FINANCIAL

DERIVATIVES
Submitted to: Ms. Sarwat Ahson

Saadia Ahmed-12809

Institute of Business
Management

Derivatives in Pakistans Capital

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

Derivatives Available in Pakistan

Cash-Settled Futures (CSF) at the KSE Yet to Gain Popularity

They were introduced early in 2007. And did not gain popularity at all.
Presently 15 companies are available for these cash-settled futures.
Standard contract is of 30, 60 and 90 day duration, with daily marked-to
market of losses & gains. There is necessarily an equal number of buyers and
sellers in the market and thus smooth settlement on the last day of the
contract is ensured.
Mutual fund are not allowed to trade in future as per Section 58 of NBFC
regulation
Not gaining popularity because of the availability of other resembling
leveraging instrument of CFS and also because of liking for deliverable
futures for various reasons.
However, on the recommendation of the committee CFS MK II and
deliverable futures have been discontinued recently.

Deliverable Futures at the KSE (Discontinued recently)

Investors can BUY (go long) or SELL (go short) in a future, depending upon his
/ her view about the stock. Shares of 42 companies are eligible for trading on
the futures counter at the KSE.
Standard contract of up-to five-week duration. In the last week of every
month, the contract for the next month is opened (roll-over week). First
Wednesday of next month is the settlement date.
Excessive positions / trading discouraged to avoid / reduce manipulation.
Risk management is stringent (client-wise and broker-wise position limits are
in place).
Provisional trading at the time of the IPO of a share is also an example of
futures trading.

Stock Index Futures

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

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

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

Stock Index Futures (Regulatory Framework)

The need of a derivative market in Pakistan:

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