Professional Documents
Culture Documents
“Markaz”
RESEARCH
Across the globe derivatives, especially Options and Futures, has played a
very crucial role in capital market development. Equity Derivatives market
has now reached a size of $114.1 trillion (Appendix 1). The presence of
strong equity culture along with limitations of GCC capital markets provides
a compelling platform for introduction of derivatives market in the GCC
region. Strategic investors can unlock their potential without diluting their
stake. Institutional investors would welcome this as they are familiar with
using such instruments for fixed income and other instruments.
Equity Debt
Market Market
GCC
Capital
Markets
Derivatives
Market
In terms of market depth, it can be seen that relative to the size of some of
the GCC markets (Saudi Arabia and UAE, especially), the number of
companies are relatively small. The average market cap ratio for Saudi
Arabia 4.03 is significantly higher than say India’s 0.17 or Malaysia’s 0.23.
GCC markets are “long-only”
markets limiting the possible
c. Skewed Liquidity & High Speculation
trading strategies and hence
The GCC markets are classified as “long only markets” where trading
growth.
strategies are limited to “buying when market is expected to go up and
liquidating when it is expected to fall down”. In fact, the absence of the
short-sale activities in such markets does not allow investors to enhance
their returns during the down trend. Thus investors are left with no choice
but to liquidate their positions which on one hand will exacerbate the effect
of the downfall while on the other hand will adversely affect the liquidity of
the market. The size of the decrease in the liquidity levels is driven to a
great extent by the size of the corresponding downfall. Thus if the downfall
is very sharp the liquidity could be completely drained- out.
Kuwaiti market during the period 2005 to 2006 can be offered as a good
example. Although the Kuwaiti market is characterized by the presence of a
wide diversity of sectors with a major presence for the blue chip companies
such as NBK, MTC, and PWC…etc, the market was not able to sustain
liquidity during the correction movement in February 06. Investors as well
as fund managers, in the lack of the hedging tools such as the put options,
were desperately trying to liquidate their positions while the market was
heading down and “draining out” the liquidity with it. This results in a
Domino effect. (Figure 4)
13,000 400,000,000
12,000 350,000,000
11,000 300,000,000
10,000 250,000,000
9,000
200,000,000
8,000
7,000 150,000,000
6,000 100,000,000
5,000 50,000,000
4,000 0
Jan-06
Feb-05
Apr-05
Jul-05
Oct-05
Apr-06
Jul-06
Sep-06
Value Traded (KD) Price Index
Most of the GCC stock markets are speculative as well, though in varying
degrees. While volumes are concentrated in few stocks, even these are
among penny stocks. To present an example (Table 3), we can see in Saudi
Arabia the most active shares constitute nearly 30% of total volume while
they account only for 6% of market capitalization. The second highest
traded stock in Saudi Arabia (Al Mawashi Al Mukarish) is a penny stock with
0.19% share in the market cap.
0%
Kuwait
-20%
-40% Dubai
-60%
Qatar
-80%
Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07
*% change in value traded to the corresponding period one year before
400%
300% Saudi
Arabia
200%
Kuwait
100%
Dubai
0%
Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07
Qatar
-100%
*% change in volume traded to the corresponding period one year before
Liquidity is the heart of a market. While GCC markets have grown during the
past few years in size, it has failed to mature in terms of market breadth.
Narrow market structure leads to price spikes resulting in increased
volatility.
d. High Volatility
GCC markets experienced GCC countries experienced relatively very high risk compared to other
very high volatility in the international indices. Among GCC, Saudi Arabia, Dubai, Abu Dhabi and
past. Qatar exhibited high levels of risk while Kuwait, Oman and Bahrain has
been at levels comparable to other international markets. The increase in
risk for Saudi Arabia has been remarkable from 24% to 49% literally
doubling. (Figure 3)
60.00%
49.46%
50.00%
2006 2005
38.40%
35.24%
40.00%
30.89%
28.68%
26.99%
25.68%
24.40%
24.12%
30.00%
19.73%
18.07%
17.10%
16.88%
15.42%
15.42%
15.09%
14.16%
20.00%
13.38%
12.51%
12.49%
12.17%
11.96%
11.48%
10.28%
10.02%
9.98%
10.00%
0.00%
a
SM
kt
a)
0
t
i
an
aq
IC
r
5
ba
ai
ta
bi
50
ai
22
M
i
BR
Om
sd
w
nd
Qa
ra
Du
AD
hr
Ku
ng
P
ei
Na
iA
Ba
(I
S&
kk
gi
ex
ud
Ni
er
ns
Sa
Em
Se
e. Lack of Institutional Investment
Participation of institutions in the capital market lends stability and
The representation of credibility as institutional investors are considered to be more rational and
institutions in the GCC market long-term oriented than individual investors. Though a difficult thing to
is sparse. measure, a broad proxy would be the mutual fund segment. It is
understood that other categories of institutions in the GCC like pension
funds, central banks, etc prefer to invest through mutual funds. Table 4
provides statistics pertaining to mutual funds. Except Saudi Arabia and
Kuwait, all other markets have very meager institutional participation.
Curiously enough, in spite of a respectable figure, Saudi Arabia continues to
be the most volatile and speculative market in the GCC.
B. Application Areas
Short Selling
Options strategies
Trading Volatility &
Structured Products
a. Short Selling
It is interesting to note that historical stock market speculative excesses
Short-selling refers to selling have been committed not only on the bull side but on the bear side as well.
a stock that is not owned. While speculation per se is good for the market, excesses are not. Both
Shorting (selling high and over-valuation and under-valuation of stocks reflect market inefficiencies.
buying low) is not allowed in
GCC. A short sale is a sale of securities which the seller does not own at the time
of effecting a sale. The theoretical pinning to this is very simple. In a
scenario where a particular stock is under valued, market participants will
identify this and buy up the stock with the result that the stock price tends
to rise eliminating under-valuation. In this case, the market participant
makes a profit and the market’s pricing efficiency will also improve. The
same logic can be applied to over-valued stocks. Similar to earlier logic,
market participants will now sell over-valued stocks which will reduce the
market price and improve pricing efficiency. Hence, there is nothing
immoral about this. However, short-selling strategy is not as straight
forward as the strategy of buying under-valued stocks. In the case of short-
selling, the short seller has to borrow the stocks sold short during the entire
process till he returns the borrowed stock.
In short, short selling promotes more active search for over-valued stocks
and more speedy adjustment of market prices to company performance.
b. Option Strategies
Both covered call and protective put can find extensive application in the
GCC region. The high level of strategic holding by families in leading blue
chip companies provides excellent ground for generating income through
writing call options. Similarly, large exposure to GCC stock market can be
effectively protected through buying put options.
c. Trading volatility
Traditional equity trading is mainly based on speculating the market
movement of the underlying equity and can be done through two
strategies. The first one is to buy low and sell high which is a long strategy
while the second is to sell high and buy low which is called shorting (not
allowed in GCC markets).
Defining Volatility
Volatility can be either
Volatility is the term that is used to measure how actively the price of an
historical or implied.
underlying instrument (stock, future, or index) changes within a period of
time. It is also one of the most important variables to pricing options.
Volatility traders have two volatility parameters that are involved in the
decision-making process. These parameters are:
Trading Options
Recall that investors need to have a tool in order to trade volatility. In this
report we will use the options as an illustrative tool to show how volatility
can be traded. There are essentially two types of trading strategies that are
used by the option traders
Directional Trading
Traders who rely on directional trading to make profits have first to take a
guess on the movement of the underlying equity price and then establish
the corresponding position in the option market. It is advantageous to
implement this strategy using options than direct equity exposure as
options provide many benefits. (Appendix 3).
Volatility Trading
Similar to the fundamental equity trading approach where traders seek to
identify overvalued and undervalued stocks based on a comparison between
the equity market price and its intrinsic value, the volatility traders will
compare the implied volatility of an option contract with the historical
volatility. Trading actions can be summarized as follows:
Thus if the implied volatility is higher than the historical volatility, then this
One sells volatility when the
would be an indication that the option contract is overpriced, and
historical volatility is lower
consequently, "selling volatility" is recommended and vice-versa. This is
than the implied volatility.
illustrated by using the implied volatility vs. historical volatility chart of the
Intel Corporation stock. (Figure 4)
Buy
Buy Buy
Source: IVolatility.com
The chart demonstrates the fact that implied volatility exhibit a mean
reverting characteristics i.e., if the implied volatility of the stock shoots up or
down in response to a major event that is expected by the market, it will
eventually move back "revert" towards its mean.
Source: Markaz
The mean reverting behavior of volatility is evident in the above cone chart
which shows the distribution of the Intel stock volatility over different
periods for a 2-year range of data. Starting from the extreme left on the X-
axis, we can see that over 30 days period, the volatility has ranged
approximately from 13% to 39%. Over 120 days period during the last 2
years the volatility has ranged from approximately 19% to 28%. The mean
volatility has ranged from 23% to 25%. As one moves further out in time
the lines converge towards the mean, and the mean becomes stable. Thus
the volatility is indeed "mean reverting". Another implication that can be
observed from the volatility cone chart is that the range (max – min) of the
Derivatives find extensive
shorter periods (30 days) volatilities is wider than that of the longer periods
application in capital
(120 days) which indicates that the shorter the period the more the variation
guaranteed notes.
of the volatility around its mean. Kindly refer Appendix 4 for volatility cone
charts for the GCC region.
c. Structured Products
A structured product is a financial instrument that mostly combines a
conventional asset class such as equity or a fixed income security with a
derivative instrument. Structured products are usually designed to meet the
investors' specific needs taking into consideration the existing market
conditions.
There are many advantages for investing in the structured products which
includes:
• Capital Protection
• Enhanced Returns
• Controlling risk (volatility)
• Portfolio Diversification
• Utilize Current Market Trend
a. Options Market
With rapid growth worldwide, trading options did not exist in the Middle
East Stock Exchanges or in the Arab Stock Exchanges until Kuwait Financial
Centre S.A.K. “Markaz” initiated a proposal to provide the options service in
Kuwait Stock Exchange in year 2002. Markaz suggested establishing a
system for trading in options through a Fund viz., “Forsa Fund” to work as a
market maker for options trading in the first stage. After analyzing the
characteristics of the Kuwait Stock Exchange (KSE), its nature of risks and
determining the needs of investors, Markaz suggested a complete
mechanism for option trading at KSE after taking into account the current
mechanism in international markets. Many trials and simulations were
carried out using historical data for system compatibility with the KSE and
measuring the risks resulting from option trading in markets. Testing and
measurements were made continuously till March 2005 when KSE allowed
Call options to be traded by Forsa Fund. Trading on the first day (March 28,
2005) was on 13 stocks and 75 contracts with a total strike value of KD
2,378,150.000. Options value and volume traded fell during year 2006
compared to year 2005 mainly on the back of weak market sentiment.
(Figure 5). This reduced the total net premium (Net Premium=Premium
received-amount paid back to investor in case he sells the option back
before expiry) generated from this activity. (Figure 6)
7,000,000 120,000,000
6,000,000 100,000,000
Volume Traded
Value Traded
5,000,000 80,000,000
4,000,000
60,000,000
3,000,000
2,000,000 40,000,000
1,000,000 20,000,000
0 0
Mar-05
Jul-05
Sep-05
Jan-06
Sep-06
May-05
Mar-06
Jul-06
Nov-05
May-06
Nov-06
Volume Traded Value Traded
2,000,000
1,500,000
1,000,000
500,000
KD
0 Jan-06
Mar-05
May-05
Jul-05
Sep-05
Nov-05
Mar-06
May-06
Jul-06
Sep-06
Nov-06
(500,000)
Forsa fund provides daily
(1,000,000)
liquidity through quoting bid
and ask prices for all option
contracts. How it works
Forsa option contracts are currently traded in the secondary market on 45
listed stocks in the Kuwait Stock Exchange. The contracts are between the
Market Maker (Forsa Fund) and the Option Buyer (trader). By this contract,
Forsa Fund confers the option buyer the right but not the obligation to buy
(in the case of call options) or sell (in the case of put options) a specific
number of stocks at a specific price called the strike price before or at a
specific date called the expiration date. In return, the option buyer will pay
Forsa Fund the price of the option contract or the option premium.
Therefore, the option buyer during the term of the contract, may exercise
his right to buy (in the case of call options) the underlying stocks from
Forsa Fund at the strike price, or exercise his right to sell (in the case of put
options) the underlying stocks to Forsa Fund at the strike price. If the
investor does not exercise the option during the term of the contract, the
validity of the contract will expire at the expiration date. It should be noted
that KSE presently permits only call options. Any statement above on the
put option is purely for explanatory purposes only and does not imply its
existence.
In order to provide the necessary liquidity to the market, the Forsa Fund
will daily quote bid and ask prices to all the option contracts it writes with a
purpose of creating a trading environment that confers the trader the
opportunity to sell or exercise the contract.
The investor has three ways in which he can settle the Option Contract.
He can sell the contract back to the buyer i.e. Forsa Fund. Forsa
Fund is obliged to provide bid price for all the Option it sold and be
ready to buyback the Option from the buyer of the Option.
He can exercise his right to buy, in case of Call Option and right to
sell, in case of put option. Forsa Fund is obliged to perform the
contract. If the investor wishes to sell or exercise his contract back,
it should be done through the same broker who executed the
original trade. &
Take no action and let the Option expire where if the Option is in
the money, the contract will be automatically cash settled. The
settlement cycle of the option contracts is the same as that of the
spot and the forward markets. The brokerage and commission
charges will be applied as per the KSE Rules.
Major Players
At the moment, only Kuwait Financial Center S.A.K “Markaz” through the
Forsa Fund can make market in call options.
To illustrate, in the NBK call option example presented previously the option
buyer and the market maker has each to pay KD 70 (2,550 * 2.75%) at the
time the contract is initiated and KD 79.2 (2,880 * 2.75%) at the time the
contract is settled. Statistics regarding Kuwait options market is presented
in Appendix-5
At the inception of the forward contact, the forward buyer will pay an
Futures market operates very
upfront premium (price of the forward contract) to the market maker plus
similar to forward market.
40% of the equity spot price as an initial margin. In return, the seller will
deposit the shares with the Kuwait Clearing Company (KCC) that will
preserve them to the buyer who should settle the remaining 60% of the
value of the equity specified in the forward contract to the market maker
before the maturity of the forward contract. If the buyer decides not to pay
the remaining 60% (incase the price of the underlying stock decreased),
then at maturity the ownership of the shares will return back to the market
maker leaving the buyer with a loss of the premium paid as well as the 40%
initial margin.
Any corporate actions related to the shares under the forward contract are
preserved with KCC to be submitted to the buyer once he settles the
remaining 60% balance. In case the forward contract expires without
settling the remaining 60% balance the dividends are returned to the seller
along with the underlying shares.
In order to reduce the market makers’ credit risk in case the spot price of
the underlying declines significantly – a 40% decline would wipe out the
buyers down payment margin – the buyer has to pay a 10% margin call
minimum to keep the contract active or can voluntarily close the contract.
Failing to do either of the above results in the contract being terminated
and the stock and dividends etc. returned to the seller, who retains the
original margins. If the stock cannot be liquidated promptly, in this case,
the seller could lose money on the liquidation.
During periods of decline, 60% of the investors whose contracts have fallen
below the coverage level prefer to pay the margin calls. The reason being
that the investor’s psyche does not allow him to let go of a contract in
which he has invested the upfront payment of 40%. The buyer receives the
Margin Calls and thereby minimizes his risk further by 10% (minimum). A
graphical presentation on the workings of the forward market is presented
in Appendix: 6
Futures Market
The futures market operates in a completely similar manner as the forward
market except that the future market operates during the spot trading
session (9:30AM to 12:15PM). Because forwards are traded after the close
of the spot market, the manager has to maintain a minimum inventory
holding and be able to find the liquidity to cover it, whereas in the case of
the futures market, traders would first request for the shares, whereby the
market maker would make the direct purchase of shares from the spot
market and pass them on to the trader through the future contract after
adding the premium and commissions. Thus there will be no need to
accumulate stocks unlike the forward market.
Market Players
Unlike options market where there is only one market maker, the futures
and forward market enjoys many players. An indicative list of players is
provided in Appendix: 7. Statistics regarding Kuwait futures market is
presented in Appendix-6
D. Road Map
A major motivation for introduction and growth of derivatives in the GCC
region is that it can enable transfer of risk between individuals and firms in
the economy. More simply, it is like buying and selling insurance. While the
risk-averse investor buys insurance, a risk-seeking investor sells the
insurance. Past researches have produced very encouraging findings, some
of which are summarized below.
As we can see from the above, except for Kuwait none of the other GCC
markets have taken any of the steps suggested above. Even in the case of
Kuwait, introduction of derivatives in the form of call options did not adhere
to a structured process as explained above. There are still gaps to be
addressed (Appendix: 8).
Global exchange-based trading in equity derivatives has almost doubled over the last three years from $54
trillion in 2002 to $114.1 trillion of notional value (on 6.3 billion contracts by end-2005). The volume of
global trading in 2006 had already reached $96.1 trillion as of August 2006. On Asia’s exchanges, equity
derivatives have witnessed the most rapid growth of all traded derivative products (foreign exchange,
interest rate, equity, commodities, and credit derivatives). Equity derivative trading in emerging Asia has
mushroomed from $16.5 trillion in 2002 to $40.3 trillion in 2005 (and $37.1 trillion by the end of August
2006), and now represents 38.6 percent and 43.9 percent of worldwide equity derivatives turnover by
notional value and number of trades respectively. This mainly represents very rapid growth in Korea, which
hosts the world’s most active derivatives market––the Korean Futures Exchange. Equity derivatives are
mainly traded on organized exchanges rather than OTC. Annual OTC equity derivatives trading in Asia
(excluding Japan) is only around $100 billion (BIS, 2005).
Most equity derivatives are exchange-traded (ETD), as opposed to foreign exchange and interest rate
derivatives, which are mostly traded OTC. Formalized and regulated exchanges are leading the growth in
Asian derivative markets, which can be divided into three categories: (i) fully demutualized exchanges (Hong
Kong SAR and Singapore), which offer a wide range of derivative products; (ii) partially demutualized
exchanges (Korea, India, and Malaysia), which have specialized in equity futures and index products; and
(iii) derivative markets with no or marginal exchange-based trading and limited OTC derivative trading
(China, Indonesia, the Philippines, and Thailand).
Equity derivatives markets are much less well-developed in other emerging Asian countries. In general, high
levels of ETD tend to be associated with high equity trading in deep and sufficiently wide cash markets,
mainly because the development of derivatives necessitates sufficient liquidity of cash markets (including
pricing benchmarks) to ensure efficient price discovery. Since 2000, growth in overall derivative trading only
in Korea, Hong Kong SAR, and Taiwan POC has outstripped growth of both domestic market capitalization
and cash trading in equity markets. These countries currently exhibit high turnover ratios of almost 1½ to
more than 36 times of outstanding stock, while average global turnover ratios of equity derivatives tend to
converge to one (BIS, 2004; and WFE, 2005). Since most of equity derivative contracts are traded in these
countries, their high turnover ratio has kept aggregate equity derivative trading in emerging market Asia at
more than 10 times GDP, stock market capitalization, and stock trading. Although stock exchanges in
countries such as China, Indonesia, Malaysia, Thailand, and the Philippines also have strong trading activity
in cash markets, similar to that in emerging market and mature market countries with established derivative
markets, trading in equity derivatives remains very limited.
Contract sizes in emerging Asian countries have more than doubled, from $8,200 in 2003 to $19,000 by
August 2006, but they still lag behind global averages. Contract sizes of equity derivatives in countries like
India and Malaysia are still less than half of the notional amount per trade in Asia and less than a third of
the notional amount per trade in the United States. Besides Hong Kong SAR, only the equity derivative
market in Korea offers contract sizes in emerging Asia similar to mature market economies.
The strong development of equity derivatives in Korea and India reflects a robust operational and legal
infrastructure (Fratzscher, 2006). For example, both countries have well-designed trading platforms, which
provide access to both domestic and foreign institutional investors. Indonesia has just established the
Jakarta Futures Exchange and introduced equity index futures at the Surabaya Stock Exchange. The
Thailand Futures Exchange (TFEX), in operation since 2004, started trading its first stock index future only in
April 2006. In the Philippines, equity derivatives have not been traded since the Manila Futures Exchange
closed in 1997. By comparison, countries that are lagging have (for example) weak trading infrastructures,
shortcomings in relevant laws that create uncertainty about whether derivatives contracts can be enforced
(or even whether trading derivatives is permitted), tax provisions that are unfriendly to derivatives, bans on
short selling, and restrictions on investment by foreigners. Reaping the full benefits of equity derivatives
markets by fostering their wider development also requires careful management of risks to financial stability.
In Asian countries without formal derivative exchanges, the rising popularity of OTC derivatives entails
greater emphasis on disclosure and transparency, good governance and risk management. Systemic risk is
potentially reduced when trading occurs in well-structured and formally regulated exchanges that impose
appropriate margin requirements and position limits, administer centralized clearing and settlement, engage
in market surveillance, undertake adequate disclosure, and mutualize risks through loss-sharing
arrangements, capital deposits of members, and international excess-of-loss insurance. It is also reduced
when supervisors and regulators can ascertain the exposure of systemically important financial institutions to
derivatives markets. Sizable retail trading of derivatives may pose its own challenges and could (in principle)
entail significant knock-on effects on real sectors; for example, a market downturn that inflicted widespread
losses on households could affect confidence and spending. A good understanding of all these issues is
incumbent on country officials charged with safeguarding financial stability.
Source: Asian Equity Markets: Growth, Opportunities & Challenges by Catriona Purfield, Hiroko
Oura, Charles Kramer, and Andreas Jobst. IMF Working Paper WP/06/266.
Appendix 2: Illustrations
1. Covered Call
An investor owns 1000 shares of NBK at KD 2.000. He also sells a 1 month call option contract on NBK for
1000 shares at a strike price of KD 2.000 for a premium of 50 Fills, which he receives per share from the
buyer of the Option. This position initiated is called a Covered Call because the investor is covered with the
stock in case the buyer exercises his right to buy the shares at the strike price. The strategy is favored when
the investor expects the share price to exhibit a small movement over the lifetime of the option contract.
The investor desires to either generate additional income (over dividends) from shares of the underlying
stock owned, and/or provide a limited amount of protection against a decline in underlying stock value.
Trade Details
Stock Value 1000 shares at KD 2 each = KD 2000
Number of call options sold 1000
Strike Price KD 2.000
Option premium per share 50 Fills
Total option premium received KD 50
Profit / Loss
100
50
0
Profit/ Loss
-100
-150
-200
Stock Price
Covered Call Writer
2. Protective Put
For example if an investor is holding 1000 shares of NBK at a price of KD 2.000 and the investor buys a 1
month put option contract of 1000 shares at strike KD 2.000 then it is called as a protective put strategy.
Stock View
The strategy is implemented with a positive view on the stock; however the investor wants to hedge his
downside risk. Buying a put option is like buying insurance for the stock and hence if the stock does not go
down in price, he loses only the premium paid.
Trade Details
Stock Value 1000 shares at KD 2 each = KD 2000
No of put options bought 1000
Strike Price KD 2.000
Option premium per share 50 Fills
Total option premium paid KD 50
150
100
50
Profit/ Loss
0
1.90 1.95 2.00 2.05 2.10 2.15 2.20
-50
-100
-150
-200
Stock Price
Protective Put Writer
A 3-year 100% capital guaranteed note with a participation rate of 45% Linked to a Kuwait Basket of
Shares.
The note provides 100% capital guarantee at maturity which is 3 years thereby eliminating the downside
risk. On the upside, it gives 45% of the appreciation in the Kuwait Basket of shares over the 3 year period.
This note will be suitable for an investor who has a bullish view on the Kuwait market and seeks to have
exposure to it, but on the other hand wants to fully protect his capital.
Structure
The issuer of the guaranteed note will receive a capital of KD 1000 from the investor who purchased the
note. The issuer will invest the proceeds in buying:
1) A zero coupon bond that matures in 3 years. The price of the bond will be the present value of the
capital received PV (KD 1000)5.55% or KD 850. The bond will guarantee that the issuer will be able at
maturity to pay the capital that was initially received from the investor.
2) A call option on the Kuwait Basket with 3 years to expiry that will cost approximately 33.3% of the total
value of the Kuwait Basket. Hence by paying the remaining KD 150 for the call Option, the issuer will get
a 100% exposure (participation) to a basket of total value of KD 450 (150/33.33%) which is equal to
45% of the amount of capital invested by investor (KD1,000) thereby 45% of capital invested is exposed
to market returns. In other words, the participation rate is calculated by dividing the relative amount left
for the options (15%) by the relative option premium (33.33%) or 45%.
Hence such a structured product is a combination of a zero coupon bond (asset class) and a call option
(derivative instrument).
Investor
Thus if the performance of the Kuwaiti basket is 60% at maturity, then the investor will receive KD
1000*100% + KD 1000*45%*60% or KD 1,270, and if the Kuwaiti basket did not perform positively, then
the investor will receive only his capital invested or KD 1000.
4. CPPI
Suppose a 5 years 100% capital guaranteed CPPI structure is issued with minimum investment of KD 1000.
The issuer will invest the proceeds in:
A zero coupon bond that matures in 5 years. The price of the bond will be the present value of the
capital received PV (KD 1000)6% or KD 750. The bond will provide the capital protection.
The issuer invests the remaining amount (KD 250) in a risky asset, together with an amount borrowed
from the money-market. The amount borrowed will be normally equal to the amount invested in the
zero coupon bond so that the total amount invested in the risky assets is equal to the initial investment.,
Thus total amount borrowed will be KD 750 which makes the total investment in the risky asset KD
1000. The cost of the borrowing needs to be paid from the return generated by the risky asset. The
investment in the risky asset will grow if the return generated is higher than the borrowing cost of KD
750. The risky asset portfolio is rebalanced periodically and if the returns are zero or less, than the only
the guaranteed capital is paid at maturity. If there is any positive return generated by the risky asset,
than the investor gets KD 1000 (capital guaranteed) + any excess return generated by the risky asset.
There are others types of CPPI structure too where the capital is not guaranteed with the use of a zero
coupon bond but other combination are created to provide capital guarantee. However, the basic design
remains the same that the asset is allocated between a risk free asset and a risky asset and rebalanced
according to the market condition.
Investor
KD 250 KD 750
Returns KD 1000
at maturity
Return generated
5 - yrs Zero Coupon from the portfolio Dynamic Asset
Bond with face Rebalancing between
value of KD 1000 Risky Asset and Risk
less Asset
5. Call option
A call option contract was issued by Forsa Fund on 06-Jan-2007 with the following terms:
Underlying Stock: National Bank of Kuwait (NBK)
Strike price: KD 2.160
Avg. Traded Price KD 2.162
Implied Volatility 27.53%
Quantity: 10,000
Expiration date: 27-June-2007
Ask price: KD 0.255
Bid Price: KD 0.229
The buyer of this contract on 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amount
of KD. 2,550/-.
(Ask price * number of stocks i.e., KD 0.255 * 10,000 = KD. 2,550/-)
The Average traded price for the NBK share increased to reach KD 2.246 on 09-Jan-2007 and the
corresponding Ask and Bid prices increased to KD 0.311 and KD 0.280 respectively. So the option buyer can
settle his contract as follows:
Sell the option back to the market maker (Forsa Fund) at the Bid price (KD 0.280).
Profit: 25 Fils (0.280 - 0.255) per stock or KD 250.
Return: 9.8 %.
Or
Buy 10,000 stocks of NBK from the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. In
this case, the option buyer pays KD 21,600/- to the market maker without the deduction of the premium
paid (KD 2,550/-).
6. Put option
Assume the Put option contract was issued by Forsa Fund at 06-Jan-2007 with the following terms:
Underlying Stock: National Bank of Kuwait (NBK)
Strike price: KD 2.160
Avg. Traded Price KD 2.162
Implied Volatility 27.53%
Quantity: 10,000
Expiration date: 27-June-2007
Ask price: KD 0.129
Bid Price: KD 0.116
The buyer of this contract at 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amount
of KD 1,290/-.
(Ask price * number of stocks i.e., KD 0.129 * 10,000 = KD 1,290/-)
Assume the stock price on 07-Feb-2007 decreased to KD 2.007, the Ask and the Bid prices will therefore
increase to KD 0.238 and KD 0.214 respectively. The option buyer can settle his contract as below:
Sell the option back to the market maker at the Bid price (214 Fills).
Profit: 85 Fills (214-129) per stock or KD 850
Return: 65.8 %.
Or
Sell 10,000 stocks of NBK to the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. In this
case, the option buyer receives KD 21,600/- from the (Forsa Fund) and transfers 10,000 NBK stocks to the
market maker’s account.
Please note that currently put options are not available in KSE.
ii) Leverage
Trading in options can allow the investor to benefit from a change in the stock price without having to pay
the full value of the stock, thus allowing him to make a higher return from a smaller initial outlay. The
following table shows the difference between the return of investment in options and the return of direct
investment in the underlying stock:
Characteristics Buying the option Buying the stock
10% 20%
18%
8% 16%
14%
6% 12%
10%
4%
8%
6%
2%
4%
2%
0%
0 30 60 90 120 150 180 210 240 270 0%
0 30 60 90 120 150 180 210 240 270
Min Median Max Last Min Mean Max Last
20%
25%
18%
20% 16%
14%
15% 12%
10%
10% 8%
6%
5% 4%
2%
0% 0%
0 30 60 90 120 150 180 210 240 270
0 30 60 90 120 150 180 210 240 270
50%
50% 45%
40%
40% 35%
30%
30%
25%
20%
20%
15%
10% 10%
5%
0% 0%
0 30 60 90 120 150 180 210 240 270 0 30 60 90 120 150 180 210 240 270
25%
20%
15%
10%
5%
0%
0 30 60 90 120 150 180 210 240 270
% Price of
Stock Total Final
Contract % Margin Margin Interest the
Price Premium Paid Down Payment
Initiated Required Paid for 3 Forward
(KD) Payment Required
months Contract
t=0 1 40% 0.4 3.25% 0.0195 1.0195 0.4195 0.6
Kuwait And Middle East Finance Invest Co Wafra International Investment Co.
Kipco Asset Management First Investment Company
Securities Group Company K.S.C The Securities House
National Investments Company Bayan Investment Co. K.S.C.C
International Financial Advisers K.S.C. Global Investment House
Coast Investment & Development Co. Al-Muthanna Investment Co.
Al-Madar Finance And Investment Co. Al-Aman Investment Co.
Noor Investment Co. Gulf invest International Co.
Manafee Investment Co.
Trade options during the market trading hours. Currently options are traded off the market hours. Including the
options trading during the trading hours (as is the case with other
international markets) will enhance the participation levels.
Allow options on Index Introduction of equity derivatives has always been through index
options. Enabling market makers to write and sell index options will
provide excellent hedging tool to both institutional investors and
retail investors
Circuit Breakers: The highest and lowest prices that a stock is permitted to reach in a given trading session. Once
reached, no trading occurs on that stock until the following session. also called price limit or daily trading limit.
Emerging Markets: A financial market of a developing country, usually a small market with a short operating history.
GCC: Gulf Co-operation Council countries comprising Saudi Arabia, UAE, Kuwait, Qatar, Oman & Bahrain.
Moving Average: A technical analysis term meaning the average price of a security over a specified time period (the
most common being 20, 30, 50, 100 and 200 days), used in order to spot pricing trends by flattening out large
fluctuations. This is perhaps the most commonly used variable in technical analysis. Moving average data is used to
create charts that show whether a stock's price is trending up or down. They can be used to track daily, weekly, or
monthly patterns. Each new day's (or week's or month's) numbers are added to the average and the oldest numbers are
dropped; thus, the average "moves" over time. In general, the shorter the time frame used, the more volatile the prices
will appear, so, for example, 20 day moving average lines tend to move up and down more than 200 day moving
average lines.
Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a
given stock, at a specified price (the strike price) during a specified period of time.
Portfolio: A collection of investments all owned by the same individual or organization. These investments often include
stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn
interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals
or according to indices.
Range: The high and low transaction prices of a given security or commodity during a given period. Also called trading
range.
Relative Volatility: The standard deviation of an investment's or portfolio's return divided by the standard deviation of
another portfolio. Relative volatility is used to compare the risk levels of different portfolios.
Standard Deviation: The standard deviation of a series is a measure of the extent to which observations in the series
differ from the arithmetic mean of the series. The standard deviation of a series of asset returns is the measure of the
volatility, or risk, of the asset.
Technical Analysis: A method of evaluating securities by relying on the assumption that market data, such as charts of
price, volume, and open interest, can help predict future (usually short-term) market trends. Unlike fundamental
analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict
the future price of a stock by looking at its historical prices and other trading variables. Technical analysis assumes that
market psychology influences trading in a way that enables predicting when a stock will rise or fall. For that reason,
many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to the
market as a whole as to an individual stock.
Underweight: Having too little of, relative to other things. In the case of a portfolio, containing too little exposure to a
given company, sector or country. opposite of overweighed.
Volatility: The relative rate at which the price of a security moves up and down. Volatility is found by calculating the
annualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short time
periods, it has high volatility. If the price almost never changes, it has low volatility.
Source: www.investorwords.com
Synopsis: The report examines issues behind asset allocation for GCC equity funds. The study points out
that fund managers have overweight Kuwait and underweight Saudi Arabia. Compared to their market
share, allocation to Qatar, Bahrain and Oman was observed to be high. Nearly 10 funds were observed to
allocate highest to their home country, implying “home bias”. The report concludes that current overweight
to Kuwait and underweight to Saudi Arabia looks justified given the historical performance and current
valuation. Relative to the overall market, blue chips appear expensive in many markets. Future out
performance can come through stock selection among mid-cap and small-cap segment. However,
geographical allocation will remain the key challenge.
Synopsis: The report establishes a framework involving fundamental variables likely to affect GCC stock
markets for the year 2007. The report examined nine important variables: economic factors, valuation
attraction, economic liquidity, fund managers average, earnings growth potential, moving average, investor
sentiment, geopolitical developments and market liquidity. On a scale of 1-5, Oman top scored at 2.93,
followed by Bahrain (2.85) and Kuwait (2.84). Saudi Arabia scored 2.66 while UAE was at the bottom with a
score of only 2.18. Accordingly, the report suggests overweight to Kuwait, Oman and Bahrain, neutral
weight to Saudi Arabia and underweight to UAE. Among GCC sectors, the report assigns positive ratings to
banking, telecom, and services sectors; neutral rating to industrial sector and negative rating to real estate
sector.
Synopsis: The report devises risk-based portfolio strategies to benefit from the high-risk environment of
GCC stock markets. The report discusses four strategies: Relative vol, Contrarian, Technical and Options-
based strategy.
Kuwait Financial Centre S.A.K. “Markaz” - Client Relations & Marketing Department
Tel: +965 224 8000 Ext. 1804
Fax: +965 2414499
Postal Address: P.O. Box 23444, Safat, 13095, State of Kuwait
Email: info@markaz.com
Disclaimer
This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait.
The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a
solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction.
The information and statistical data herein have been obtained from sources we believe to be reliable but in no way are warranted by
us as to its accuracy or completeness. Opinions, estimates and projections in this report constitute the current judgment of the author
as of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. Markaz has
no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein,
or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the
subject company is withdrawn.
This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person
who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or
investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may
not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security’s price or value
may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to
future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with
companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could
affect the objectivity of this report.