FINANCIAL DERIVATIVES

Submitted to: Ms. Sarwat Ahson

Saadia Ahmed-12809 12/11/14 Institute of Business Management

Derivatives in Pakistan’s Capital Market

Derivative products offered at the Karachi Stock Exchange (KSE)Equity derivatives products were launched on the Karachi Stock Exchange in 2001. Initially one month deliverable single stock futures were introduced. Nine years later this market is still considered to be underdeveloped when compared to India. In most developed or developing markets investors prefer to take positions and derivatives instruments are often preferred over underlying assets in the spot market. In Pakistan this not the case. In the first two quarters of the calendar year 2010 (i.e. from Jan to Jun) futures market constituted 3% and 8% in terms of volume and value of the spot market. However, during late 2004 and early 2005 the deliverable future contract were picking up in volume terms. During that period, futures volumes constituted 30 to 40% of the spot market volumes. But unfortunately due to weak market infrastructure and risk management measures of that time the market could not sustain the outgoing leverage position in the market thus leading to the 2005 March crisis. After the crisis several risk management measures have been taken to reduce systematic risk.The National Clearing Company of Pakistan has recently started releasing data on the futures market. Accordingly in the first two quarters of the calendar year 2010 on an average 211, 000 equity derivatives contracts were traded per month. Institutions have not been heavy users of exchange traded derivatives. In the said period banks, NBFC’s and companies contributed 1%, 2% and 4% of the future volumes respectively. Individuals and other investors contributed 93%of the total volumes in exchange traded equity derivatives.

Derivatives Available in Pakistan

Cash-Settled Futures (CSF) at the KSE – Yet to Gain Popularity They were introduced early in 2007. And did not gain popularity at all.

Presently 15 companies are available for these cash-settled futures. Standard contract is of 30, 60 and 90 day duration, with daily marked-to

market of losses & gains. There is necessarily an equal number of buyers and sellers in the market and thus smooth settlement on the last day of the contract is ensured.

Mutual fund are not allowed to trade in future as per Section 58 of NBFC regulation

Not gaining popularity because of the availability of other resembling leveraging instrument of CFS and also because of liking for deliverable futures for various reasons.

However, on the recommendation of the committee CFS MK II and deliverable futures have been discontinued recently.

Deliverable Futures at the KSE (Discontinued recently) Investors can BUY (go long) or SELL (go short) in a future, depending upon his

/ her view about the stock. Shares of 42 companies are eligible for trading on the futures counter at the KSE.

Standard contract of up-to five-week duration. In the last week of every month, the contract for the next month is opened (roll-over week). First Wednesday of next month is the settlement date.

Excessive positions / trading discouraged to avoid / reduce manipulation. Risk management is stringent (client-wise and broker-wise position limits are in place).

‘Provisional trading’ at the time of the IPO of a share is also an example of futures trading.

Stock Index FuturesStock Index Futures Trading is simply buying or selling a specified number of contracts whose mark-to-market difference is settled through National Clearing Company’s standard pay-in-collect system on daily basis. The underlying instruments for the Stock Index Futures are as follows: - KSE-30 Index, consisting of 30 stocks, commonly known as KSE-30 Index. - OGTI, Oil and Gas Tradable Sector Index - BKTI, Banking Sector Tradable Index

Stock Index Future Contracts of 1-3 months are available only on a rolling basis- for example, for Jan, Feb and March months. When the Jan contract expires, there will be a fresh contract month available for trading viz. the April Contract. These months are called the Near Month, Middle Month and Far Month respectively.

Final Settlement Price of the KSE-30 based Index Futures is based on a set of 121 reading of 15 second intervals (price points) of the underlying index levels taken between the last half an hour of trading. The highest and lowest 20 price points will be ignored and the closing price computed as an average of the remaining 81 price point will be the Final Settlement Price for the settlement of the contract.Daily Settlement Price is the Volume Weighted Average value of last half hour of trading in the KSE30 Index based Stock Index Futures. This reference price is used as a basis for collection of M2M losses on daily basis.Margin money is like a security deposit or insurance against a possible Future loss of value. Once the transaction is successfully settled, the margin money held by KSE is released / adjusted against the settlement liability.The basic objective of the Initial Margin is to cover the largest potential loss in a single day. Both buyer and seller have to deposit the margins. The Initial Margins are deposited in two parts: - 5% as pre-trade at the time of entering the order - 7.5% after the execution of orderThe initial margin is currently fixed at 12.50% of the notional value of the stock index futures contract.

Stock Index Futures (Regulatory Framework)

The need of a derivative market in Pakistan:In Pakistan, the derivatives market is in the nascent stage. It has just started to emerge with few contracts of forward trade agreements, plain vanilla swaps and currency options. The total volume of transactions is around Rs5 billion.As the market is not fully developed to take large exposures, the State Bank says it "has been actively intervening in these riskier initiatives of the banks". All derivative agreements require formal approval of the central bank, given on a case-to-case basis, considering the concerned bank's potential of risk management.Major foreign banks and multinationals have been exposed to risks of derivative products in a volatile global financial market and possess the knowledge and expertise in this area to manage the risks as well as gain by it. It is they who have been keen to develop a local derivative market. The State Bank acceded to their demand but is moving cautiously. It satisfies itself that parties to the agreement are fully aware of the risk of the derivative products. Local firms and banks need to be made aware of the downside or the risks in the hedging business.Sources here said the SBP is also preparing the risk management guidelines for derivatives. These derivatives, if used cautiously, are expected to be a positive step towards gaining economic efficiency. But the risk is that many want to become multi-millionaires overnight.In Pakistani market, the entry of derivatives began in early 1990s with currency swaps called "dirty swaps" when foreign exchange reserves plummeted to low levels. Inter-bank players have also been carrying out swaps to square their daily currency exposures. But, to quote bankers, the market appetite for formal derivatives has risen from the need for risk management strategies, prevailing low interest rates and a relatively stable exchange rate."Some big players with overseas operations took the initiative and responded to the private sector's demands to lock in their liabilities and the future currency inflows at better prices," says an SBP report.The implications of the derivatives have been also summed up by central bank as follows: Using financial derivatives brings up a number of concerns. In addition to risk sharing properties, derivative instruments facilitate information gathering.The basic risks associated with derivative transactions are explicit market risks along with risks related to credit, liquidity, operations, legal and those stemming from information and functional characteristics of given financial market structure. Since they facilitate the specific identification and management of these risks, derivatives have the potential to enhance safety and soundness of financial institutions and to produce more efficient allocation of financial risks.