives which tradeon an exchange are called Exchange-Traded Derivatives, while aderivative contract which is privately negotiated is called an OTCderivative. Trades on an exchange generally take place with anonymityand go through a clearing corporation while that of OTC do not. Hence,forming a derivatives exchange will be the most important first step to

be taken.


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2. Draft Regulatory Framework: GCC capital markets are neitheremerging markets (from an economic strength point of view) nor adeveloped market from a market microstructure point of view. Hence, itis pertinent to form a committee of highly experienced and qualifiedpeople drawn from various financial institutions to come up with a

customized regulatory framework for the orderly governance ofderivatives. A lot can be learned from the experience of some of the

Asian capital markets that have successfully set-up such frameworks.3. Introduce Index Equity Derivatives: Equity derivatives are the

most common worldwide, especially index futures followed by indexoptions and security-specific options. Internationally, options onindividual stocks are common; futures on individual stocks are not thatcommon. Index based equity derivatives (options and futures) are quitepopular among investors as they are excellent hedging tools and alsopresent few regulatory headaches when compared to leveraged tradingon individual stocks. This has led to regulatory encouragement of indexfutures and discouragement against futures on individuals stocks.

4.

Introduce Short-Selling: As we explained earlier, market efficiencycan be significantly enhanced through introduction of short-selling. Justas we have margin requirements on the long-side, we can have similarregulatory checks to prevent misuse of this important tool. If dealt withproperly, short-sales can check bear-side excesses in a falling market.

5. Introduce Stock Equity Derivatives: With a well stabilized indexbased equity derivatives, the risks of stock-based equity derivatives iswell contained.

As we can see from the above, except for Kuwait none of the other GCCmarkets have taken any of the steps suggested above. Even in the case ofKuwait, introduction of derivatives in the form of call options did not adhereto a structured process as explained above. There are still gaps to be

addressed (Appendix: 8).


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Appendix 1: Growth of Derivatives Market in Asia

Global exchange-based trading in equity derivatives has almost doubled over the last three years from $54trillion in 2002 to $114.1 trillion of notional value (on 6.3 billion contracts by end-2005). The volume ofglobal trading in 2006 had already reached $96.1 trillion as of August 2006. On Asias exchanges, equity

derivatives have witnessed the most rapid growth of all traded derivative products (foreign exchange,interest rate, equity, commodities, and credit derivatives). Equity derivative trading in emerging Asia hasmushroomed from $16.5 trillion in 2002 to $40.3 trillion in 2005 (and $37.1 trillion by the end of August2006), and now represents 38.6 percent and 43.9 percent of worldwide equity derivatives turnover bynotional value and number of trades respectively. This mainly represents very rapid growth in Korea, whichhosts the worlds most active derivatives marketthe Korean Futures Exchange. Equity derivatives aremainly traded on organized exchanges rather than OTC. Annual OTC equity derivatives trading in Asia(excluding Japan) is only around $100 billion (BIS, 2005).

Most equity derivatives are exchange-traded (ETD), as opposed to foreign exchange and interest ratederivatives, which are mostly traded OTC. Formalized and regulated exchanges are leading the growth in

Asian derivative markets, which can be divided into three categories: (i) fully demutualized exchanges (Hong

Kong SAR and Singapore), which offer a wide range of derivative products; (ii) partially demutualizedexchanges (Korea, India, and Malaysia), which have specialized in equity futures and index products; and(iii) derivative markets with no or marginal exchange-based trading and limited OTC derivative trading(China, Indonesia, the Philippines, and Thailand).

Equity derivatives markets are much less well-developed in other emerging Asian countries. In general, highlevels of ETD tend to be associated with high equity trading in deep and sufficiently wide cash markets,mainly because the development of derivatives necessitates sufficient liquidity of cash markets (includingpricing benchmarks) to ensure efficient price discovery. Since 2000, growth in overall derivative trading onlyin Korea, Hong Kong SAR, and Taiwan POC has outstripped growth of both domestic market capitalizationand cash trading in equity markets. These countries currently exhibit high turnover ratios of almost 1 tomore than 36 times of outstanding stock, while average global turnover ratios of equity derivatives tend toconverge to one (BIS, 2004; and WFE, 2005). Since most of equity derivative contracts are traded in thesecountries, their high turnover ratio has kept aggregate equity derivative trading in emerging market Asia atmore than 10 times GDP, stock market capitalization, and stock trading. Although stock exchanges incountries such as China, Indonesia, Malaysia, Thailand, and the Philippines also have strong trading activityin cash markets, similar to that in emerging market and mature market countries with established derivativemarkets, trading in equity derivatives remains very limited.

Contract sizes in emerging Asian countries have more than doubled, from $8,200 in 2003 to $19,000 byAugust 2006, but they still lag behind global averages. Contract sizes of equity derivatives in countries likeIndia and Malaysia are still less than half of the notional amount per trade in Asia and less than a third ofthe notional amount per trade in the United States. Besides Hong Kong SAR, only the equity derivativemarket in Korea offers contract sizes in emerging Asia similar to mature market economies.

The strong development of equity derivatives in Korea and India reflects a robust operational and legalinfrastructure (Fratzscher, 2006). For example, both countries have well-designed trading platforms, whichprovide access to both domestic and foreign institutional investors. Indonesia has just established theJakarta Futures Exchange and introduced equity index futures at the Surabaya Stock Exchange. TheThailand Futures Exchange (TFEX), in operation since 2004, started trading its first stock index future only in

April 2006. In the Philippines, equity derivatives have not been traded since the Manila Futures Exchangeclosed in 1997. By comparison, countries that are lagging have (for example) weak trading infrastructures,shortcomings in relevant laws that create uncertainty about whether derivatives contracts can be enforced(or even whether trading derivatives is permitted), tax provisions that are unfriendly to derivatives, bans onshort selling, and restrictions on investment by foreigners. Reaping the full benefits of equity derivativesmarkets by fostering their wider development also requires careful management of risks to financial stability.In Asian countries without formal derivative exchanges, the rising popularity of OTC derivatives entails

greater emphasis on disclosure and transparency, good governance and risk management. Systemic risk is


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potentially reduced when trading occurs in well-structured and formally regulated exchanges that imposeappropriate margin requirements and position limits, administer centralized clearing and settlement, engagein market surveillance, undertake adequate disclosure, and mutualize risks through loss-sharingarrangements, capital deposits of members, and international excess-of-loss insurance. It is also reducedwhen supervisors and regulators can ascertain the exposure of systemically important financial institutions to

derivatives markets. Sizable retail trading of derivatives may pose its own challenges and could (in principle)entail significant knock-on effects on real sectors; for example, a market downturn that inflicted widespreadlosses on households could affect confidence and spending. A good understanding of all these issues isincumbent on country officials charged with safeguarding financial stability.

Source: Asian Equity Markets: Growth, Opportunities & Challenges by Catriona Purfield, HirokoOura, Charles Kramer, and Andreas Jobst. IMF Working Paper WP/06/266.

Appendix 2: Illustrations

1. Covered CallAn investor owns 1000 shares of NBK at KD 2.000. He also sells a 1 month call option contract on NBK for

1000 shares at a strike price of KD 2.000 for a premium of 50 Fills, which he receives per share from thebuyer of the Option. This position initiated is called a Covered Call because the investor is covered with thestock in case the buyer exercises his right to buy the shares at the strike price. The strategy is favored whenthe investor expects the share price to exhibit a small movement over the lifetime of the option contract.The investor desires to either generate additional income (over dividends) from shares of the underlyingstock owned, and/or provide a limited amount of protection against a decline in underlying stock value.

Profit and loss of the trade

Trade Details

Stock Value 1000 shares at KD 2 each = KD 2000

Number of call options sold 1000

Strike Price KD 2.000Option premium per share 50 Fills

Total option premium received KD 50

Scenario Payoff Rationale

If Share price moves to KD 3 KD 50 The option premium which is KD 50, since the option holderwill exercise the option and the underlying shares will have tobe delivered.

If Share price stays flat at KD2

KD 50 The option will expire worthless and hence the option writerkeeps the premium which is KD 50

If Share price falls to KD 1 (KD950)

Loss of underlying stock value which is KD 1 per share i.e., KD1000.

Profit on premium received which is KD 50.Net loss: KD 950


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-200

-150

-100

-50

0

50

100

1.80 1.85 1.90 1.95 2.00 2.05 2.10 2.15 2.20

Stock Price

Profit/Loss

Profit / Loss

Covered Call Writer

2. Protective Put

For example if an investor is holding 1000 shares of NBK at a price of KD 2.000 and the investor buys a 1month put option contract of 1000 shares at strike KD 2.000 then it is called as a protective put strategy.

Stock View

The strategy is implemented with a positive view on the stock; however the investor wants to hedge hisdownside risk. Buying a put option is like buying insurance for the stock and hence if the stock does not godown in price, he loses only the premium paid.

Profit and Loss of the trade

Trade Details

Stock Value 1000 shares at KD 2 each = KD 2000

No of put options bought 1000

Strike Price KD 2.000

Option premium per share 50 Fills

Total option premium paid KD 50

Scenario Payoff Rationale

If Share price moves to KD3

KD 950 The underlying position value improves due to stock priceappreciation. However, the put option expires worthless andhence the premium paid is wasted.

If Share price stays flat atKD 2 -KD 50 The put option will expire worthless and hence the loss will bethe premium paid.

If Share price falls to KD 1 -KD 50 Sine the option is in the money, the option holder will exercisehis option. Profit on exercising the option will be KD 1000.However the underlying equity position also loses its value to theextent of KD 1000 and hence they are neutralized.Hence, the net loss will be equal to the premium paid which isKD 50


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-200

-150

-100

-50

0

50

100

150

200

1.90 1.95 2.00 2.05 2.10 2.15 2.20

Stock Price

Profit/Loss

Stock price Profit / Loss

Protective Put Writer

3. Capital Guaranteed Note

A 3-year 100% capital guaranteed note with a participation rate of 45% Linked to a Kuwait Basket ofShares.

The note provides 100% capital guarantee at maturity which is 3 years thereby eliminating the downsiderisk. On the upside, it gives 45% of the appreciation in the Kuwait Basket of shares over the 3 year period.This note will be suitable for an investor who has a bullish view on the Kuwait market and seeks to haveexposure to it, but on the other hand wants to fully protect his capital.

StructureThe issuer of the guaranteed note will receive a capital of KD 1000 from the investor who purchased thenote. The issuer will invest the proceeds in buying:

1) A zero coupon bond that matures in 3 years. The price of the bond will be the present value of thecapital received PV (KD 1000)5.55% or KD 850. The bond will guarantee that the issuer will be able atmaturity to pay the capital that was initially received from the investor.

2) A call option on the Kuwait Basket with 3 years to expiry that will cost approximately 33.3% of the totalvalue of the Kuwait Basket. Hence by paying the remaining KD 150 for the call Option, the issuer will geta 100% exposure (participation) to a basket of total value of KD 450 (150/33.33%) which is equal to45% of the amount of capital invested by investor (KD1,000) thereby 45% of capital invested is exposedto market returns. In other words, the participation rate is calculated by dividing the relative amount leftfor the options (15%) by the relative option premium (33.33%) or 45%.

Hence such a structured product is a combination of a zero coupon bond (asset class) and a call option(derivative instrument).


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Thus if the performance of the Kuwaiti basket is 60% at maturity, then the investor will receive KD1000*100% + KD 1000*45%*60% or KD 1,270, and if the Kuwaiti basket did not perform positively, thenthe investor will receive only his capital invested or KD 1000.

4. CPPI

Suppose a 5 years 100% capital guaranteed CPPI structure is issued with minimum investment of KD 1000.The issuer will invest the proceeds in:

A zero coupon bond that matures in 5 years. The price of the bond will be the present value of thecapital received PV (KD 1000)6% or KD 750. The bond will provide the capital protection.

The issuer invests the remaining amount (KD 250) in a risky asset, together with an amount borrowedfrom the money-market. The amount borrowed will be normally equal to the amount invested in thezero coupon bond so that the total amount invested in the risky assets is equal to the initial investment.,Thus total amount borrowed will be KD 750 which makes the total investment in the risky asset KD1000. The cost of the borrowing needs to be paid from the return generated by the risky asset. Theinvestment in the risky asset will grow if the return generated is higher than the borrowing cost of KD750. The risky asset portfolio is rebalanced periodically and if the returns are zero or less, than the onlythe guaranteed capital is paid at maturity. If there is any positive return generated by the risky asset,than the investor gets KD 1000 (capital guaranteed) + any excess return generated by the risky asset.

There are others types of CPPI structure too where the capital is not guaranteed with the use of a zerocoupon bond but other combination are created to provide capital guarantee. However, the basic designremains the same that the asset is allocated between a risk free asset and a risky asset and rebalancedaccording to the market condition.

Invest the remainingKD 150 (1000 850)Invest KD 850

Contributes 45% of theupside of the basket at

maturity

Returns KD 1000at maturity

Issuer of theStructured Note

Receives KD 1000

Buy a 3- yrs Zero

Coupon Bond with

face value of KD 1000

Buy a Call Option with

3- yrs maturity on the

Kuwait Basket

Investor

Pays KD 1000

at inception

Pays KD 1000 plus 45%

participation at maturity


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5. Call option

A call option contract was issued by Forsa Fund on 06-Jan-2007 with the following terms:Underlying Stock: National Bank of Kuwait (NBK)Strike price: KD 2.160

Avg. Traded Price KD 2.162Implied Volatility 27.53%Quantity: 10,000Expiration date: 27-June-2007

Ask price: KD 0.255Bid Price: KD 0.229

The buyer of this contract on 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amountof KD. 2,550/-.

(Ask price * number of stocks i.e., KD 0.255 * 10,000 = KD. 2,550/-)

The Average traded price for the NBK share increased to reach KD 2.246 on 09-Jan-2007 and thecorresponding Ask and Bid prices increased to KD 0.311 and KD 0.280 respectively. So the option buyer cansettle his contract as follows:

Sell the option back to the market maker (Forsa Fund) at the Bid price (KD 0.280).Profit: 25 Fils (0.280 - 0.255) per stock or KD 250.Return: 9.8 %.OrBuy 10,000 stocks of NBK from the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. Inthis case, the option buyer pays KD 21,600/- to the market maker without the deduction of the premium

paid (KD 2,550/-).

6. Put option

Assume the Put option contract was issued by Forsa Fund at 06-Jan-2007 with the following terms:Underlying Stock: National Bank of Kuwait (NBK)Strike price: KD 2.160

Avg. Traded Price KD 2.162Implied Volatility 27.53%Quantity: 10,000Expiration date: 27-June-2007

Ask price: KD 0.129

Bid Price: KD 0.116

Borrowed

Invest KD 750

ReturnsKD 1000at maturity

Issuer of the CPPI

Structured NoteReceives KD 1000

5-yrs Zero CouponBond with face

value of KD 1000

Dynamic Asset

Rebalancing between

Risky Asset and Risk

lessAsset

Investor

Pays KD 1000

at inceptionPays KD 1000 plus return on

the risky asset portfolio

KD 750KD250

Bank

Returngeneratedfrom the portfolio


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The buyer of this contract at 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amountof KD 1,290/-.(Ask price * number of stocks i.e., KD 0.129 * 10,000 = KD 1,290/-)

Assume the stock price on 07-Feb-2007 decreased to KD 2.007, the Ask and the Bid prices will therefore

increase to KD 0.238 and KD 0.214 respectively. The option buyer can settle his contract as below:

Sell the option back to the market maker at the Bid price (214 Fills).Profit: 85 Fills (214-129) per stock or KD 850Return: 65.8 %.OrSell 10,000 stocks of NBK to the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. In thiscase, the option buyer receives KD 21,600/- from the (Forsa Fund) and transfers 10,000 NBK stocks to themarket makers account.Please note that currently put options are not available in KSE.

Appendix 3: Benefits of Options

Buying options provides the following benefits:

i) Limited risk, unlimited profitOptions will ideally suit a trader where trading options is distinguished by the small capital required (incomparison with trading stocks in the cash market) and the speed of entering and exiting positions (byselling the option contract back to the market maker as a substitute for exercising the right of settlement inkind). These advantages help in reaping profits in trading. For example, if the option buyer predicts theincrease in the stock price, he can attain profits by buying the call options and if he expects a fall in thestock price, he can profit by buying put options. In both cases, the option buyer can sell the option back tothe market maker before the expiration date for profit taking.

ii) Leverage

Trading in options can allow the investor to benefit from a change in the stock price without having to paythe full value of the stock, thus allowing him to make a higher return from a smaller initial outlay. Thefollowing table shows the difference between the return of investment in options and the return of directinvestment in the underlying stock:

Characteristics Buying the option Buying the stock

Stock price/ strike price( Fils ) 1000 1000

Quantity ( Stock) 1 1

The premium ( Fils ) 35 ------

Total investment 35 1000

Stock price before expiration 1050 1050

Total profit ( Fils per Stock ) 50 50

Net profit ( Fils per Stock ) 15 50

Investment return 43% 5%

As shown in the table, the option contract provides leverage as they maximize the profit in comparison withbuying fully-paid stocks. This is because the premium represents only a slight portion of the price of theunderlying stock and still makes the same amount of profit; this leads to higher returns for the investedcapital.iii) Insurance (Hedging Tool)

Another reason investors may use options is for portfolio insurance. Option contracts can give the riskaverse investor a method to protect his/her downside risk in the event of a stock market crash. An exampleof this is called Protective Put.


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Kuwait General Market IndexJan 05 - Jan 07

0%

2%

4%

6%

8%

10%

0 30 60 90 120 150 180 210 240 270

Min Median Max Last

Bahrain General Market Index

Jan 05 - Jan 07

0%2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Dubai General Market Index

Jan 05 - Jan 07

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Saudi General Market IndexJan 05 - Jan 07

0%

5%

10%

15%

20%

25%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Appendix 4: Volatility Cone Charts for GCC Markets


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Abu Dhabi General Market Index

Jan 05 - Jan 07

0%

5%

10%

15%

20%

25%

30%

35%

40%45%

50%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Qatar General MarketIndex Jan 05 - Jan 07

0%

10%

20%

30%

40%

50%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Muscat General Market Index

Jan 05 - Jan 07

0%

5%

10%

15%

20%

25%

0 30 60 90 120 150 180 210 240 270

Min Median Max Last


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Appendix 5: Options Statistics for Kuwait

Premiums

(KD)Volume

Underlying

Value (KD)

Value Paid

(KD)Volume % Vol Volume % Vol Volume % Vol

101 341,641 3,526,000 6,721,480 446,676 3,115,000 88.34% 0 0.00% 411,000 11.66%

106 693,871 21,719,000 13,926,460 654,466 14,723,000 67.79% 500,000 2.30% 6,496,000 29.91%

107 514,523 19,537,000 9,127,465 386,481 11,692,000 59.85% 10,000 0.05% 7,835,000 40.10%

108 537,796 6,099,000 11,411,520 600,741 5,243,000 85.96% 0 0.00% 856,000 14.04%

204 1,921,654 24,108,000 26,214,000 2,082,356 20,025,000 83.06% 0 0.00% 4,083,000 16.94%

205 852,227 37,274,000 13,727,550 1,079,813 30,959,000 83.06% 0 0.00% 6,315,000 16.94%

219 757,053 26,370,000 12,410,440 711,525 20,231,000 76.72% 0 0.00% 6,139,000 23.28%

221 644,509 26,107,000 13,240,360 722,136 18,791,000 71.98% 100,000 0.38% 7,216,000 27.64%

402 715,566 27,178,000 10,307,665 474,278 16,407,000 60.37% 0 0.00% 10,771,000 3 9.63%

404 136,465 3,855,000 2,820,800 136,420 3,560,000 92.35% 40,000 1.04% 255,000 6.61%

414 478,521 16,974,000 7,013,260 391,096 11,813,000 69.59% 0 0.00% 5,161,000 3 0.41%

418 436,650 21,238,000 7,306,250 411,325 13,724,000 64.62% 0 0.00% 7,514,000 3 5.38%

501 1,304,092 21,354,000 22,225,880 2,244,486 18,874,000 88.39% 85,000 0.40% 2,395,0 00 1 1.22%

502 1,477,793 21,272,000 20,244,170 1,151,357 15,031,000 70.66% 145,000 0.68% 6,096,0 00 2 8.66%

504 227,879 3,657,000 3,222,660 116,272 3,408,000 93.19% 0 0.00% 249,000 6.81%

514 1,473,933 20,619,000 22,860,780 1,164,723 14,777,000 71.67% 10,000 0.05% 5,832,0 00 2 8.28%

605 1,967,389 7,837,198 36,517,458 2,131,321 6,763,198 8 6.30% 9,000 0.11% 1,065,000 13.59%

608 190,080 5,120,000 3,610,100 143,583 3,500,000 68.36% 0 0.00% 1,620,000 31.64%

613 893,740 7,676,000 16,528,420 866,492 7,320,000 95.36% 0 0.00% 356,000 4.64%

614 819,425 5,150,000 8,912,000 350,228 2,917,000 56.64% 0 0.00% 2,233,000 43.36%

702 661,321 21,617,000 10,751,735 1,079,870 18,603,000 8 6.06% 100,000 0.46% 2,914,00 0 1 3.48%

Total 05 17 ,046 ,128 34 8, 28 7, 198 279, 100, 453 17, 345, 642 261 ,476 ,1 98 75. 1% 999, 000 0 .29% 85 ,8 12,0 00 24. 6%

101 409,638 4,572,000 3,084,242 331,010 4,259,000 93.15% 0 0.00% 313,000 6.85%

106 392,019 12,215,000 7,084,207 364,536 10,203,000 83.53% 0 0.00% 2,012,000 1 6.47%

107 394,110 8,450,000 4,635,010 312,399 6,530,000 77.28% 0 0.00% 1,920,000 22.72%

108 474,954 4,161,000 3,361,879 344,410 3,597,000 86.45% 0 0.00% 564,000 13.55%

204 468,725 6,817,000 4,566,786 257,745 4,523,000 66.35% 0 0.00% 2,294,000 33.65%

205 1,139,164 25,483,000 18,229,875 678,675 15,799,000 62.00% 0 0.00% 9,684,000 38.00%

210 235,053 1 3,495,000 7,409,772 155,124 9,742,000 72.19% 0 0.00% 3,753,000 27.81%

217 204,398 3,438,000 1,582,172 258,995 2,520,000 73.30% 0 0.00% 918,000 26.70%

219 331,972 13,117,000 7,049,404 213,444 9,021,000 68.77% 100,000 0.76% 3,996,000 30.46%

220 496,680 19,753,000 10,209,285 794,866 15,815,000 80.06% 110,000 0.56% 3,828,000 19.38%

221 273,957 9,694,000 6,652,750 118,407 5,249,000 54.15% 0 0.00% 4,445,000 45.85%222 115,880 3,716,000 1,997,510 75,523 2,746,000 73.90% 0 0.00% 970,000 26.10%

226 369,407 19,448,000 10,474,214 282,979 12,421,000 63.87% 0 0.00% 7,027,000 36.13%

302 23,428 1,057,000 962,120 26,267 1,052,000 99.53% 0 0.00% 5,000 0.47%

401 80,091 7,723,000 3,744,724 41,960 4,498,000 58.24% 0 0.00% 3,225,000 41.76%

402 263,120 1 3,500,000 9,088,740 149,061 9,070,000 67.19% 0 0.00% 4,430,000 32.81%

403 200,765 4,451,000 2,189,876 149,562 3,741,000 84.05% 0 0.00% 710,000 15.95%

404 96,540 2,925,000 1,777,415 108,030 2,400,000 82.05% 0 0.00% 525,000 17.95%

405 40,608 4,635,000 2,285,428 14,790 2,290,000 49.41% 0 0.00% 2,345,000 50.59%

410 166,629 14,359,000 9,289,220 92,413 7,409,000 51.60% 0 0.00% 6,950,000 48.40%

412 27,555 2,390,000 1,535,720 16,660 1,745,000 73.01% 0 0.00% 645,000 26.99%

414 118,377 6,630,000 4,245,450 79,308 4,190,000 63.20% 0 0.00% 2,440,000 36.80%

418 165,247 6,992,000 3,701,205 123,098 5,667,000 81.05% 0 0.00% 1,325,000 18.95%

501 1,211,921 1 1,756,000 8,036,360 898,429 9,469,000 80.55% 0 0.00% 2,287,000 19.45%

502 301,349 8,856,000 5,672,870 282,751 7,123,000 80.43% 0 0.00% 1,733,000 19.57%

504 109,388 3,974,000 2,015,050 100,080 2,925,000 73.60% 0 0.00% 1,049,000 26.40%506 287,809 1 0,838,000 6,589,680 448,560 9,205,000 84.93% 0 0.00% 1,633,000 15.07%

513 255,157 8,011,000 4,215,512 115,612 5,212,000 65.06% 0 0.00% 2,799,000 34.94%

514 155,353 2,784,000 1,787,875 85,510 1,940,000 69.68% 0 0.00% 844,000 30.32%

522 210,411 8,139,000 5,656,710 176,961 6,092,000 74.85% 0 0.00% 2,047,000 25.15%

603 759,461 5,120,000 3,110,040 587,467 4,470,000 87.30% 0 0.00% 650,000 12.70%

605 597,253 3,675,000 2,289,337 555,285 3,192,000 86.86% 0 0.00% 483,000 13.14%

607 53,547 2,692,000 2,145,730 35,640 2,200,000 81.72% 0 0.00% 492,000 18.28%

608 80,540 2,440,000 1,272,580 37,090 1,670,000 68.44% 0 0.00% 770,000 31.56%

610 494,070 6,953,000 4,348,205 351,495 5,830,000 83.85% 0 0.00% 1,123,000 16.15%

613 195,504 1,910,000 1,291,580 140,310 1,689,000 88.43% 0 0.00% 221,000 11.57%

614 678,863 6,737,000 3,944,764 425,169 4,952,000 73.50% 0 0.00% 1,785,000 26.50%

622 43,710 4,562,000 2,126,180 12,471 2,067,000 45.31% 0 0.00% 2,495,000 54.69%

701 97,503 4,068,000 2,608,651 74,531 3,278,000 80.58% 0 0.00% 790,000 19.42%

702 570,674 17,742,000 10,376,310 300,236 11,174,000 62.98% 0 0.00% 6,568,000 37.02%

Total 0612, 590, 830 319, 278, 000 192, 64 4, 43 8 9, 61 6,85 7 2 26,9 75,0 00 71. 1% 210, 000 0 .07% 92 ,0 93,0 00 28. 8%

Total 2 9, 63 6, 95 8 6 67 ,5 65 ,1 98 4 71 ,7 44, 89 1 2 6, 96 2, 49 9 4 88 ,4 51 ,1 98 7 3. 2% 1 ,2 09 ,0 00 0 .1 8% 1 77 ,9 05 ,0 00 2 6. 6%

Expired Contracts

Codes

Sold Contracts Repurchased Contracts Exercised Contracts


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Appendix 6: Futures/Forward Illustration

ContractInitiated

StockPrice(KD)

% MarginRequired

MarginPaid

%Interest

for 3

months

Premium Paid

Price ofthe

Forward

Contract

TotalDown

Payment

FinalPaymentRequired

t = 0 1 40% 0.4 3.25% 0.0195 1.0195 0.4195 0.6

Additional Requirements Action Taken by the Buyer

TradingDay

StockPrice(KD) Additional

% Margin

MarginRequired

(KD)

RemainingBalance

(KD)

Continue tohold thecontract

Close the contract

Net P&Lof the

buyer ifcontractis closed

t = 1 1.2 0% 0 0.6

Hold the Contractin anticipation of apotential increasein the Stock Price

Sell the shares in themarket at KD 1.2 andpay the remainingbalance

0.1805

t = 2 0.8 0% 0 0.6

Hold the Contractin hope for arecovery in theStock Price

Sell the shares in themarket at KD 0.8 andpay the remainingbalance

-0.2195

t = 3 0.59 10% 0.06 0.54Pay additional10% margin tothe market maker

If the additional marginis not paid, the KCC willclosed the contract (totalloss of down payment)

-0.4295

t = 4 0.5 10% 0.054 0.486Pay additional10% margin tothe market maker

If the additional marginis not paid, the KCC willclosed the contract (lossof down payment + 10%

additional margin)

-0.4795

t = m(Maturity)

1 0% 0 0.486 Contract expiresSell the shares in themarket at KD 1 and paythe remaining balance

-0.0195

Appendix 7: Futures/Forward Market Players (Kuwait)

Kuwait And Middle East Finance Invest Co Wafra International Investment Co.

Kipco Asset Management First Investment Company

Securities Group Company K.S.C The Securities House

National Investments Company Bayan Investment Co. K.S.C.C

International Financial Advisers K.S.C. Global Investment HouseCoast Investment & Development Co. Al-Muthanna Investment Co.

Al-Madar Finance And Investment Co. Al-Aman Investment Co.

Noor Investment Co. Gulf invest International Co.

Manafee Investment Co.


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Appendix 8: Kuwait Derivatives: Road Map

Action Point Road Map

Develop a mechanism for Introducing call

options into KSE

Accomplished

Introduce put options into the KSE. Until and unless put options are allowed, the role of derivatives as ahedging mechanism cannot be complete. Put option is the primarytool through which portfolios are hedged.

Expanding the number of market makers Presently Kuwait Financial Center S.A.K through its Forsa Fund isallowed to operate as a market maker on a covered call basis. Thisrestricts the market growth. We would welcome encouraging otherinstitutions to act as market makers in order to significantly grow theoptions market in the GCC.

Allow investors to write options through themarket maker (MM).

Many high net worth investors hold significant strategic stake inleading Kuwait companies. These are not traded and normallydormant. Allowing these strategic investors to write options willenable investors to reap additional income via options premium. Thiswill also provide the needed liquidity to the market and enhance the

price discovery function.Reduce the brokerage, clearing and settlementfees

The current fee structure at around 5.5% is way above internationalstandards. In the presence of such extraordinary fees compared toother international markets, the volume of option contracts is notexpected to grow.

Allow the price to change during the tradinghours of options.

This will allow option contract to be priced more efficiently in a waythat fulfills the investors' greatest demand/supply situation, therebyincreasing the volume of options traded during the day.

Start a book order mechanism to create acompetition with the market maker.

This will enhance the option trading mechanism and will move themarket from the "choice of buying or selling at the market maker's

proposed price" to the "choice of buying or selling at the investors'price"

Trade options during the market trading hours. Currently options are traded off the market hours. Including theoptions trading during the trading hours (as is the case with otherinternational markets) will enhance the participation levels.

Allow options on Index Introduction of equity derivatives has always been through indexoptions. Enabling market makers to write and sell index options willprovide excellent hedging tool to both institutional investors andretail investors


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Appendix 9: GLOSSARY OF IMPORTANT TERMS

BRIC: Stands for Brazil, Russia, India and China

Correlation: A relationship between two variables.

Circuit Breakers: The highest and lowest prices that a stock is permitted to reach in a given trading session. Oncereached, no trading occurs on that stock until the following session. also called price limit or daily trading limit.

Emerging Markets: A financial market of a developing country, usually a small market with a short operating history.

GCC: Gulf Co-operation Council countries comprising Saudi Arabia, UAE, Kuwait, Qatar, Oman & Bahrain.

Moving Average: A technical analysis term meaning the average price of a security over a specified time period (themost common being 20, 30, 50, 100 and 200 days), used in order to spot pricing trends by flattening out largefluctuations. This is perhaps the most commonly used variable in technical analysis. Moving average data is used tocreate charts that show whether a stock's price is trending up or down. They can be used to track daily, weekly, ormonthly patterns. Each new day's (or week's or month's) numbers are added to the average and the oldest numbers aredropped; thus, the average "moves" over time. In general, the shorter the time frame used, the more volatile the prices

will appear, so, for example, 20 day moving average lines tend to move up and down more than 200 day movingaverage lines.

Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of agiven stock, at a specified price (the strike price) during a specified period of time.

Portfolio: A collection of investments all owned by the same individual or organization. These investments often includestocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earninterest; and mutual funds, which are essentially pools of money from many investors that are invested by professionalsor according to indices.

Range: The high and low transaction prices of a given security or commodity during a given period. Also called tradingrange.

Relative Volatility: The standard deviation of an investment's or portfolio's return divided by the standard deviation ofanother portfolio. Relative volatility is used to compare the risk levels of different portfolios.

Risk: The quantifiable likelihood of loss or less-than-expected returns.

Standard Deviation:The standard deviation of a series is a measure of the extent to which observations in the seriesdiffer from the arithmetic mean of the series. The standard deviation of a series of asset returns is the measure of thevolatility, or risk, of the asset.

Technical Analysis: A method of evaluating securities by relying on the assumption that market data, such as charts ofprice, volume, and open interest, can help predict future (usually short-term) market trends. Unlike fundamentalanalysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predictthe future price of a stock by looking at its historical prices and other trading variables. Technical analysis assumes that

market psychology influences trading in a way that enables predicting when a stock will rise or fall. For that reason,many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to themarket as a whole as to an individual stock.

Underweight: Having too little of, relative to other things. In the case of a portfolio, containing too little exposure to agiven company, sector or country. opposite of overweighed.

Volatility: The relative rate at which the price of a security moves up and down. Volatility is found by calculating theannualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short timeperiods, it has high volatility. If the price almost never changes, it has low volatility.

Source: www.investorwords.com


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Markaz Latest Published Research

1. GCC Equity Funds: The Asset Allocation Challenge (September 2006)Synopsis:The report examines issues behind asset allocation for GCC equity funds. The study points outthat fund managers have overweight Kuwait and underweight Saudi Arabia. Compared to their marketshare, allocation to Qatar, Bahrain and Oman was observed to be high. Nearly 10 funds were observed toallocate highest to their home country, implying home bias. The report concludes that current overweightto Kuwait and underweight to Saudi Arabia looks justified given the historical performance and currentvaluation. Relative to the overall market, blue chips appear expensive in many markets. Future outperformance can come through stock selection among mid-cap and small-cap segment. However,geographical allocation will remain the key challenge.

2. GCC Leverage Risk: How real it is? (November 2006)Synopsis: The report examines the risks behind increased exposure of GCC financial system to stockmarket. The report observes that while bank lending has increased proportional to economic growth, theshare of personal/consumer loans has gone up significantly leading to the risk perception. While the increasehas been significant, they are not alarming when benchmarked with other leading emerging markets. Thereport considers four key variables: Size, Asset Intermediation, Cross border activity and Capital marketrepresentation. The report also analyses the linkage between bank credit growth and interest rate margin.

According to the report, UAE appears vulnerable to leverage risk given the high bank credit share to theeconomy and the extent of personal loan exposure. Vulnerability assessment for Kuwait, Qatar, Bahrain &Saudi Arabia was ranked medium while that of Oman assessed low. The report also observes that GCCbanks have risk-averse portfolios backed by more than adequate capital adequacy ratios. Stress testsconducted by central banks points to adequate resilience.

3. GCC for fundamentalists: A top-down framework (December 2006)Synopsis: The report establishes a framework involving fundamental variables likely to affect GCC stockmarkets for the year 2007. The report examined nine important variables: economic factors, valuationattraction, economic liquidity, fund managers average, earnings growth potential, moving average, investorsentiment, geopolitical developments and market liquidity. On a scale of 1-5, Oman top scored at 2.93,followed by Bahrain (2.85) and Kuwait (2.84). Saudi Arabia scored 2.66 while UAE was at the bottom with ascore of only 2.18. Accordingly, the report suggests overweight to Kuwait, Oman and Bahrain, neutralweight to Saudi Arabia and underweight to UAE. Among GCC sectors, the report assigns positive ratings tobanking, telecom, and services sectors; neutral rating to industrial sector and negative rating to real estatesector.

4. Managing GCC Volatility (February 2007)Synopsis:The report devises risk-based portfolio strategies to benefit from the high-risk environment ofGCC stock markets. The report discusses four strategies: Relative vol, Contrarian, Technical and Options-based strategy.

To obtain a copy, contact:

Kuwait Financial Centre S.A.K. Markaz - Client Relations & Marketing DepartmentTel: +965 224 8000 Ext. 1804Fax: +965 2414499

Postal Address: P.O. Box 23444, Safat, 13095, State of KuwaitEmail: [email protected]


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Disclaimer

This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait.The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or asolicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction.

The information and statistical data herein have been obtained from sources we believe to be reliable but in no way are warranted by

us as to its accuracy or completeness. Opinions, estimates and projections in this report constitute the current judgment of the authoras of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. Markaz hasno obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein,or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on thesubject company is withdrawn.

This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific personwho may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities orinvestment strategies discussed or recommended in this report and should understand that statements regarding future prospects maynot be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or valuemay rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide tofuture performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, withcompanies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that couldaffect the objectivity of this report.

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