mba fyp final report final
DESCRIPTION
mehdiTRANSCRIPT
RISK MANAGEMENT PRACTICESRISK MANAGEMENT PRACTICES
A CASE OF PAKISTAN STOCK MARKETA CASE OF PAKISTAN STOCK MARKET
FYP REPORTFYP REPORT
Submitted by:
SANDEEP KUMAR
09-3306(MBA)
Supervised by:
MR. SYED BABAR ALI
Program:
Master of Business Administration (MBA)
FAST-SCHOOL OF BUSINEESFAST-SCHOOL OF BUSINEES
NATIONAL UNIVERSITY OF COMPUTER & EMERGING SCIENCENATIONAL UNIVERSITY OF COMPUTER & EMERGING SCIENCEMANAGEMENT SCIENCE DEPARTMENT, KARACHMANAGEMENT SCIENCE DEPARTMENT, KARACH
ACKNOWLEDGMENTS
All praises and thanks are for
Almighty ALLAH Who is the source of
all knowledge and wisdom endowed
to mankind and to the humanity as a
whole. I would particularly like to
thanks Mr. Syed Babar Ali (Course
Supervisor & PROFESSOR NU: FAST)
and Mr. Zaki Rashidi (Course
coordinator & PROFESSOR NU: FAST)
for many insights he provided us
throughout this FINAL YEAR PROJECT
report. Discussions with them have
also proven most helpful.
The encouragement and assistance of
our parents and friends are gratefully
acknowledged. Most of all, I wish to
thank Mr. Nadeem Yaseen and Mr.
Jamil Ahmed Mehar who provided me
the important and relevant
information to complete this report.
2
In the end, I express my deep
appreciation to all the people who
share their experience and knowledge
with me. I am grateful for the
inspiration and wisdom of them.
Table of ContentsChapter .01...............................................................................................................................7
1. Introduction..........................................................................................................................7
1.1 Overview of Topic 7
1.2 Historical background 8
RISK........................................................................................................................................9
2.1. Defining Risk 9
2.1.1. Definitions of risk...................................................................................................9
2.2 Types of Risks 10
2.2.1 Fundamental Types of Risks.................................................................................10
2.2.2 Specific Types of Risks.........................................................................................10
3. Risk management...............................................................................................................12
3.1 Introduction: 12
3.2 Methodology 12
3.3 Process 12
3.4 Potential risk treatments 13
3.4.1 Risk avoidance......................................................................................................13
3.4.2 Risk reduction.......................................................................................................13
3.4.3 Risk retention........................................................................................................14
3.4.4 Risk transfer..........................................................................................................14
3.5 Risk-management plan 15
3
3.6 Implementation 15
3.7 Areas of risk management15
3.8 Financial risk management 16
4. The Stock Market...............................................................................................................17
4.1 HISTORY OF STOCK EXCHANGES 17
4.2 PAKISTAN STOCK MARKETS 18
4.2.1 Lahore Stock Exchange.................................................................................................18
4.2.2The Islamabad Stock Exchange (ISE)............................................................................18
4.2.3 The Karachi Stock Exchange........................................................................................19
5. Objective of the Study........................................................................................................20
6. Research Question..............................................................................................................20
7. Issues behind the Study......................................................................................................20
8. Limitations and Scope........................................................................................................20
9. Background and Justification.............................................................................................21
Chapter .02.............................................................................................................................23
1. Literature Review...............................................................................................................23
1.1 Defining Risk 23
1.2 Risk Management24
1.3 Levels of Risk Management Activities.....................................................................24
1.3.1 Strategic level........................................................................................................25
1.3.2 Macro Level..........................................................................................................25
1.3.3 Micro Level:..........................................................................................................25
1.4 Risk Evaluation/Measurement 26
1.5 Misconception 26
1.6 Issues in Risk Measurement 27
1.6.1 Are Returns Normally Distributed.........................................................................27
1.6.2 Serial Correlation..................................................................................................27
1.6.3 Correlation among Outcomes................................................................................27
1.6.4 Risk Ignorance.......................................................................................................28
1.7 Risk Mitigation.........................................................................................................28
1.7.1 Risk Migration.......................................................................................................29
1.8 Implications..............................................................................................................29
4
1.8.1 Implications for Managers.....................................................................................29
1.8.2 Implications for Regulators...................................................................................30
2. The Influence of Enterprise Risk Management on Stock Market performance 31
2.1 Overview31
2.2 Purpose of Enterprise Risk Management 32
2.3 Illustrating Some Major Events 32
3. Stock Market Volatility and Risk Management..................................................................34
4. Calculating Value-at-Risk..................................................................................................36
4.1 Overview36
4.2 Measurement of Risk 37
Chapter.03..................................................................................Error! Bookmark not defined.
Research Methodology...........................................................................................................38
1. Overview: 38
2. Research Design: 38
3. Procedure: 38
4. Software employed: 39
5. Research Schedule: 39
6. Population: 39
7. Sample: 39
8. Measurement Selection: 40
Chapter.04..............................................................................................................................41
4.1 Analysis of Risk Management Practices at KSE:.............................................................41
4.1.1 Eligibility of Listing: 41
4.1.2 Products and services: 43
4.1.3 Netting:45
4.1.3.1 Netting rules at KSE:..........................................................................................45
4.1.4 Mark to market procedures: 46
4.1.5 Clearing: 47
4.2 Settlement and clearing for Deliverable Future Contracts:...............................................48
4.2.1 Daily Clearing: 48
4.2.2 Final Clearing 49
4.2.3 Special Clearing 49
5
4.3 Settlement and clearing for Cash Settled Future Contracts:..............................................49
4.3.1 Daily Clearing 49
4.3.2 Final Clearing & Settlement 50
4.3.3 Special Clearing 50
4.4 Other initiatives by KSE:.................................................................................................51
4.5 KSE Risk Management Practices:....................................................................................52
Chapter.05..............................................................................................................................54
Conclusion and Recommendations........................................................................................54
5.1 Conclusion:......................................................................................................................54
5.2 Future Outlook:................................................................................................................55
Bibliography...........................................................................................................................55
References.............................................................................................................................55
Appendix...………………………………………………………………………… 44
6
Chapter .01
1. Introduction
1.1 Overview of TopicRisk management is the identification, assessment, and prioritization of risks
followed by coordinated and economical application of resources to minimize,
monitor, and control the probability or impact of unfortunate events. The risk can
come from hesitation in monetary market, project failure, legal liability, credit risk,
accident, natural cause and disaster.
Risk Mitigation Practices as well faces difficulties to allocate capital. This is the
scheme of opportunity cost. Resources depleted on risk management could have been
spent on more profitable activities. Again, ideal risk management minimizes spending
while maximizing the reduction of the negative effects of risks.
Understanding risk in emerging markets is a critical success factor for management
today. Risk management is about prohibited decision making rather than risk evading.
7
Corresponding risk and reward is increasingly important but return does not come
without risk. Risk Management in rising markets is mainly concerned with the risks
facing long-term investors who deposit their money in real assets rather than financial
ones such as investing in stock markets.
Risk management Practice basically Financial Risk Management practice is the
practice of creating economic value in a firm by using financial instruments to
manage exposure to risk, particularly credit risk and market risk. Additional types
include foreign trade, outline, Volatility, region, Liquidity, price increases risks, etc.
Risks can appear from ambiguity in financial markets, project failures, legal liability,
credit risk, accidents, innate causes and disaster as well as deliberate attacks from an
opposition.
Due to dynamic market environment of Stock markets the investors are more exposed
to the Risk and this is the most important reason of paying so much attention to the
risk management practices by the regulatory bodies of stock markets. Pakistan stock
market is one the growing stock market in its region and but it is also very much
exposed to the risk in fact Pakistan stock market is even more uncertain because
political instability in the country. So Risk Management has become a vital to
everyone who is directly or indirectly engages in stock market.
1.2 Historical backgroundThe term risk may be traced back to classical Greek rizikon (Greek ριζα, riza),
meaning root, later used in Latin for cliff. The term is used in Homer’s Rhapsody M
of Odyssey "Sirens, Scylla, Charybdee and the bulls of Helios (Sun)" Odysseus tried
to save himself from Charybdee at the cliffs of Scylla, where his ship was destroyed
by heavy seas generated by Zeus as a punishment for his crew killing before the bulls
of Helios (the god of the sun), by grapping the roots of a wild fig tree.
Niklas Luhmann - the Sociologist said that the term 'risk' is a neologism which
appeared with the transition from traditional to modern society. "In the center Ages
the term riscium was used in highly explicit contexts, over all ocean trade and its
8
ensuing authorized problems of loss and spoil." In the vernacular languages of the
16th century the words rischio and riezgo were used, both terms derived from the
Arabic word "رزق", "rizk", meaning 'to seek prosperity'. The introduction of this
happened in continental Europe, during interaction of Middle Eastern and North
African Arab dealers. The term risk in the English words emerged only in the 17th
century, and "looks to be brought in since continental Europe." When the terminology
of risk took ground, it replaced the older notion that thought "in terms of good and
bad fortune." Niklas Luhmann (1996) seeks to explain this transition: "Perhaps, this
was simply a loss of plausibility of the old rhetorics of Fortuna as an allegorical
figure of religious content and of prudentia as a (noble) virtue in the emerging
commercial society."
2. RISK
2.1. Defining RiskRisk is a concept that denotes the precise probability of specific eventualities. In
principle, the term of risk is autonomous as of the notion of value and, as such,
eventualities may have both helpful and unfavorable cost. Though, in common usage
the convention is to focus only on likely pessimistic impact to some trait of value that
may occur from a prospect event.
Risk can be definite as “the warning or likelihood that an action or incident will
negatively or constructively affect an organization’s capacity to accomplish its
objectives”. In easy terms risk is ‘Uncertainty of results’, either from pursue of a
prospect optimistic chance, or an accessible negative threat in trying to attain a
present goal.
9
2.1.1. Definitions of risk
"Risk is a Combination of the likelihood of an occurrence of a hazardous event or
exposure(s) and the severity of injury or ill health that can be caused by the event or
exposure(s)" OHSAS 18001:2007
"Risk is the unwanted subset of a set of uncertain outcomes” (Keating)
Qualitatively, risk is proportional to both the expected losses which may be caused by
an event and to the probability of this event. Superior loss and superior event
probably result on the whole in a greater risk.
Regularly in the theme of literature, risk is defined in pseudo-formal form where the
mechanism of the description are unclear and distracted, for instance, risk is measured
as an sign of threat, or depends on coercion, vulnerability, impact and uncertainty.
2.2 Types of Risks
2.2.1 Fundamental Types of Risks
2.2.1.1Systematic Risk
Systematic risk influences a large number of assets. An important political occasion,
for instance, might affect quite a few of the resources in your portfolio. It is almost
impractical to protect yourself against this kind of risk.
2.2.1.2Unsystematic Risk
Unsystematic risk is at times referred to as "explicit risk". This class of risk affects a
very little amount of assets. An illustration is rumor that affects an explicit supply
such as an impulsive strike by workers. Diversification is the only way to protect you
from unsystematic risk.
2.2.2 Specific Types of Risks
2.2.2.1. Credit Risk
Credit risk is the risk that a company or individual will be unable to pay the
contractual interest or principal on its debt obligations. This type of risk is of
10
particular concern to investors who hold bonds in their portfolios. Government bonds,
especially those issued by the federal government, have the least amount of default
risk and the lowest returns, while corporate bonds tend to have the highest amount of
default risk but also higher interest rates. Bonds with a lower chance of default are
considered to be investment grade, while bonds with higher chances are considered to
be junk bonds.
2.2.2.2. Country Risk
Country risk refers to the risk that a country won't be able to honor its financial
commitments. When a country defaults on its debt, this can harm the performance of
all other financial instruments in that country as well as other countries it has relations
with. Countryside risk is relevant to stocks, bonds, mutual funds, options and futures
that are issued within a particular country. This sort of risk is most frequently seen in
rising markets that have a severe debit.
2.2.2.3. Foreign-Exchange Risk
When spending in foreign countries you must think about the piece of information
that currency exchange rates can vary the price of the asset as well. Foreign-exchange
risk relates to all financial instruments that are in prevalence other than your local
currency. As an example, if you are a resident of America and invest in some
Canadian stock in Canadian dollars, even if the share value appreciates, you may lose
money if the Canadian dollar depreciates in relation to the American dollar.
2.2.2.4. Interest Rate Risk
Interest rate risk is the risk that an investment's value will change as a result of a
change in interest rates. This risk affects the value of bonds more directly than stocks.
2.2.2.5. Political Risk
Political risk represents the financial risk that a country's government will suddenly
change its policies. This is a major reason why developing countries lack foreign
investment.
11
2.2.2.6. Market Risk
This is the most well-known of the entire risks. Also referred to as volatility, market
risk are the day-to-day fluctuations in a stock's price. Market risk concerns primarily
to stocks and options. As a whole, stocks are likely to achieve well during a bull
market and poorly in a bear market - volatility is not so much a cause but an effect of
certain market forces. Instability is a determinant of risk as it refers to the
performance, or "nature", of your speculation rather than the grounds for this
behavior. Because market movement is the reason why people can make money from
stocks, volatility is essential for returns, and the more unstable the investment the
more chance there is that it will experience a dramatic change in either direction.
3. Risk management
3.1 Introduction:Risk management is the identification, assessment, and prioritization of risks
followed by coordinated and economical application of resources to minimize,
monitor, and control the probability and/or impact of unfortunate events. The risk can
come from hesitation in monetary market, project failure, legal liability, credit risk,
accident, natural cause and disaster. The strategy to deal with risk contain transferring
the risk to a different party, avoiding the risk, dropping the pessimistic effect of the
risk, and tolerant a little or all of the cost of a particular risk.
3.2 Methodology
For the most part, these methodologies consist of the following elements, performed,
more or less, in the following order.
1. identify, characterize, and assess threats
2. assess the vulnerability of critical assets to specific threats
3. determine the risk (i.e. the expected consequences of specific types of attacks
on specific assets)
12
4. identify ways to reduce those risks
5. Prioritize risk reduction measures based on a strategy.
3.3 Process1. Identification of risk in a selected domain of interest
2. Planning the remainder of the process.
3. Mapping out the following:
o the social scope of risk management
o the identity and objectives of stakeholders
o The basis upon which risks will be evaluated, constraints.
4. T o Define a structure for the activity and a schedule for identification.
5. Develop a study of risks concerned in the procedure.
6. Improvement of risks using accessible scientific, human and
organizational capital.
3.4 Potential risk treatments
Once risks have been identified and assessed, all techniques to manage the risk fall
into one or more of these four major categories:
1. Avoidance (eliminate)
2. Reduction (mitigate)
3. Transfer (outsource or insure)
4. Retention (accept and budget)
3.4.1 Risk avoidance
It includes none performing an activity that could carry risk. An example would be
not buying a property or business in order to not take on the liability that comes with
13
it. Another would be not flying in order to not take the risk that the air-planes was to
be hijacked. Avoidance possibly will appear the counter to all risks, but avoiding
risks also means down out on the probable increase that accepting the risk may have
permissible. Not entering an industry to keep away from the risk of failure also avoids
the likelihood of earning income.
3.4.2 Risk reduction
It involves methods that reduce the severity of the loss or the likelihood of the loss
from occurring. For example, sprinklers are designed to put out a fire to reduce the
risk of loss by fire. This means may origin a bigger loss by stream damage and as a
result may not be apt. Halon fire suppression systems may mitigate that risk, but the
cost may be prohibitive as a strategy. Risk management may also take the form of a
set policy, such as only allow the use of secured IM platforms (like Brosix) and not
allowing personal IM platforms (like AIM) to be used in order to reduce the risk of
data leaks.
Outsourcing could be an example of risk reduction if the outsourcer can demonstrate
higher capability at managing or reducing risks. In that situation companies
subcontract only some of their departmental requirements. For instance, a business
may outsource only its software advance, the developer of hard goods, or client
support needs to another company, while treatment the business organization itself.
This technique can focus more on business development exclusive of having to worry
as much about the manufacturing process, managing the development team, or
decision a physical position for a call center.
3.4.3 Risk retention
It involves accepting the loss when it occurs. True self insurance falls in this category.
Risk retention is a feasible policy for little risks where the price of insuring against
the risk would be greater over time than the total wounded constant. All risks that are
not avoided or transferred are retained by default. This includes risks that are so large
14
or disastrous that they either cannot be insured against or the premiums would be
infeasible.
This may also be satisfactory if the possibility of a very large loss is small or if the
price to cover for greater reporting amounts is so great it would hold back the goals of
the organization too much.
3.4.4 Risk transfer
In the terminology of practitioners and scholars alike, the purchase of an insurance
contract is often described as a "transfer of risk." However, technically speaking, the
buyer of the contract generally retains legal responsibility for the losses "transferred",
meaning that insurance may be described more accurately as a post-event
compensatory mechanism. For example, a personal injuries insurance procedure does
not relocate the risk of a car mishap to the insurance business.
3.5 Risk-management plan
Select appropriate controls or countermeasures to measure each risk. Risk
improvement desires to be accepted by the proper level of supervision. The risk
management plan should propose applicable and effective security controls for
managing the risks. For instance, an experiential high risk of computer viruses could
be mitigated by acquiring and implementing antivirus software. A high-quality risk
executive plan is supposed to contain a plan for control implementation and
responsible persons for that trial.
3.6 Implementation
Follow all of the planned methods for mitigating the effect of the risks. Acquire
insurance policies for the risks that have been determined to be transferred to an
insurer, evade all risks that can be avoided without sacrificing the entity's goals,
diminish others, and hold the rest.
15
3.7 Areas of risk management
As applied to corporate finance, risk management is the technique for measuring,
monitoring and controlling the financial or operational risk on a firm's balance sheet.
See value at risk.
The Basel II framework breaks risks into market risk (price risk), credit risk and
operational risk and also specifies methods for calculating capital requirements for
each of these components.
3.8 Financial risk managementFinancial risk management is the practice of creating economic value in a firm by
using financial instruments to manage exposure to risk, particularly credit risk and
market risk. Further type include Foreign trade, Shape, Volatility, region, Liquidity,
price increases risks, and so on. Parallel to broad risk management, monetary risk
management requires identify its sources, measuring it, and device to deal with them.
Financial risk management be capable of be qualitative and quantitative too. As in the
field of risk management, financial risk management focuses on when and how to
evade using financial instruments to supervise costly exposures to risk.
In the banking segment globally, the Basel Accords are usually adopted by
internationally lively banks for tracking, coverage and revealing operational, credit
and marketplace risks. The concepts of financial risk management change
dramatically in the international realm. Multinational Corporations [[MNC}] s are
faced with many different obstacles in overcoming these challenges.
16
4. The Stock Market
4.1 HISTORY OF STOCK EXCHANGESIn 11th century France the courtiers de change was concerned with managing and
regulating the debts of agricultural communities on behalf of the banks. As these men
also traded in amount outstanding, they might be called the first broker.
Nevertheless, it is more probable that in the overdue 13th century goods traders in
Bruges gathered within the residence of a man called Van der Burse, and in 1309 they
institutionalized this until now informal meeting and became the "Bruges Bourse".
The plan reach rapidly in the region of Flanders and neighboring counties and
"Bourses" soon opened in Ghent and Amsterdam. The house of the Beurze family on
Vlaamingstraat Bruges was the site of the world’s first stock Exchange, in 1415. The
term Bourse is believed to have derived from the family name Beurze.
In the middle of the 13th century, Venetian bankers began to trade in government
securities. In 1351, the Venetian administration outlawed spreading rumors proposed
to inferior the price of government resources. There were people in Pisa, Verona,
Genoa and Florence who also began trading in government securities during the 14th
century. This was only likely since these were free city states lined by a council of
significant citizens, not by a duke.
The Dutch later started joint stock companies, which let shareholders invest in
business ventures and get a share of their profits - or losses. In 1602, the Dutch East
India Company issued the first shares on the Amsterdam Stock Exchange. It was the
17
first company to issue stocks and bonds. In 1688, the trading of stocks began on a
stock exchange in London.
o Corporate governance
o Creating investment opportunities for small investors
o Government capital-raising for development projects
o Barometer of the economy
4.2 PAKISTAN STOCK MARKETSPakistan has a total of 3 stock exchanges that are given below:
o Karachi Stock Exchange - KSE
o Lahore Stock Exchange – LSE
o Islamabad Stock Exchange – ISE
4.2.1 Lahore Stock Exchange It was established in October 1970 and is the second largest stock exchange in the
country with a market share of around 12-16% in terms of daily traded volumes. LSE
has 519 companies, across 37 sectors of the financial system, that are listed on the
Exchange with total scheduled capital of Rs. 555.67 billion having market
capitalization of approximately Rs. 3.64 trillion. LSE has 152 members of whom 81
are business and 54 are individual members.
4.2.2The Islamabad Stock Exchange (ISE) It was incorporated as a guarantee limited Company on 25th October, 1989 in
Islamabad Capital territory of Pakistan with the main object of setting up of a trading
and settlement infrastructure, information system, skilled resources, accessibility and
a fair and orderly market place that ranks with the best in the world. The reason for
institution of the stock exchange in Islamabad was to provide to the needs of less
urbanized areas of the northern part of Pakistan. At present there are 118 members
18
out of which 100 are corporate bodies including commercial and investment banks,
DFIs and brokerage houses.
The supplementary 18 Members are individual persons who are well
learned, enterprising with progressive minded. At the moment there are 247
companies/securities listed including 6 Open- End Mutual Fund and 4 TFCS on the
Exchange with an aggregate capital of Rs. 526,487.571 million. The market
capitalization was at Rs. 358, 0474.104 million as on 30-04-2008. The pace of listing
has remained slow as the economy of the Country is under consistent pressure due to
internal as well as external factors.
4.2.3 The Karachi Stock ExchangeThe oldest exchange in Pakistan was established in 1947 and became a registered
company limited a few years later. Since then it has experienced a remarkable
progress with only 5 companies listed and 90 members on the Exchange in the 1950s
and 663 listed companies and 200 members in 2006.
In 2002, the Karachi Stock Exchange was renowned globally by the journal 'Business
Week' as one of the best performing stock markets in the globe.
The association in the Karachi Stock Exchange is restricted. Just 200 individual and
business entities can list as members in the KSE. In 2005, 162 members traded
dynamically on the Exchange. In addition, overseas business entities may also happen
to the members of the KSE with the state that the candidate member of the company
is a resident of Pakistan.
Karachi Stock Exchange is the major and most liquid trade and has been affirmed as
the “most excellent Performing Stock Market of the globe for the year 2002”. As on
December 31, 2007, 654 companies were listed with the market capitalization of Rs.
4,329,909.79 billion (US $ 70.177) having listed capital of Rs. 671.269 billion (US $
10.880 billion) The KSE 100 Index closed at 14075.83 on December 31, 2007.
19
KSE has been well into the 6th year of being one of the Best Performing Markets of
the world as declared by the international magazine “Business Week”. Likewise the
US newspaper, USA Today, termed Karachi Stock Exchange as one of the most
excellent performing bourses in the globe.
5. Objective of the Studyo To determine the Effectiveness of the Risk Management Practice in Pakistan
Stock Market.
6. Research Questiono Are Risk Management Practices in Pakistan Stock Market in line or align with
the emerging Stock Markets (like Indian, Australian, and Russian etc)?
7. Issues behind the StudyThe emerging stock markets are very expose to risks and risks can be of various type
like credit risk political risk etc and risk can be of volatility of returns or it can
changing market conditions, uncertainty and dynamic business environment. That is
why it has been very important to manage the risk so that the uncertainty can be
minimized. Investors are seeking value on their investment but due to the volatile
market condition they are exposed many potential losses and this is the main issue
behind the study of risk management around the world in many different aspects to
minimize the risk through quality risk management practices.
20
8. Limitations and Scope
Risk management is simply a practice of systematically selecting cost effective
approaches for minimizing the effect of threat realization to the organization. All
risks can never be fully avoided or mitigated simply because of financial and practical
limitations. Therefore all organizations have to accept some level of residual risks. If
risks are improperly assessed and prioritized, time can be wasted in dealing with risk
of losses that are not likely to occur. Spending too much time assessing and managing
unlikely risks can divert resources that could be used more profitably. Unlikely events
do occur but if the risk is unlikely enough to occur it may be better to simply retain
the risk and deal with the result if the loss does in fact occur. Qualitative risk
assessment is subjective and lacks consistency.
In the years leading up the financial crisis, some regulators identified weaknesses in
the risk management systems of large, complex financial institutions. Regulators told
us that despite these identified weaknesses, they did not take forceful action—such as
changing their assessments—until the crisis occurred because the institutions reported
a strong financial position and senior management had presented the regulators with
plans for change. Moreover, regulators acknowledged that in some cases they had not
fully appreciated the extent of these weaknesses until the financial crisis occurred and
risk management systems were tested by events.
In several instances, regulators identified shortcomings in institutions’ oversight of
risk management at the limited number of large, complex institutions we reviewed
but did not change their overall assessments of the institutions until the crisis began.
Risk evaluation and risk management instruments are difficult to use and monitor.
Understanding them often requires a good grasp of mathematics and statistics. It is,
consequently, not clear that audit-committee members without specialized training
would be up to monitoring the in-and-outs of coverage and even speculations
presented to them, often in rapid and very summary fashion.
21
9. Background and JustificationThe primary justification for a formal risk assessment process is legal and
bureaucratic. Prioritizing too highly the risk management processes could keep an
organization from ever completing a project or even getting started. This is especially
true if other work is suspended until the risk management process is considered
complete. It is also important to keep in mind the distinction between risk and
uncertainty. Risk can be measured by impacts x probability.
Financial institutions need systems to identify, assess, and manage risks to their
operations from internal and external sources. These risk management systems are
critical to responding to rapid and unanticipated changes in financial markets.
Risk management depends, in part, on an effective corporate governance system that
addresses risk across the institution and also within specific areas of risk, including
credit, market, liquidity, operational, and legal risk. The board of directors, senior
management (and its designated risk-monitoring unit), the audit committee, internal
auditors, and external auditors, and others have important roles to play in an
effectively operating risk-management system. The different roles that each of these
groups play represents critical checks and balances in the overall risk-management
system, Regulators also have a role in assessing risk management at financial
institutions. In particular, oversight of risk management at large financial institutions
is divided among a number of regulatory agencies.
22
Chapter .02
1. Literature Review
1.1 Defining RiskFor the purpose of these guidelines financial risk in organization is possibility that the
outcome of an action or event could bring up adverse impacts. Such outcomes could
either result in a direct loss of earnings / capital or may result in imposition of
constraints on company’s ability to meet its business objectives. Such constraints
pose a risk as these could hinder a company’s ability to conduct its ongoing business
or to take benefit of opportunities to enhance its business (Guidance for practitioners
2007).
Management of Risk (2007 Edition) Guidance for Practitioners
Regardless of the sophistication of the measures, companies often distinguish
between expected and unexpected losses. Expected losses are those that the bank
knows with reasonable certainty will occur (e.g., the expected default rate of
corporate loan portfolio or credit card portfolio) and are typically reserved for in
some manner. Unexpected losses are those associated with unforeseen events (e.g.
losses experienced by companies in the aftermath of nuclear tests, Losses due to a
sudden down turn in economy or falling interest rates). Companies rely on their
capital as a buffer to absorb such losses (Chapman 2004). Project Risk Management -
Processes, Techniques and Insights Chris Chapman, (2004)
” Risks are usually defined by the adverse impact on profitability of several distinct
sources of uncertainty. While the types and degree of risks an organization may be
exposed to depend upon a number of factors such as its size, complexity business
activities, volume etc, it is believed that generally the companies face Credit, Market,
Liquidity, Operational, Compliance / legal / regulatory and reputation risks. Before
overarching these risk categories, given below are some basics about risk
23
Management and some guiding principles to manage risks in organization” (Ward
2003) Stephen Ward (2003
1.2 Risk Management
“Risk Management is a discipline at the core of every financial institution and
encompasses all the activities that affect its risk profile. It involves identification,
measurement, monitoring and controlling risks to ensure that (Well-Stam, Lindenaar
& Kinderen & Bunt 2004): D. van Well-Stam, F. Lindenaar, S. van Kinderen, B.P.
can den Bunt (2004):
a) The individuals who take or manage risks clearly understand it.
b) The organization’s Risk exposure is within the limits established by Board of
Directors.
c) Risk taking Decisions are in line with the business strategy and objectives set by
BOD.
d) The expected payoffs compensate for the risks taken
e) Risk taking decisions are explicit and clear.
f) Sufficient capital as a buffer is available to take risk”
“The acceptance and management of financial risk is inherent to the business. Risk
management as commonly perceived does not mean minimizing risk; rather the goal
of risk management is to optimize risk-reward trade -off. Notwithstanding the fact
that companies are in the business of taking risk, it should be recognized that an
institution need not engage in business in a manner that unnecessarily imposes risk
upon it: nor it should absorb risk that can be transferred to other participants” (Vose
2008).
Risk Analysis: A Quantitative Guide David Vose (2008)
24
1.3 Levels of Risk Management Activities
In every financial institution, risk management activities broadly take place
simultaneously at following different hierarchy levels (Crouhy & Galai 2000). Risk
Management Michel Crouhy, Dan Galai, Robert Mark (2000)
1.3.1 Strategic level
It encompasses risk management functions performed by senior management and
BOD. For instance definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish adequate systems
and controls to ensure that overall risk remain within acceptable level and the reward
compensate for the risk taken.
1.3.2 Macro Level
It encompasses risk management within a business area or across business lines.
Generally the risk management activities performed by middle management or units
devoted to risk reviews fall into this category.
1.3.3 Micro Level:
It involves ‘On-the-line’ risk management where risks are actually created. This is the
risk management activities performed by individuals who take risk on organization’s
behalf such as front office and loan origination functions. The risk management in
those areas is confined to following operational procedures and guidelines set by
management.
“Expanding business arenas, deregulation and globalization of financial activities
emergence of new financial products and increased level of competition has
necessitated a need for an effective and structured risk management in financial
institutions. A company’s ability to measure, monitor, and steer risks
comprehensively is becoming a decisive parameter for its strategic positioning. The
risk management framework and sophistication of the process, and internal controls,
used to manage risks, depends on the nature, size and complexity of institutions
25
activities. Nevertheless, there are some basic principles that apply to all financial
institutions irrespective of their size and complexity of business and are reflective of
the strength of an individual company’s risk management practices” (Chapman &
Ward 2002). Managing Project Risk and Uncertainty Chris Chapman, Stephen Ward
(2002)
1.4 Risk Evaluation/Measurement“Until and unless risks are not assessed and measured it will not be possible to control
risks. Further a true assessment of risk gives management a clear view of institution’s
standing and helps in deciding future action plan. To adequately capture institutions
risk exposure, risk measurement should represent aggregate exposure of institution
both risk type and business line and encompass short run as well as long run impact
on institution. To the maximum possible extent institutions should establish systems /
models that quantify their risk profile, however, in some risk categories such as
operational risk, quantification is quite difficult and complex. Wherever it is not
possible to quantify risks, qualitative measures should be adopted to capture those
risks. Whilst quantitative measurement systems support effective decision-making,
better measurement does not obviate the need for well-informed, qualitative
judgment. Consequently the importance of staff having relevant knowledge and
expertise cannot be undermined. Finally any risk measurement framework, especially
those which employ quantitative techniques/model, is only as good as its underlying
assumptions, the rigor and robustness of its analytical methodologies, the controls
surrounding data inputs and its appropriate application” (Borge 2001) The Book of
Risk Dan Borge (2001)
1.5 MisconceptionA popular misconception is that the objective of risk management is to eliminate risk.
In fact, firms appear to pick and choose among the types and degrees of exposures,
assuming those that they believe they have a competitive advantage in managing and
laying others off into the capital markets, or accepting small or moderate exposures
while insuring against catastrophic ones (Stulz 1996). Thus, a commercial bank may
26
accept credit risk but avoid interest rate risk, while an investment bank does the
opposite
1.6 Issues in Risk Measurement
1.6.1 Are Returns Normally Distributed?
Using the distribution of potential outcomes to measure risk is a great conceptual
advance, but it is a difficult one to implement. Estimation of a potential return
distribution is usually based on historical data, but the availability of such data is
often limited, and even when available, older data may have little forecasting value
because of institutional or structural changes in the environment. In particular,
estimation of the tails of the distribution, the area of special interest for risk managers,
is difficult, since by definition the number of observations in the tails is limited
(Shanley 1996). (Mark Shanley. 1996)
1.6.2 Serial Correlation
An attractive simplification when analyzing risk is to assume serial independence,
that is, that outcomes are not correlated over time, so that the outcome next period
does not depend on the outcome this period. The assumption of serial independence
has two major implications. If outcomes are serially independent, then the standard
deviation of returns increases with the square root of time. That is, daily data can be
used to estimate weekly, monthly, or annual volatility by multiplying the standard
deviation of the daily data by the square root of the number of trading days in the
longer period (Frederic 1999). (Frederic M. 1999)
1.6.3 Correlation among Outcomes
(William R. Nelson. 1999) Nelson (1999) explained that in measuring the risk
exposure of a firm or financial institution, the estimation of the correlation among
27
asset returns is as important as or more important than the estimation of the
distribution of the individual asset returns. This is so because the risk of a portfolio of
assets depends not only on the stand-alone risks (standard deviations) of the
individual assets but also on the correlation (covariance) among them (Antulio 1999).
Bomfim, Antulio(1999) Unless the different assets are perfectly positively correlated,
then the assets will act as partial natural hedges for each other, so that diversification
of the portfolio among different asset types provides an inexpensive and readily
available means to mitigate risk (Federal Reserve Bulletin, June, pp. 369–95).
1.6.4 Risk Ignorance
Merton H. Miller. (1995). Miller (1995) in his studies said that assumptions of
normality, serial independence, or non-varying return correlation are all examples of
“model error.” Model error occurs when the potential exposure is recognized but
misestimated because some parameter of the distribution of outcomes is
misestimated, or because the correlation between different risks is misestimated.
Journal of Model error often results either because managers make inappropriate ex
ante assumptions concerning the shape of the distribution, or because the conceptual
models fail to capture some important aspect of reality (Applied Corporate Finance,
Winter, pp. 62–76).
But a second and extreme form of risk measurement error occurs when the firm fails
to recognize it has any exposure whatsoever. Such a case might be termed “risk
ignorance (Christopher 1995). Culp, Christopher (1995)
1.7 Risk Mitigation
“A firm does not necessarily have to accept a particular distribution of outcomes, but
often can modify the probability of adverse outcomes through its own efforts. These
efforts to alter the distribution of outcomes can be termed “risk mitigation.” To the
extent that a firm successfully mitigates its risks, then its distribution of outcomes will
be less extreme, and it will require less equity capital than if it had undertaken no risk
mitigation (Pan 1997). Jun Pan (1997)
28
Duffie, Darrel (1997) Darrel (1997) explained that risk mitigation can take a number
of different forms. Perhaps the two most obvious are the purchase of insurance, where
the firm pays an unrelated third party to assume the exposure, and hedging, where the
firm takes an offsetting position in a security, commodity, or currency that is closely
correlated with the exposure it wishes to mitigate. But firms also employ a number of
other measures to mitigate exposures, including market research, geographic and
product line diversification, screening and monitoring of customers, outsourcing,
imposing risk premiums in pricing products, carrying inventories or slack in
productive capacity, and imposing defined procedures designed to minimize
operational risks (The Economist 1996). (The Economist 1996 “Coming A Cropper in
Copper)
Eugene F. (1965) According to Eugene (1965), Risk mitigation efforts may be
ineffective for a number of reasons. Perhaps the best known is agency risk, the risk
that a manager or employee, inadvertently or purposefully, will fail to follow the
policies or procedures designed to mitigate risk. For example, a rogue trader whose
compensation or tenure is dependent upon his trading results may fail to abide by
position limits or hide cumulative losses, or maintenance personnel may overlook an
incipient equipment failure. Agency risk has been responsible for a number of
notorious episodes, including the bankruptcies of Orange County and Barings, and
the large losses of Sumitomo (Fama 2000).
1.7.1 Risk Migration
But risk mitigation efforts can also fail for more subtle and indirect reasons (Stephen
1994). The first is the tendency for risk to shift or change form. While an individual
firm may mitigate its risks by purchasing insurance or hedging, these actions do not
reduce systemic risk in the economy, but only transfer it elsewhere ( Figlewski- The
Journal of Derivatives). Moreover, in many cases hedging or purchasing insurance
does not really transfer risk, but merely transforms the nature of the exposure.
29
1.8 Implications
1.8.1 Implications for Managers
Longin & Solnik (1995) explained the existence of non-normality in returns, positive
serial correlation and state-sensitive correlation in returns means that managers must
view their ability to forecast the distribution of future outcomes with some
skepticism. Use of simplifying assumptions such as normality is likely to result in
significant underestimation of the probability of seriously adverse outcomes. Many
institutions have recognized the danger of building their risk management processes
upon assumptions such as normality, and have developed approaches that address
model error (Journal of International Money and Finance, vol. 14, pp. 3–26).
1.8.2 Implications for Regulators
As noted above, risk tends to migrate in the financial system. In particular, hedging
does not reduce systemic risk, but only transfers the exposure elsewhere or transforms
the type of the exposure (Rol & Richard 1988). Thus, risk migration has three
important implications.
First, because risk mitigation activities such as hedging do not reduce the amount of
systemic risk in the system, they also do not reduce the aggregate amount of equity
capital needed to absorb this risk (Parsons 1995). J. E. Parsons. (1995) That is, the
amount of equity capital needed system wide is independent of the amount of risk
mitigation that is undertaken.
Second, the greater the amount of risk mitigation undertaken through hedging or the
purchase of insurance, the more likely that unforeseen losses will migrate quickly
from one market to another, or from one country to another. Journal of Applied
(Corporate Finance, Spring, pp. 106–20) That is, while hedging acts to reduce
independent risk, it can enhance systemic risk.
30
Finally, as risk migrates through the system, it tends to emerge in its most basic form,
as credit risk. This tendency for errors in risk management to ultimately emerge as
credit exposures means that those institutions that specialize in managing and
absorbing credit risks, that is, commercial banks, play a special role (Mello 1991).
Mello, A. (1991)
2. The Influence of Enterprise Risk Management on Stock Market performance
2.1 OverviewThe performance of ERM of the financial sector is limited within hedging activities
of the firm (Stulz 1996; Nacco & Stulz 2006). (Stulz, R. M., 1996; Nacco, B. W., &
Stulz, R. M., 2006) The financial literature suggests that firms should hedge based on
the understanding of efficient market hypothesis of finance. In practice, market is not
efficient and shareholders, at least in theory, do not value firms risk management
initiatives. They can manage their unsystematic risk through diversification. In
contrast, the strategic management literature argues that risk management provides
competitive advantage (Collins & Ruefli, 1992; Miller 1998). However, such
theoretical perspectives about the performance of risk management always remain
inconsistent and mutually exclusive.
In fact, the understanding of risk management could provide contrasting views if
analyzed either from management theories or finance theories. Notwithstanding,
ERM should the theorized by integrating these two matured disciplines while giving
appropriate weights considering the purpose and resource of the specific organization.
Despite several attempts of academics e.g., (Hoyt & Liebenberg 2008) the ultimate
question that still remains unanswered whether ERM above disciplinary silos add
value to the firm. Notwithstanding, all the previous studies were unable to provide a
single indicator in measuring firms risk management capabilities. In such incomplete
theoretical foundation, the study, in line with the asymmetric information theories,
31
accepts insurers’ stock market performance as the ultimate indicator of the
combination of both perspectives.
In line with the conclusion of Mehr & Forbes (1973) the study assumes that the
increase of shareholder value (i.e., finance theory expectation) and achievement of
competitive advantage (management theory expectation) is truly reflected in insurers’
superior stock market performance. Alternatively, the performance of ERM has been
aligned with the overall performance of the organization in the stock market.
Consequently, the hypothesis of the study is that in normal situation insurers’ stock
market performance is positively correlated with the performance of ERM. It is
further hypothesized that if the stock market performance of the insurer maintains an
increasing trend then it can be assumed that the ERM is functioning well. In other
words, ERM practicing insures will demonstrate superior stock market performance.
If the trend is negative then the performance of ERM is not up to the industry level.
2.2 Purpose of Enterprise Risk ManagementLiebenberg & Hoyt (2003), Beasley et’el (2005) suggested the purpose of ERM is to
achieve and balance between the three key objectives. They are
1. Optimization of the risk-adjusted returns for investors;
2. Maintenance of the capital strength required to support firm’s businesses and
future growth opportunities; and
3. Maintenance of capital and risk governance requirements of regulatory and
rating agencies.
2.3 Illustrating Some Major Events
1. September 11 incident: World Trade Center losses in 2001 impacted the insurance
industry over USD 21bn (Swiss 2004). As a result the economy experienced
strong rate increase in the reinsurance market despite government’s bailout to
risky by the insurance industry, in particular, insurance.
32
2. 2001-2002 credit crises: Following the long bull market from 1982 to 2000 the
world stock market crashed in 2002. The market capitalization plunged by billions
of dollars where price losses in the US capital market was calculated at USD
7,000 billion since March 2000.
3. 2004 US Hurricanes: In 2004 the capital losses from hurricane Charley, Frances,
Ivan and Jeanne were priced at USD 28 billion and the economic losses were
calculated at USD 56billion (Swiss 2005).
4. 2005 KRW worst ever insurance loss: The equity market losses from hurricane
Katrina, Rita and Wilma (KRW) in 2005 are estimated at USD 65 billion and total
damage to the economy is calculated at USD 170bn (Swiss 2006). A recent study
conducted by Aon stock price reaction to KRW found that the stock price of
insurance companies were more sensitive to a single large loss rather than to an
aggregation of loss events. The study concludes that companies can illustrate
better stock market performance if they introduce an ERM to manage the
catastrophic losses.
5. 2002 D&O related losses from Enron & WorldCom: Several in settled substantial
amount of losses for D&O related losses arising from the collapse of Enron and
WorldCom. Thereafter the cost of D&O insurance went up 260% from mid-2001
to mid-2003, driven by the lawsuits that arose from the wake of accounting
scandals of these companies.
6. 2007-2008 subprime mortgage crisis and subsequent financial meltdown: The
subprime mortgage crisis threatens some well ranked institutional investing
companies those have exposure on the structured financial products (e.g., CDOs).
Although the insurance industry as a hold does not hold large exposure on the
financial market due to that crisis the life insurance industry are much affected by
interest rate falls.
33
In addition, the industry is affected by 2008 equity market disruption which
eroded their investment income and reduced their capital reserves. There is no
enough information about the ERM initiatives of insurance companies. Although
several insurers realized the need of ERM, there is no consistent understanding
and framework of ERM in the global insurance industry (Acharyya & Johnson
2006). In addition to the industry recognition, the regulators and rating agencies
emphasis on the holistic management of insurers risk. Some rating agencies, in
particular S&P and A.M. Best, take insurers’ ERM initiatives on their financial
strength rating process. Despite the initiatives of several parties it is not still clear
which insurance company is practicing ERM, in particular, what is the correct
structure of their ERM and how are they implemented and how are the
performance of their ERM is evaluated.
In this circumstance, it is difficult to research on the ERM initiatives of insurers
from an empirical perspective. With these limitations the study hold the view that
ERM is the management of all risks irrespective of type whether it comes from
financial and non-financial activates of the insurer. Indeed, such concept is purely
theoretical and difficult to formulate in mathematical terms. The selection of
performance measurement criteria of ERM is even difficult in the lack of market
consistent infrastructure and understanding.
3. Stock Market Volatility and Risk Management
The existence of uncorrelated returns in international stock markets is fundamental in
a context of global portfolio diversification. In presence of high stock market
volatility, risk management represents the main aim for portfolio managers and
international diversification is the key to achieve it. Since the first work by Solnik
(1974) up to some recent papers such as Heston and Rouwenhorst (1994) and Gri¢ n
and Karolyi (1998), evidence on the advantages of cross-country diversification has
been the focus of extensive research.
34
Many investors believe that cross-border diversification increases risk while most of
the literature on this topic provides evidence of its value as a risk reducer. Numerous
studies have investigated international diversification using various methodologies
and dataset. Starting from the early studies by Grubel (1968) and Levy and Sarnat
(1970) ending with the work by Longin and Solnik (2001) have shown different
results on this issue. The early works in the 70s witnessed that correlations among
national stock market returns were low and national markets were largely responding
to domestic economic fundamentals. In the eighties the use of stochastic calculus to
analyses financial markets brought evidence of high and statistically significant level
of interdependence between national markets.
The hypothesis that global markets were becoming more integrated could be verified.
In the last decade, recent studies using larger data set have shown some interesting
results, supporting partially both findings. The main assumption is that certain global
extreme events, i.e. the 1987’s stock market crash, the Kuwait’s invasion by Iraq, the
terrorisms attack in 2001, tend to move world equity markets in the same direction,
thus reducing the effectiveness of international diversification. On the other hand, in
the absence of global events national markets are dominated by domestic
fundamentals and international investing increases the benefits of diversification. In
this paper we want to investigate this assumption using the common trend and
common cycle methodology (Vahid & Engle 1993).
The idea of testing if a set of economic variables move together and identifying
possible co-movements among time series has a long history in economics. Recent
econometric application study the common components in time series using co-
integration and common trends as in Granger (1983) Engle and Granger (1987),
Stock and Watson (1988), common features (Engle & Kozicki 1993) and
codependency (Gourieaux et al. 1991). Co-movements among time series indicate the
existence of common components which would imply a reduction to a more
parsimonious and probably more informative structure. An indicator of co-
35
movements among non stationary variables is co-integration, when the variables are
co-integrated they share some common stochastic trends that drive their long run
swings and at least one linear combination of them exists which has no long swings,
i.e. it is stationary. This methodology has been widely applied to understand the
dynamic of macroeconomic phenomena, i.e. to investigate to what extent business
cycles are transmitted from one country to another, while, in our knowledge, little
evidence of its application to financial data could be found. Hecq (2000); Mills
(2002) and Sharma et al (2002) are the only examples of application of such
methodology to decompose a financial time series using the Beveridge-Nelson
approach. Hecq studies the nature of the relationship between five major international
stock market indices trying to identify a long run component and a cyclical
component, and controls the presence of external shocks using dummy variables. He
uses quarterly data in real US dollars taking the third observation of monthly data in
order to avoid conditional heteroskedasticity problem.
Mills sets up a VECM framework to investigate the presence of common trend and
common cycles of the UK financial markets. He uses weekly data for the period
1969-95. Sharma et al. analyze the degree of long term and short term co-movements
in the stock markets of five Asean countries trying to shed some light on the long-
term and short-term market efficiency/inefficiency in the region.
4. Calculating Value-at-Risk
4.1 OverviewIn volatile financial markets, both market participants and market regulators need
models for measuring, managing and containing risks. Market participants need risk
management models to manage the risks involved in their open positions. Market
regulators on the other hand must ensure the financial integrity of the stock exchanges
and the clearing houses by appropriate margining and risk containment systems
(Varma 1999).
Prof. Jayanth R. Varma (July 1999)
36
The market risk of a portfolio refers to the possibility of financial loss due to the joint
movement of systematic economic variables such as interest and exchange rates.
Quantifying market risk is important to regulators in assessing solvency and to risk
managers in allocating scarce capital. Moreover, market risk is often the central risk
faced by financial institutions. Investment and commercial banks, as well as treasury
operations of many corporations, hold portfolios of complex securities whose value
depends on exogenous state variables such as interest and exchange rates. To allocate
capital, assess solvency, and measure the profitability of different business units
(ranging from individual traders to the entire bank), managers and regulators quantify
the magnitude and likelihood of possible portfolio value changes for various forecast
horizons. This process is often referred to as “measuring market risk”, which is a
subset of the risk management function.
4.2 Measurement of RiskVAR can be derived by placing assumptions on each of these two elements (Garbade
1986; Morgan 1994; Hsieh 1993 & Wilson 1994).
(1) The portfolio function approximation method.
(2) The state variable approximation method.
Garbade (1986), J.P. Morgan (1994), and Hsieh (1993) assume that changes in the
portfolio function can be well-approximated by the delta3 of the portfolio, but differ
in how changes in the state variables are modeled. Garbade (1986) assumes that
changes in the state variables over the forecast period can be modeled as a
multivariate normal (the delta-normal model) J.P. Morgan (1994) refines the
modeling of the changes in the state variables to reflect non-linearity’s by weighting
the residuals in computing the variance (the delta-weighted normal model). Hsieh
(1993) further generalizes the modeling of the evolution of the state variables with an
EGARCH model (the delta-GARCH model). Wilson (1994) enhances the modeling of
the portfolio function but reverts to the Garbade (1986) assumptions on the state
37
variables. Wilson (1994) models the convexity of the portfolio by explicitly
incorporating the gradient and Hessian of the portfolio function (the gamma-normal
model).
Chapter.03
Research Methodology
1. Overview: Financial risk management is always one of the important topics either in theory or in
practice. In the last 25 years, international financial market has developed greatly, and
financial storms have much influence on human’s entire economic behavior with the
mode of over imagination. In early 1990’s, a kind of new risk management
methodology was developed, which is VAR methodology. Value at Risk
methodology is becoming to be the international standard of risk measurement.
The market risk of a portfolio refers to the possibility of financial loss due to the joint
movement of systematic economic variables such as interest and exchange rates.
Quantifying market risk is important to regulators in assessing solvency and to risk
managers in allocating scarce capital. Moreover, market risk is often the central risk
faced by financial institutions.
2. Research Design: It will be both qualitative and quantitative study because the study “Risk management
Practices” is basically focused on the system, policies and measures taken to
minimize the risk faced by investors in stock markets and the analysis will be done on
the basis of both market data and risk management practices guidelines therefore,
study is both Qualitative and Quantitative.
38
3. Procedure: The Steps in which study will be completed:
Step .01 The policies and guidelines of Risk Management from sample stock market
will be collected for analysis. Following are some of the factors on the basis of that
risk management analysis will be done based on the comparison of effectiveness and
efficiency of these factors in Pakistan stock Market and the emerging stock market
(Australia, India and Russia).
o Eligibility of Listings
o Clearing
o Mark to Market Procedures
o Services and Products
o Originations of Products
o Netting and etc
Step.02 In the second step, market performance will be compared with and without
risk management factors to check the effectiveness of the guidelines of the Risk
management.
4. Software employed: The Software that will be used is Spreadsheet.
5. Research Schedule: The time frame of this research is approximately one year.
39
6. Population: The Population of the study is the Equity Market of Pakistan. The study is intended to
find out that whether or not risk management practices in Pakistan stock markets are
align with that of stock markets of emerging countries like Australian, Indian and
Russian stock Markets.
7. Sample: Karachi Stock Exchange is the sample of this study. Equity market of Pakistan is
consisting of Karachi Stock Exchange, Lahore Stock Exchange and Islamabad Stock
Exchange. Since the KSE is one of the best performing stock market of Asia and
characterize with the high level of volatility and its market capitalization is higher
than that of other stock exchanges in Pakistan that is the reason KSE is taken as
sample of this study. This sample that is taken is “Convenience sampling” based on
convenience to cover KSE.
8. Measurement Selection: Data collection method will be secondary i.e. all the data from risk management
guidelines and market performance will be taken of the selected stock markets.
40
Chapter.04
Data Analysis and Findings
4.1 Best Risk management practices of emerging Stock market
Following are the best practices of risk management in emerging stock markets (Australia, Malaysia, Bombay, New York and London Stock exchange)
4.1.1 Listing Eligibility:
Bombay Stock Exchange, the companies need to have minimum market capitalization
requirements of Rs.250 millions and minimum public float of 100 million because
India is a growing market and its stock exchange consists of huge number of big
companies i.e. 4900 therefore their capital requirements are higher than KSE. In
London Stock Exchange, the company must have requirement of minimum market
capitalization of 700000 pounds with a minimum public float of 25%. To be listed on
NASDAQ, a company must have issued at least 1.25 million shares of stock worth
$70 million, and to get listed on NYSE, a company must have issued shares worth
$100 million and must have earned $10 million over 3 years. All the bigger stock
exchanges have different requirements to get listed which solely depend on their
market capitalization.
4.1.2 Products portfolio
41
Diversification is the most important component to help you reach your long-range
financial goals by investing into variety of product portfolio while minimizing your
risk. No matter how much diversification the investors opt for, it can never reduce
risk down to zero.
The diversification could be achieved through various means and they are:
Diversifying the portfolio by investing it among different investment avenues
like stocks, bonds and mutual funds can reduce risk.
The securities that the investors invest into vary in the risk factor and they are
not restricted to pick only blue chip companies but picking different
investments with different rates of return ensures that the large gains offset
losses in a particular area.
The securities that the investors invest into should vary by industry and
minimize the unsystematic risk to small group of companies. The theory of
portfolio suggests that after investing into 10-12 diversified stocks, the
investors achieve diversification and hence, they need to buy stocks of
different sizes from various industries.
Diversification substantially reduces risk with little impact on potential returns. The
key involves investing into categories or securities that are dissimilar because their
returns are affected by different factors and they face different kinds of risks.
Diversification among the major asset categories such as stocks, fixed-income and
money market investment can help reduce market risk, inflation risk and liquidity
risk, since these categories are affected by different market and economic factors.
There are various products being offered by KSE so that investors invest into the
portfolio of securities and diversify their risk. It is basically one of the most efficient
techniques to decrease risk by diversifying it. Apart from that, the customized
services and infrastructure being provided by KSE also saves investors from high
risk. Fully automated system for clearing, trading and settlement minimizes the
chances of fraud and hence, give crystal clear picture for trading of stocks. KSE is
continuously adopting changes in order to have safe and secure transaction therefore;
42
they have installed internet routed trading facility and gateway trading i.e. Order
Management System. To avoid risk and provide secure transaction, investors and
fund managers also have an access to information through Display Only Terminal. To
ensure security of data and to maintain it, brokers are connected to KSE through VPN
which a unique identity is provided to each broker to have protected transaction.
KSE tickers are displayed on all business TV channels through live feeds from KSE
system so that investors have an idea of the prices of various stocks and take decision
to invest into the stocks of certain company. Customized data is provided to investors
for the purpose of trading and assessment of their portfolio. Moreover, KSE website
provide market data on real time basis which includes company’s profiles, their
financial position and summary of marketing activities that are going on in that
company which provides a clear picture of companies to the investors where they
intend to invest and hence, minimizes the risk of loss.
4.1.3 Netting
While identifying the best practices for Netting, the question arises that from whose
perspective the best practices should be identified either from a single ISO’s
perspective or from ISO market participants’ perspective. For netting, the financial
impacts on market participants should be considered and the Subcommittee has
decided that the “best’ should be defined from ISO market participants’ perspective
along with the systematic impacts. Because these ISOs exist to serve the markets and
their market participants are responsible for bearing the default risks, the market
participants’ perspective seems appropriate. As there is a variety of market
participants, the best practice for netting varies by the type of these participants. For
example, a small municipality may find the main source of its netting benefits from
Intra-ISO netting rather than Inter-ISO netting. Therefore, the municipality’s
preferred “best practice” for netting may be the solution with the lowest direct impact
on ISO administrative fees. Alternatively, a power generator using natural gas located
43
in multiple markets may find that it receives more netting benefits from
Inter-ISO/Cross-Market (including OTC natural gas) netting. Therefore, the generator
might find the “best practice” for netting as a solution that maximizes the netting
across multiple ISO and physical OTC power and natural gas markets.
Some of the best practices for Intra-ISO netting and Inter-ISO netting are as under:
Best Practice for Intra-ISO Netting: This approach obtains a security interest in the
market participant’s positions and receivables to be a low cost way to protect ISOs
and other market participants and allow them netting off against other obligations to
the ISOs. The market participants who materially benefit from Intra-ISO netting will
need to bear the incremental cost and complexity of re-arranging their security
interest agreements with financial or other entities.
Best Practice for Inter-ISO/Cross-Market Netting: The global best practice for
Inter-ISO/Cross-Market Netting is reflected in the European experience with
European Commodities Clearing and NASDAQ OMX in which there is netting
across ISO, OTC and exchange markets using a third party clearinghouse. Since ISOs
parallel other Central Counterparty type marketplaces, it seems logical that ISOs
interfacing with clearinghouses or other Central Counterparty entities would bring
greater capital and credit risk management efficiencies.
4.1.4. Mark to Market:
Market risk is significant in public investment portfolios. Due to price volatility,
valuing investments at their current price is necessary to provide a realistic measure
of a portfolio’s true liquidation value. Over time, reporting standards for state and
local government investment portfolios have been enhanced so that investors,
governing bodies, and the public remain informed of the current market value of the
portfolio. Regular disclosure of the value of a governmental entity’s investments is an
44
important step to furthering taxpayer and market confidence in state and local
government investment practices. The Government Finance Officers Association
(GFOA) recommends that state and local government officials responsible for
investment portfolio reporting determine the market value of all securities in the
portfolio on at least a quarterly basis. These values should be obtained from a
reputable and independent source and disclosed to the governing body or other
oversight body at least quarterly in a written report.
It is recommended that the written report include the market value, book value, and
unrealized gain or loss of the securities in the portfolio. If there is a significant event
in the local or national economy that might affect the value of the portfolio, then a
mid-term valuation of the portfolio should be conducted. Governments that employ a
more active portfolio management style should consider more frequent marking to
market and reporting.
4.1.5 Clearing and settlements:
In the context of securities clearing and settlement systems, the nature of governance
planning acquires a dimension that goes beyond their traditional function in corporate
law. They comprise a tool for regulators and central banks to achieve their respective
policy goals relating to market operation, market integrity, and systemic stability.
Whatever the model of corporate governance used in a jurisdiction, securities clearing
and settlement systems should adopt and ensure effective implementation of the
highest corporate governance standards or best practices adopted or recommended for
companies in the authority in which it operates as such standards or practices evolve
over time. Generally, this would imply that securities clearing and settlement systems
at minimum should adopt and implement the best practices recommended for listed
companies. Additionally, a securities clearing or settlement system should adopt
corporate governance mechanisms adequate to address the interests of users and the
public in the operation of the system. Board members should also take into account
the interests of users and the public in board decisions, in particular, those relating to
qualifications for system access, fair pricing, and the integrity of the risk management
45
system, innovation and efficiency, and the achievement of the policy objectives of
competent authorities. Securities clearing and settlement systems should make
adequate disclosures regarding their corporate governance arrangements so that users
and the public can ascertain the manner in which conflicts of interest among owners,
the board, users and the public interest are prevented or mitigated. Corporate
governance arrangements of securities clearing and settlement systems should be the
subject of adequate regulation and oversight to ensure that services are provided at
fair prices to users under fair and equitable conditions of access; that the risk
management programs of system operators are effective; that risk management
decisions are not affected by considerations extraneous to the risk management
function; and that, to the maximum extent possible, functional service providers
compete in equivalent conditions of competition. Looking forward the adoption of a
harmonized regulatory regime for securities, clearing and settlement systems should
be considered to complete the internal market within the Community and to better
achieve the policy goals relating to the governance of those systems.
4.2 Benchmarking of Risk Management Practices
Based on above best practices of risk management of emerging stock market we can set a benchmark.
Factor Best practice
Eligibility of Listing
Minimum Market Capitalization Range $50 million above.
Netting
Intra-ISO Netting: best practice of netting Small Investors who are usually risk averse is to transact within the market with different investors of same risk and return characteristics to net off their obligations.
Inter-ISO/cross Market Netting: Best practice defines that the large investors
46
should net off their obligations cross markets.
Mark to Market
Valuing Investments at their current price to provide a realistic measure of portfolio’s true liquidation value.
Over time, Reporting, standards for state and local governments investment portfolio have been enhanced so that investors, governing bodies, and the public remain informed of the current market value of the portfolio.
Standards reports should include market value, book value and unrealized gain or loss of the securities in the portfolio.
Product Portfolio
Diversifying the portfolio by investing it among different investment avenues like stocks, bonds and mutual funds etc.
Securities that the investors invest into vary in the risk factor.
The securities that the investors invest into should vary by industry and minimize the unsystematic risk
Clearing and settlements
Securities clearing and settlement systems should adopt and ensure effective implementation of the highest corporate governance standards.
Corporate governance mechanisms to address the interests of users and the public in the operation of the system.
Corporate governance arrangements so that users and the public can ascertain the manner in which conflicts of interest among owners, the board, users and the
47
public interest are prevented or mitigated.
Clearing and settlement systems should be the subject of adequate regulation and oversight to ensure that services are provided at fair prices to users under fair and equitable conditions of access.
4.3 Analysis of Risk Management Practices at KSE
Karachi Stock Exchange was established for the purpose of assisting, regulating and
controlling business of buying, selling and dealing in securities. It provides a market
for trading of securities to individuals and organizations who want to invest their
saving through purchase of shares in Stock Exchange and it provides a physical
location for buying and selling of securities. Risk in stock market is an ordinary
phenomenon. If half of the investment is lost, you must double your returns in order
to reach break-even. Managing risk in stock markets first need to require identifying
the type of risk and take actions to minimize the impact of risk on your investments
portfolio. In order to minimize risk, investors firstly need to invest with the trend of
the market which can reduce the likelihood that your stock will fall when market
trend is rising. Secondly, investors need to diversify their investment portfolio across
different companies and sectors. By following these guidelines, a company or
investor could make fine and sound investment without any fear of risk or loss.
Following are some of the factors on the basis of which risk management analysis
will be done on comparative basis of effectiveness and efficiency of these factors in
Pakistan stock Market and the emerging stock market (Australia, India and Russia).
4.3.1 Eligibility of Listing:
Listing requirements are the set of conditions imposed by a given Stock Exchange
upon companies that want to be listed. These conditions include minimum number of
48
shares outstanding, minimum market capitalization and minimum annual income.
Investors or companies who are interested in investing into the stocks of any country,
they need to be eligible for investing and must meet all the criteria which allow them
to invest into the stocks of certain company. For any investment company to be listed
on KSE, several regulations need to be followed in order to reduce risk and help
investors to maintain their rights.
No company will be listed on KSE unless it is registered under the Ordinance
as a public Limited company and its minimum paid-up capital is Rs.200
million.
To succeed public offer of equity, it has to be subscribed by at least 500
companies.
The offering document has to be cleared by KSE before it is submitted to
SECP for approval.
The company who is seeking to list is required to fulfill the relevant
requirements of exchange under the listing regulations and the disclosures as
required under the second schedule of company’s ordinance 1984 and
company’s rules 1996 (KSE Website).
All these regulations for listing need to be followed in order to maintain safe
investment and avoid deregulations. All the investors and companies are required to
register under Ordinance as a public limited company with Rs.200 million paid-up
capitals in order to insure that companies are capable enough to pay for its losses if
any occur while investing into securities. Moreover, the companies need to invest into
a portfolio of shares in order to diversify risk and more capital is required to invest in
those securities. Therefore, these companies need to subscribe themselves by 500
companies and kept clearing by KSE.
4.3.2 Products and services:
49
KSE offers several products and services to its investors to invest in the portfolio of
investments and diversify their risk. Their products include ready market; cash settled
future market, deliverable future market and stock index future market. Ready
market is also known as regular market where sellers and buyers gather for the
intention of trade and the settlement of trade occurs after 2 days after trade. All the
short term investments are done into Ready Market whose settlement period is less.
Cash settled futures are standard contracts to buy or sell certain instruments at a
certain date in future at specified price and settlement period is 30, 60 and 90 days
after purchase of contract. All settlement occurs purely on cash basis. Stock index
futures are traded in the number of contracts where settlement occurs after 90 days of
purchase of contract. Deliverable futures are forward contracts to buy and sell
certain instruments and settlement period are 30 days after purchase.
Services provided by Karachi Stock Exchange are:
They provide customized services and state-of-the-art technology
infrastructure which give it an edge over other exchanges in the country.
It provides fully automated trading, clearing and settlement system.
Internet routed trading facility and gateway trading (Order Management
System)
Investors and fund managers can also access information through Display
Only Terminal
Internet trading facilities are available and order driven system
Brokers are connected to KSE through VPN (to ensure security of data)
Moreover it provides data services which are:
KSE tickers are displayed on TV channels through live feeds from KSE
system
Investors provided customized data packages for trading and assessment of
their portfolio on a real time basis.
50
Data feed provided to major international redistributors (Reuters, Bloomberg)
on real time basis.
KSE website offers data of market on real time basis, including listed
company profiles, snap shot of financials, press releases and summary of
market activities on real
time basis.
4.3.3 Netting:
In the local context, netting means offsetting sales and purchases by a broker in each
security to reduce his cumulative unsettled trades called “exposure.”
Netting refers to allowing positive value and a negative value to set-off and cancel
each other out to terminate their effect. Netting decreases credit exposure, increases
business with existing counterparties, and reduces both operational and settlement
risk and operational costs.
Netting is used in energy and other markets to reduce cash requirements and credit
exposure. Such exposure can be reduced by “netting” such transactions together, as
long as the proper legal documents and appropriate risk processes are in place.
According to the netting rules, exposure of each member will be calculated by
security wise, client-wise and market-wise by Exchange trading system at any point
in time. No netting of open positions will be allowed across markets.
Two types of netting are there:
Intra-ISO netting
Inter-ISO and cross-market netting
Intra-ISO Netting means an ISO would net the buys and sells of “comparable”
transactions with any one member.
51
Inter-ISO/Cross-Market Netting has a couple dimensions. First, it could include
netting of transactions across multiple ISOs. A second dimension of the
Inter-ISO/Cross-Market Netting is the netting across ISO and OTC markets.
The Netting Subcommittee searched for “best practices” and several guidelines were
provided. First, for a practice to be a “best practice” it had to be an existing practice at
one of the power markets. Preferably, this “best practice” would exist at a US ISO,
but the Subcommittee did look to other ISOs around the world.
4.3.3.1 Netting rules at KSE:
Netting within Ready Markets: Netting shall be allowed between buy and
sell positions in the same security on the same day for the same client.
Likewise buy and sell positions of a Member’s proprietary trades in same
security on the same day can be netted against each other (KSE).
Netting within Deliverable Futures Market: Netting shall be allowed
between buy and sell positions in the same security for the same client in the
same contract period. Likewise buy and sell positions in same security in the
same contract period for the proprietary trades of a member can be netted
against each other.
Netting shall only be allowed between buy and sell positions in the same
security for the same client in the same contract period and not for the
different client. Likewise netting is not allowed between buy and sell position
in different scrip for the same client and it is not allowed across different
contracts (30, 60 & 90) for the same client in the same scrip (KSE).
Netting within CSF (Cash-Settled Futures) Market: CSF Market shall be
considered a separate market for the purposes of calculating exposure of a
Member and netting shall not be allowed with Ready or Deliverable Futures
Contract Market (KSE).
52
Netting within Stock Index Futures Contract Market: Regulations
Governing Stock Index Futures Contract Market shall govern the netting of
open positions of a member for determining such members Exposure for the
purposes of these Regulations.
No netting shall be allowed across clients, across markets, across contract
period, across settlement period and across different securities (KSE).
4.3.4 Mark to market procedures:
Mark to market procedure involves recording the price or the value of a security,
portfolio or account on daily basis to calculate profits and losses or to confirm
that margin requirements are being met. It is the act of assigning market value to an
asset and a mode of analysis for portfolio credit risk.
Determination of MtM Losses: MtM Loss (or profit) shall be calculated on trade to
trade basis for each scrip separately, for each client and for proprietary open positions
of a member on the basis of the last executed prices during trading hours on a trading
day. The final determination and collection of MtM Losses at the end of trading day
shall be at the Closing Prices as determined by the Exchange. Provided that the basic
exemption permissible to a member under the regulations applicable to a particular
Market will be deductible, while calculating such MtM Losses of the member (KSE).
Netting: While determining the MtM Losses (or profit) payable by a member, netting
shall be permissible across trades in different securities for the same client or across
trades in different securities for proprietary trades of a member, in the same
settlement date or contract period. No other netting such as across clients, across
markets, across contract periods, across settlement dates shall be allowed (KSE).
MtM Losses deposit:
53
(a) Each member will pay its MtM Losses to the Exchange at any point in time (as
demanded by the Exchange) or at the end of each trading day but not later than prior
to opening of trading on the next day.
(b) MtM losses of members (client as well as proprietary positions) having total
Exposures in the Deliverable Futures Contract Market of more than Rs. 200 million
will be collected twice a day, including at the end of each trading day (KSE).
4.3.5 Clearing and Settlements:
Clearing denotes all activities from the time a commitment is made for
a transaction until it is settled. Clearing is necessary because the speed of trades is
much faster than the cycle time for completing the underlying transaction. In its
widest sense clearing involves the management of post-trading, pre-settlement credit
exposures, to ensure that trades are settled in accordance with market rules, even if a
buyer or seller should become insolvent prior to settlement.
Processes included in clearing are reporting/monitoring, risk margining, netting of
trades to single positions, tax handling, and failure handling.
A clearing house is a financial institution that
provides clearing and settlement services for financial and commodities derivatives
and securities transactions. These transactions may be executed on a futures
exchange or securities exchange, as well as off-exchange in the over-the-
counter (OTC) markets. Its purpose is to reduce the risk of one or more clearing firm
failing to honor its trade settlement obligations. Once a trade has been executed by
two counterparties either on an exchange or in the OTC markets, the trade can be
handed over to a clearing house which then steps between the two original traders'
clearing firms and assumes the legal counterparty risk for the trade.
The settlement in the Karachi Stock Exchange takes place through the centralized
clearing house. The shares that are traded from the Karachi Stock Exchange on
Monday and Tuesday of any week are settled the following Monday. The payments
that are made to the members or the investors are channelized through the Clearing
House (KSE).
54
4.3.5.1 Settlement and clearing for Deliverable Future Contracts:
The Clearing House shall receive payments from Members on settlement days within
the time specified as per the Regulations of the Clearing Company. In case any
Member fails to make any payment to the Clearing House within the specified time,
default proceedings shall be initiated against that member under relevant Regulations
of the Clearing Company. In the event of declaration of dividend, bonus, right and
privileges pertaining to securities being traded in the Deliverable Futures Market for
which the Share Transfer Books of the Company are to be closed during the pendency
of the settlement, the Exchange shall predate the last day of business and the
settlement date of that particular security.
Daily Clearing: It shall be at the Daily Settlement Price of the day and MtM amounts, after
adjustments of MtM Losses received during the day in cash, in respect of a Client
account in a particular scrip, shall be collected from Members in cash on T+0
settlement basis i.e. by day-end on trade day through Clearing House. The Exchange
shall hold back MtM profits of a Member on his Client account in particular scrip
until its Final Settlement. However, MTM profit of a Member on his Client account
in particular scrip will be adjusted against the MtM Loss in the same scrip of such
Client Account on UIN basis (KSE).
Final Clearing It shall be on last day of Contract Period at Final Settlement Price of that day on T+2
settlement basis through the Clearing House. However, Mark to Market Losses shall
continue to be collected on a daily basis, based on closing price of the security for the
55
purpose of Risk Management in the Ready Market. MtM Profits withheld by the
Exchange will be paid to the respective members on the T+2 settlement day through
Clearing Company (KSE).
Special Clearing It is where the exchange determines that circumstances warrants in the best interest of
the Market and Market Participants that suspension of the scrip is necessary, the
Exchange may announce a special clearing in the particular Contract. In case special
clearing is announced, trading in particular scrip shall be suspended until such time
the MtM Losses are settled in cash and the market shall open after all MtM Losses
have been settled in the suspended scrip (KSE).
4.3.5.2 Settlement and clearing for Cash Settled Future Contracts:
Daily Clearing It shall be held at the Daily Settlement Price of the day and MtM Losses/Profits shall
be settled on in the following manner:
Net MtM Losses shall be collected from Members in cash on T+0 settlement
basis (by day-end on trade day) through Clearing House.
Net MtM Profits shall be disbursed to Members in cash on T+1 settlement
basis through Clearing House.
Scrip-wise outstanding position of Brokers will be revalued at relevant Daily
Settlement Price. The system will consider such revalued amounts as traded
values for collection of mark-to-market losses and for making payment of
mark to market profits (KSE).
Final Clearing & Settlement It is done upon closing of contract, final settlement shall take place on T+1 basis and
the resulting profits or losses, calculated on the basis of “Final Settlement Price” shall
be settled in cash. The payment and collection of profits or losses on final settlement
56
to/from Brokers shall be carried out by the Clearing Company within the stipulated
time and in the prescribed manner (KSE).
4.3.5.3 Special Clearing It is when the exchange may announce a special clearing in a Contract or in particular
scrip in a Contract subject to the prior approval of the Commission, in an emergency
situation which may include riot or strike, fire, accident at the Exchange, change of
government or act of God or for any other catastrophic event. In case a special
clearing is announced, trading shall be suspended and all Open Interest will be
required to be settled within one day of the suspension or prior to the opening of the
market. The market would remain suspended till further notice from the Exchange
(KSE).
There are three types of clearing for the safety of investors. One of them is done on a
daily basis where settlement and clearing is done at the end of the day. Final clearing
is done on the last day of contract period while special clearing is made on special
circumstances like emergency situation of riots or strikes, change of the government
or natural calamity. All these types of clearing were initiated in order to provide safe
environment to the investors to invest into certain securities and provide them with
greater confidence to invest in KSE.
4.4 Other initiatives by KSE:
Apart from that, there are many initiatives being taken by KSE regulatory bodies to
increase investor’s confidence into the market.
Customer Services Department is developed to resolve disputes between
investors and brokers with the help of arbitrators.
Investor Protection Fund (IPF) has been created to protect investors in case of
broker default.
57
Clearing House Protection Fund (CHPF) is created to protect brokers in the
event of another member/broker default.
Moreover, investor’s guide is available and education seminars are also held
on regular basis and investor’s help desk is created to help answer queries of
investors (KSE).
In year 2006, KSE with the help of SECP revised Risk Management measures with a
view to safe and orderly transition of market to a new risk management. Several
changes in the previous risk management measures were made in order to give safe
and sound environment to the investors for making such transactions. In the new risk
management practices presented by SECP, CFS financed scrip were increased to 40
where CFS and Ready market were separated and new market margins were
introduced for CFS in order to have secure investment. New netting regime for CFS,
Ready and Future markets were developed and new VAR based margin was
introduced.
VAR is a measure use to estimate how much the value of shares or portfolio of shares
could decrease over a period of time under daily movement of share prices. It is used
by Stock Exchanges to measure the market risk of the transacted but unsettled shares.
This VAR regime is used by banks and other financial institutions in order to measure
risk on their investments. VAR calculates the maximum loss expected on an
investment, over a given time period and given a specified degree of confidence.
While making revision in the Risk Management Practices, it was explained that VAR
based system will take time to get fully implemented as it requires to install new
computer software to calculate risk at the end of each day for all scrip on client basis.
4.5 Comparing KSE Risk Management Practices against Benchmark
KSE is a platform which provides physical market to the investors to invest their
savings into the portfolio of securities. There are a lot of fluctuations in the Stock
58
Exchange market of any country because economic and political conditions have high
influence on its index points. To date, Pakistan is going through unstable conditions
which has influenced its functions; especially the credit crunch of fiscal year 2007-
2008 when KSE went down to around 4000 points and investors faced huge losses. In
order to save investors from the loss of investment, several risk management practices
are adopted by KSE so that investors do not lose their confidence and continue to
invest in its products.
Listing criteria of KSE is such that until and unless the company is not registered
under ordinance as Public Limited Company and does not contain minimum paid-up
capital of Rs. 200 million; it can not list itself with KSE. The capital requirement is
provided in order to ensure that company is capable enough to meet all the
requirements and is able enough to pay if any losses occur. Apart from that, more
capital is required by KSE so that company could invest in portfolio of securities to
avoid risk by diversification. It offers various products like ready and future markets
which gives investors a chance to invest into the portfolio of securities.
It has customized services for its investors and state-of-the-art technology
infrastructure which makes it competitive exchange compared to others. It consists of
fully automated trading, clearing and settlement system which minimizes the chances
of error and eliminate risk. Brokers are connected with KSE through VPN to ensure
that the data is secure. It has internet routed trading facility and gateway trading
which is also called Order Management System.
As for as Netting is concerned, it is only allowed between buy and sell positions in
the same security for the same client in the same contract period and not for a
different client. Likewise netting is not allowed between buy and sell position in
different scrip for the same client and it is not allowed across different contracts (30,
60 & 90) for the same client in the same scrip. In KSE, netting is not allowed across
clients, across markets, across contract period, across settlement period and across
different securities. The reason it is not allowed is because it can increase the chances
of risk if investors do it across clients, markets or different securities.
59
In order to keep track of settlement in KSE, Clearing House was found where
settlement takes place through a centralized system. The payments that are made to
the members or the investors are channelized through the Clearing House which
makes this process clear and transparent. The clearing house is required to collect
payments from the investors on the settlement days and if any investor fails to make
payment, default proceedings are initiated against him according to the regulations
which ensure other investors that their payments are in safe hands. Three types of
clearing are done at KSE i.e. daily, final and special. Daily clearing is done at the end
of each day and final trading is made upon closing of contract which is settled in cash
within stipulated time and manner.
Moreover, KSE has taken many initiatives to maintain their investor’s confidence so
that they keep on investing in the exchange like Customer Service Department is
developed to resolve disputes among investors and brokers. IPF is created to protect
investors if brokers default on any transaction and CHPF is created to protect brokers
from default. Apart from this, investor’s guide and educational seminars take place to
help answer investor’s queries.
KSE keeps on making changes in their Risk Management Practices so that they can
provide their investors and brokers with a secure environment to invest in and earn
profits using their services
60
Chapter.05
Conclusion and Recommendations
5.1 Conclusion:KSE, a physical place where buyers and sellers gather for the purpose of investing
into securities of the particular companies, is continuously making improvements in
its risk management practices in order to provide investors with a harmless
environment and sound transactions where there are fewer chances of loss and more
for profit. In 2006, KSE with the help of SECP revised risk management regulations
with a view to have orderly transition of market with these risk management
practices. Ready market and CFS were separated and new netting regime for CFS,
ready and future markets were developed. Another new regime was introduced i.e.
VAR (Value at Risk) to give investors an idea regarding their investments. VAR is
basically a measure use to estimate how much value of shares or portfolio of shares
could decrease over a period of time under daily movement of share prices. It is used
to measure the market risk of the transacted but unsettled shares and it calculates
maximum loss expected on an investment over a given period of time. Apart from it,
various technologies are being used by KSE like KATS (Karachi Automated Trading
System), disaster recovery management and business continuity programs database
back ups in order to ensure security for the investors. Customer service support is
developed to cater to member’s complaints regarding computer network and trading
system. Moreover, it has partnerships with Microsoft, Oracle, and Unisys for its IT
infrastructure. FIX (Financial Information Exchange) has been adopted for both
trading and market data. With the help of FIX, KSE is able to attract local, regional
and global liquidity by providing its members with automated trading platform and
market access to international partners. In approach to maintain security, KSE’s
listing criteria is such that the company need to have minimum paid-up capital of 200
million and has to subscribe itself with at least 500 companies so that there are less
chances of default. Various products are available for investors to invest in the
61
portfolio of stocks and diversify risk. To save investors from chances of fraud, fully
automated system for clearing, trading and settlement are being adopted by KSE.
Several netting rules have been applied in all the products being offered like Ready
market, Deliverable Future market, Cash settled future and Stock Index future market
because netting decreases credit exposure and also reduces both operational and
settlement risks. In addition to that, mark-to-market procedures are being followed to
record the price of security or portfolio of securities on a daily basis and to calculate
profits and losses. Its clearing house is activated so that the speed of trade is fast
enough to pass all transactions within time. Slowly and gradually, changes are taking
place in KSE to make it more secure environment for both the investors and brokers
and less chances for default risk.
5.2 Future Outlook:The future of KSE appears to be electronic as competition is continuously growing
between the remaining traditional specialist systems against new system i.e. ECN
(Electronic Communication Network). ECN is the term used in financial circles for a
type of computer system that facilitates trading of financial products outside of stock
exchanges. The primary products that are traded on ECNs are stocks and currencies.
ECNs increase competition among trading firms by lowering transaction costs, giving
clients full access to their order books and offering order matching outside of
traditional exchange hours. ECNs have changed ordinary stock transaction processing
into a commodity type business.
62
5.3 Recommendations:
They should adopt ECN system in order to make exchange fully electronic
which can reduce transaction costs and give their clients full access after
exchange hours.
KSE should promote derivative products into the market as they can prove to
be successful products in future and various big stock exchanges offer
derivatives.
They should come up with the investor’s education programs and seminars
where they should guide their investors to make safe and healthy investment
where there are fewer chances of default.
They should introduce online training sessions for investors who are unable to
visit KSE like foreign investors and hence, can get information through their
online training system.
63
Bibliography
1. www.hotbot.com
2. www.yahoo.com
3. www.ssrn.com
4. www.sbp.org.com.pk
5. www.online.sagepub.com
6. www.google.com
7. www.wikipedia.com
8. www.kse.com.pk
9. http://www.googlescholar.com
10. Economic Growth and Volatility in Indian Stock Market (Rakesh Kumar, South
Asian Journal of Management)
11. Stock Market Volatility: Reading the Meter (Hui Guo, Monetary Trends – March
2002)
12. Measuring Stock Market Volatility in Emerging Economy (Mala & Reddy,
International Research Journal of Finance and Economics)
13. Financial Reforms and Common Stochastic Trends in International Stock Prices
(Nishat & Irfan, IBA Business Review – Volume 2 Number 1; Jan-June 2007)
14. http://www.econpapers.repec.org/
15. http://www.ssrn.com/
64
Referenceso Crockford, Neil (1986). An Introduction to Risk Management (2nd ed.).
Woodhead-Faulkner. ISBN 0-85941-332-2.
o van Deventer, Donald R., Kenji Imai and Mark Mesler (2004). Advanced
Financial Risk Management: Tools and Techniques for Integrated Credit Risk
and Interest Rate Risk Management. John Wiley. ISBN 978-0470821268.
o Wilson, Thomas, 1994, “Plugging the GAP,” Risk, 7, 10, 74-80.
o Garbade, Ken, 1986, “Assessing Risk and Capital Adequacy for Treasury Securities, ” Topics in Money and Securities Markets, Bankers Trust.
o Hsieh, D., 1993, “Implications of Nonlinear Dynamics for Financial Risk Management”, Journal of Financial and Quantitative Analysis, 28, 1, 41-64.
o Kroner, Kenneth, and Jahangir Sultan, 1991, “Exchange Rate Volatility and Time Varying Hedge Ratios,“ in S. Ghon Rhee and Rosita P. Change, eds., Pacific Basin Capital Markets Research, Vol. II, North-Holland, 397-412.
o Working Paper 99-07-05, July 1999, Indian Institute of Management, Ahmedabad 380 015, INDIA
o Besanko, David, David Dranove, and Mark Shanley. 1996. Economics of Strategy. New York: John Wiley & Sons.
o Biddle, Frederic M. 1999. “Can Kaufman & Broad Beat the Home Building Cycle?” The Wall Street Journal, October 27, p. B4.
o Bomfim, Antulio N. and William R. Nelson. 1999. “Profits and Balance Sheet Developments at U.S. Commercial Banks in 1998.” Federal Reserve Bulletin, June, pp. 369–95.
65
o Booth, G. Geoffrey and John Paul Broussard. 1998. “REIT Returns, Probability of Large Losses, and Asset Allocation.” Eli Broad Graduate School of Management, Michigan State University, Processed.
o Campbell, John Y., Andrew W. Lo, and A. Craig McKinlay. 1997. The Econometrics of Financial Markets. Chapter 2. Princeton, NJ: Princeton University Press.
o Culp, Christopher and Merton H. Miller. 1995. “Metallgesellschaft and the Economics of Synthetic Storage.” Journal of Applied Corporate Finance, Winter, pp. 62–76.
o Duffie, Darrel and Jun Pan. 1997. “An Overview of Value at Risk.” The Journal of Derivatives, vol. 4, no. 3 (Spring), pp. 7–49.
o The Economist. 1996. “Coming A Cropper in Copper,” June 22, pp. 69–70.
o Fama, Eugene F. 1965. “The Behavior of Stock Market Prices.” Journal of Business, vol. 38 (January), pp. 34–105.
o Fay, Stephen. 1997. The Collapse of Barings. New York: W.W. Norton & Co.
o Figlewski, Stephen. 1994. “How to Lose Money in Derivatives.” The Journal of Derivatives, vol. 2, no. 2 (Winter), pp. 75–82.
o Grabowski, Martha and Karlene Roberts. 1997. “Risk Mitigation in Large-Scale Systems: Lessons from High-Reliability Organizations.” California Management Review, Summer, pp. 152–59.
o Jorion, Phillipe. 1995. Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County. San Diego, CA: Academic Press.
o Longin, F. and B. Solnik. 1995. “Is the Correlation in International Equity Returns Constant? 1960–1990.” Journal of International Money and Finance, vol. 14, pp. 3–26.
o Mello, A. and J. E. Parsons. 1995. “Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle.” Journal of Applied Corporate Finance, Spring, pp. 106–20.
o Roll, Richard R. 1988. “The International Stock Market Crash of 1987.” Financial Analysts Journal, vol. 44, no. 5, pp. 19–35.
o Simons, Katerina. 1997. “Model Error.” New England Economic Review, November/December, pp. 17–25.
66
o Stulz, Rene´. 1996. “Rethinking Risk Management.” Journal of Applied Corporate Finance, Fall, pp. 8–24.
o Whitt, Joseph. 1999. “The Role of Shocks in the sian Financial Crisis.” Federal Reserve Bank of Atlanta Review, Second Quarter, pp. 18–31.
67