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Investment Analysis and Portfolio Management

Financial Derivatives; Status and Prospects in



CIIT LHR: 1.5 Km Defence Road, off Riawand Road, Lahore

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Derivatives: The Pakistan Scenario

The Financial Derivatives Business Regulations have been formulated in exercise of the power
derived by State Bank of Pakistan under Banking Companies Ordinance 1962 and Foreign
Exchange Regulations Act 1947, to permit, regulate, and supervise financial institutions entering
into derivative transactions. State Bank of Pakistan (SBP) is the supervisory authority for all
banks and DFIs engaging in Derivative Business. Financial institutions engaging in derivative
business shall obtain the approval of the State Bank of Pakistan and be subject to the supervision
and scrutiny of the State Bank of Pakistan.

Exchange-traded derivatives ETD (Futures and Options) on currencies, interest rates, and
equities began to be actively traded on derivatives exchanges in most industrialized countries in
the 70s and 80s. Derivatives exchanges contribute towards the development of the financial
infrastructure of a country by providing links between cash markets, hedgers and speculators.
The primary purpose of a derivatives exchange is to provide liquidity and price discovery
mechanisms to transfer the underlying risks among players with varying roles in an economy.

The need for establishment of derivatives exchanges is primarily motivated by economic and
financial reasons, and also for reasons of national pride, especially in the case of several
emerging economies. The experience of four emerging markets namely Korea, Malaysia, Brazil
and India reveals that innovation and growth in derivatives activity over the past 15 years has
yielded substantial benefits in terms of market expansion and overall economic growth. ETDs
have facilitated access of businesses to international capital markets, lowering their cost of funds
and diversifying their funding sources. Thus derivatives have improved the competitive position
of firms in an increasingly competitive global economy. Another prominent feature of centralized
exchanges is information transparency which makes it possible to obtain invaluable data on the
commitment of traders. Emerging economies where index futures and options were introduced
have experienced significant gains in both stock market capitalization and trading volume.
Despite phenomenal growth, Pakistani capital market has recently witnessed extra-ordinary
volatility and is today one of the most volatile markets in the world. Following periodic crashes
at Karachi Stock Exchange (KSE) a number of investigations were carried out. They have
identified causes of aggravating market volatility. These including non-standard practices (when
viewed from the perspective of international best practices IBP) and deficiencies of Carry Over
Transactions (COT Badla). However, irrespective of the reasons for excessive volatility no one
can deny that it has led to systemic problems, market manipulation, and investor losses. One of
the patent reasons for such high volatility is the lack of hedging instruments that could protect
the investors, both individuals as well as institutions. There is an undeniable need for derivative
products that provide (1) down side protection to investors, (2) price discovery (3) and reduced
dependence on Continuous Funding System (CFS Modified Badla) as the only source of
leverage in the market. In view of the experience in other developing markets cited above, and
the current shortcomings of CFS, there is reason to believe that initiating exchange traded
derivatives will channel high risk capital, more players, products, and Foreign Direct Investment
(FDI) capital to our markets. However, compared to the direction being taken in international
markets, currently the Pakistani capital market infrastructure is relatively nascent. Proper
governance structure, risk management and capital adequacy of the exchange, clearing
participants and the clearinghouse is of the utmost importance. A sound market infrastructure
will facilitate and promote healthy growth of the derivatives market. Derivatives trading whether
it occurs at an existing exchange or at a new exchange should be in an environment that provides

a level playing field for all investors. Development of ETD will flourish when systems are in
place and conflicts of interest are eliminated
Poised to continue on its high-growth trajectory, Pakistan has now joined the league of emerging
economies. The economic turnaround owes its origin to two principal factors:

persistent political and macroeconomic stability which has helped restore investor


confidence and attracted domestic and foreign capital; and

The ongoing financial sector development and transformation which has helped meet
the growing financing requirements of the productive sectors, while generating
consumption demand that turned out to be the main driver of economic growth.

Consistent with trends observed in growing Asia, structural changes in financial markets have
been remarkable and significant. First, a word on Pakistans financial sectors scope and scale :
Financial assets grew by 70% over the past five years and by end-CY05 reached Rs 5.1
trillion, equivalent to 80% of GDP. Banking sector grew at a faster pace relative to non-bank
sectors and currently accounts for 71% of the financial industry assets. Market capitalization
of the stock exchange has grown steadily and recently peaked at 44% of GDP relative to 10.3
percent in June FY00. Second, a word on the qualitative change and improvements in the
financial sector. The liberalization and deregulation of the financial sector has helped transfer the
banking sectors majority ownership to the private sector. This has helped to reorient the sector,
which is continuously changing and restructuring itself in the wake of enhanced domestic and
external competition as Pakistans economy is rapidly integrating itself with global and regional
markets. There has been exceptional growth in the profitability and efficiency of the financial
services industry. This, among others, has induced a degree of institutional diversification as
evident from:

The growth of equity markets that, given their high returns, has attracted foreign


portfolio flows; and

Proliferation of a wide array of non-bank financial institutions which provide a range
of financial services such as leasing, investment banking and fund management, and
offer Islamic instruments such as modarabas and musharikas.

The changing characteristics and complexion of the financial sector, its dynamism and growing
strength has catalyzed economic transformation. In FY05, real GDP growth rose to 8.6%
supported by double digit growth in large-scale industry which has met domestic requirements

and has generated an exportable surplus which facilitated almost doubling of the exports to $16.5
billion in FY06 relative to $7-8 billion in the preceding decade.
Single Stock and Stock Index Futures are the two significant Products in the Derivative Segment
of Pakistani Capital Markets. The potential for derivative segment development is huge.
However, the lack of knowledge about existing derivatives, and inexistent liquidity therein, are
the two key issues hindering the development of the Derivative Segment in Pakistan. Moreover,
a vibrant and liquid ready market is also an essential element of a flourishing derivatives market,
which can be accomplished by the active participation of both hedgers and speculators.
The advantage of the derivatives market is likely to be visible in the ongoing expansion surge
being witnessed in the country. A primary example is the cement industry which under the
current phase of expansion has seen notable names enter the derivatives market to facilitate
expansion projects. Lucky Cement, Pakistans largest cement manufacturer has entered into a
combination of interest rate and currency swaps to finance its expansion projects. Under the
current interest rate swap the company receives a floating rate equivalent to 6-month T-Bill or
KIBOR in exchange for the fixed payment from 7% - 9.3%. Lucky is likely to benefit in an
environment which expects interest rates to increase. Attock Cement has also entered into an
interest rate swap arrangement to finance its expansion project. The company receives a fixed
mark-up above a floating KIBOR rate against fixed payments.