Derivative_Market_in_Pakistan

DERIVATIVE MARKET IN PAKISTAN Introduction Many decisions are full of risks; some managers’ feel like leading their companies is like on a high wire act while others feel like to be ill at ease considering the decisions of taking the levels and depth of respective risk. The opportunities to manage such risks are well-versed by many in business. The dexterous managers are very much well-versed in comprehending the risk levels for investment portfolio. The derivatives are the financial tools for financial engineering as they are used to lower the risk or to invest to gain the leverage. Derivatives are been primarily used for hedging and risk mitigating purposes. However, sometimes it is complicated to know whether hedging actually occurs keeping in view the complexity of option contracts. A sagacious investor may believe his assets are diversified by two different derivatives contracts that he made in accordance to mitigate the risk but often this does not happen and his expectations are not materialized. Financial globalization smooths the progress of greater diversification of investment and enables risk to be transferred across national financial systems through using derivatives instruments. The resulting development in allocation of risks has made overall capital markets more efficient, while the accessibility of derivatives has augmented liquidity in the underlying cash markets. The recent global financial meltdown has also laid its effects on the Pakistan’s’ financial markets and thus explores an important aspect which is that the financial markets need a complete understanding when dealing with Financial Derivatives. In Pakistan, the investors are not very indulged into derivative businesses and thus they got immense confusion about how and when to use the derivative tools. Since we know that any puzzlement regarding the use of the various tools and techniques of Financial Derivatives can lead to a disaster with mammoth negative consequences on the world markets and specifically on the financial markets of developing countries. History of Derivative Markets in Pakistan The State Bank of Pakistan, on 20 December 2004, allowed commercial banks, authorized dealers and development finance institutions (DFIs) to start financial derivatives business. State Bank of Pakistan also announced the financial derivatives business regulations (FDBR) for the first time. The regulatory framework for the FDB laid down the indispensable risk management standards and operational arrangements for this unique kind of business. The regulations revolve round the fact that Financial Derivatives Business involves a high level of inherent risks. The State Bank of Pakistan said, “ Now banks and development finance institutions DFIs that want to undertake derivatives transactions will be required to get approval from SBP to work as (ADD) or non-market maker financial institution (NMI) status.” They were allowed to undertake derivative business within the FDBR framework. Non- authorized derivatives dealers or non-NMIs were asked to obtain special permission from State Bank of Pakistan for making such transactions. The State Bank of Pakistan had, until that time, selectively allowed over the counter (OTC) financial derivatives in Pakistan, under which banks were permitted to undertake interest rate swaps (IRS), foreign exchange options or (FX) options and forward rate agreements (FRA), but only with the approval of State Bank of Pakistan. Once State Bank of Pakistan granted a bank or a development finance institutions, an authorized derivatives dealer or NMI status then no such prior approval were be considered worthy requirement for the Interest Rates Swaps, Foreign Exchange Operations and Forward Rate Agreements. These practices, however to some extent, enabled Pakistani financial markets to compete with the developing countries’ financial markets like India and Malaysia and even with advanced countries through providing an array of in-practice and much talked about financial products. The Foreign Exchange options dealings were made allowed in G-7 (Canada, France, Germany, Italy, Japan, United Kingdom and United States) currencies only. Banks were free to set the notional amount of forex options as there were no restrictions made on the minimum or maximum size of the notional principal amounts. However, to limit the risk taking environment, the maximum tenor of the option was supposed to be just on year or less than one year, but on the other hand for greater periods of options, separate approvals were required from the relevant approving authority. In order to cover long or short FX position authorized derivatives dealers were allowed to go to long positioning with FX options with a maximum maturity of six months. Option contracts were to be settled on maturity by delivery on spot or by net cash settlement. Banks were allowed to book the options or enter in to such a contract against all existing FX exposures arising out of loan exposures and trade transactions. Interest rates swaps were allowed in fixed to floating or floating to floating modes of exchanges of interest rates. SPB, at that time, provided two safety features in derivatives: * Back-to-back coverage * Facility to be used only against existing risk— and not to take speculative positions Functioning of Derivative Market After getting pleasure from tremendous growth over a couple of years, the financial derivative business of the banks declined by 3 % during the second quarter i.e. April to June of the calendar year, 2009 accompanied by narrowness in cross currency swap portfolio and foreign currency option. The outstanding notional amount of all financial derivatives products goes to Rs. 250 billion during the April-June quarter of year 2009. The respective financial derivative sector caused 11 percent downfall in march 2009 and 17 percent decline in December 2008, giving an aggregate 31 percent decrease since the respective quarter of year 2008. What does State bank of Pakistan has to say about the respective decline' “State Bank of Pakistan break-up of Derivative Business”, hoarded by SBP ring into light the rationales that the momentous decline was observed in Foreign Exchange Options i.e. FX Options which decreased by 54 percent over the quarter i.e. March-June 2009. The news that this decrease created a huge mess can be accompanied by the fact that it declined, by 88 percent in year to year basis, to Rs. 11 billion and their relative share decreased to around 4% by the end of June 2009. Consequently, with the fact that as compared to leading share during the first quarter of last year, the FX Options then quoted the lowest share in banks’ derivative portfolio. Cross Currency Swaps (CCS) remained successful to quote the largest share of banks’ financial derivatives portfolio. After observing an increase during the last quarter, the value Cross Currency Swaps marginally declined by 2.3 percent during the quarter under discussion to Rs164 billion. The leading factor behind the popularity of Cross Currency Swaps has been the greater spread between local and international interest rates thus providing the investors with possibilities of making big profits. The high interest rate differentials have induced the local corporate, particularly those with sufficient export volumes, to swap their local currency exposures with LIBOR or any other greater interest interbank offering rates. Hurdles Acclaiming the "economical culture of financial markets in Pakistan", its economy requires unwavering macro and political environments to grow. Economic growth should be strong enough to engender the appropriate issuing centers and investors along with increasing inflation and interest rates that have always been showing instability and volatility which is one of the major impediments in the stability and growth of derivative market in Pakistan. Lack of proper planning for creating infrastructure of the investor base has bring hurdles in the way of growth of derivative markets in Pakistan. The "lack of extensive and profitable interested investors" have also created problems for the establishing a well-functioning derivative market. Though with the efforts of Pakistani government and other stack holders the financial markets have performed well in this case even though warts and all and facing all such problems discussed above, the respective markets have performed well, thought they were not surely to be ill at ease. The "lack of liquidity" issues concerning derivative markets in Pakistan have also create hurdles in the well-functioning and proper structuring of this market in Pakistan. This factor also implies to the secondary markets to trade the derivative products and to take the short positing i.e. selling these derivative instruments. Now if we can highlight the "Islamic perceptive" about usage of derivatives, as part of the gambling proscription, derivative trading is like options and warrants are also condemned. The Islamic banking ethics are four-fold. First of all it is objectionable to make money from money. Subsequently there is a prohibition against riba i.e. interest. As a second element Islam aims aim of a profit and loss sharing system, involving both the lender and the borrower. Thirdly, Islam prohibits Gharar, signifies that business involving excessive uncertainty, risk or speculation shall be avoided. Finally there is the requirement that all investments must be halal, which is, permitted according to Islamic believes. Another major problem stems from the fact that there is "very little transparency and disclosure" in the derivatives markets in Pakistan. As we know that derivatives are traded on exchanges while other derivatives are traded over-the-counter (OTC) in markets that are almost lock, stock and barrel unregulated. In the OTC markets of Pakistan there is very little information provided by either the private market participants or collected by government regulators. The prices and other trading information in these markets are not made freely available to the public like is the case with futures and options exchanges. Instead that information is hoarded by each of the market participants that create fuss and confusion among the masses and thus they don’t get attracted to invest in derivative instruments. As a result of this lack of information and credibility in the OTC market, it substantially reduces the ability of the government and other market participants to anticipate and possibly preempt building market pressures, major market failures, or manipulation efforts that are surely be controlled in the financial culture of Pakistan. There are also a lot of reasons that people in Pakistan consider derivatives "hazardous and unsafe" for them. First, the payoffs from derivatives, options in particular, are often more complicated than in the case for the underlying asset. This combined with leverage can expose a non-sophisticated investor to more risk than they bargained for. The first danger posed by derivatives, as assumed by Pakistani investors, comes from the leverage they provide to both hedgers and speculators. Derivatives transactions allow investors to take a large price position in the market while committing only a small amount of capital – thus the use of their capital is leveraged. Taking on these greater risks raises the chances that the investors in Pakistan may makes or loses a handsome amount of money. And if such participating corporations suffer large losses, then they are threatened with bankruptcy. If they go ruined, then the related people, banks and other financial institutions that invested in them will have to face possible losses and in turn face bankruptcy themselves. Such thinning out of the losses and failures is called systemic risk, and it is an economy wide problem that is made worse by leverage and leveraging instruments such as derivatives instruments. Another problem faced by derivative markets ion Pakistan is the "high country risk of Pakistan". High interest, inflation and jobless rates, negative current account and low reserves constitute the high country risk of Pakistan. Pakistan’s country rating is D which is mainly due to the high-risk political and economic situations and comprising an often very difficult business environment that may have a very huge impact on corporate payment behavior. Moreover, the corporate default probability is very high which also reduces the country rating. Pakistan holds business climate ratings of C grade. And the institutional framework has many troublesome weaknesses. As when you live at that time, you need to have the appropriate resources available at low cost specifically for the issuer or option writer, as it is the one who initiates the business. But on the other hand, they were failed in establishing a likely well performing derivative markets because options and other derivative instruments need to be duly serviced and repaid, establishing the fact that issuers should be of a higher credit quality, otherwise due to lack of trust and creditworthiness there will be no buyers and writers would just be falling out and increasing their both explicit and implicit cost of search and advertisement. Significance of Introducing ETD in Pakistan LIQUIDITY Since Exchange Traded Derivatives not only set aside the investors to protect their positions but these derivatives also allow them to obtain benefit from various opportunities. Derivatives provide a greater pool of liquidity and encourage investors to enter the market which makes it more liquid and as per the liquidity issues discussed above, we would like to say that investors can increase the liquidity by giving trust and investing in derivative business. NEW PRODUCTS FOR CHANNELING THE LIQUIDITY Capital markets around the globe have grown with savvy investment opportunities and tactics. Though providing such investment opportunities and tools, Exchange Traded Derivatives have proved their significant presence in the growth of markets all over the world. Their practice and well-functioning can also have similar salutary impact on capital markets of Pakistan. LEVERAGE Derivatives facilitate investors to do well, and make higher value transactions from a change in the price of the underlying, with paying only its option price. An investor can therefore take long positioning in a future or an option for less outlay and make good money from the price movement in the underlying asset. The aptitude to earn a higher return for a smaller initial outlay is commonly known as leverage. DOWNSIDE PROTECTION Exchange Traded Derivatives function as a risk management tool for investors because they can hedge i.e. get protection by mitigating or limit the risk to their portfolio from a drop in value. For instance, the derivatives allow investors to hedge against a fall in the value of the underlying asset. Looking at it from the perspective of the crisis in preceding couple of years, such tools could have enabled investors to limit their downside risk. RETAINING THE INVESTOR For sure the furthermost inducement for introducing ETD’s in Pakistan is that we may keep our local investors engrossed in local markets rather than looking towards other markets where they may find some more attracting opportunities for diversification and leverage finance. Conclusions The development and growth of derivative markets in emerging markets plays an out of the ordinary role in this context as more institutional money is dedicated to emerging markets of countries like Pakistan, India and Malaysia that necessitates the availability of financial instruments to manage market, credit and interest rate risks. Derivatives are a financial contract whose intrinsic value derives from a pre-determined payoff formation of securities, assets, interest rates, credit risk, and foreign exchange or any other tradable assets. Derivatives assume economic gains from both risk shifting and efficient price discovery by providing hedging and low-cost arbitrage opportunities. Introduction and well-functioning of derivatives in Pakistan is not only going to assist the financial institutions and their clients to hedge their uprising and inherent risks, it is also going to give maturity and sensible functioning base to money market and foreign exchange market in Pakistan. That is the need of the hour given the fact that Pakistan is swiftly assimilate its financial sector with the international and modern financial market. In short, an established and strongly functioning derivative market can prove to drive an important role in the development of financial sector of an economy of developing countries like Pakistan and India. Since Pakistan is a developing country and therefore it has emerging markets so there is a great opportunity of investment for the developed countries. Recommendations Under the light of conclusions reached in the previous section we would like to propose some recommendations for well-functioning and improvements for derivative market in Pakistan. The derivatives involve complex transactions that have to be very carefully understood by all parties involved. They have to be suitably implemented and accounted for and the risks have to be very closely monitored. There should be adequate lawful, regulatory and governance infrastructure and oversight and controlling bodies for the monitoring. The SECP should allow for an open licensing regime so that existing or new exchanges that meet the criteria can comply and qualify for derivatives trading. SRO (Self-Regulation Authority) i.e. Trade Development Authority of Pakistan and other regulators should ensure the effective enforcement. To keep pace with the international and modern developed financial markets and especially the derivative markets it will be very thoughtful that the current futures contract and newly introduced contracts at KSE be brought into conformity level with International Best Practices. There should be proper planning for developing an infrastructure for investors. Respective authorities should publicize the feasibility and significance of trading in derivative market as to attract extensive and large investors. There should be more liquidity in derivative market of Pakistan as to provide more confidence to investors and motivation to enter into derivative market. Perhaps the most likely issue to be go under consideration is the transparency and disclosure of derivative trading as to provide protection and confidence to respective investors. Pakistani government and other related responsible authorities should strive to strengthen our image on international market and to decrease the country risk by enforcing proper law and order as to attract investors to invest in the respective market with no worries. Bibliography 1. Buffet, Warren. “Annual Letter to Shareholders.” Online Posting, 8 March, 2003 2. N. Yaquby, "Trading in Equities: A Shari'ah Perspective," Proc. 4th Harvard Univ. Forum on Islamic Finance. Harvard CEMS: 2000, p. 119 3. Bouchaud, Jean-Philippe and Marc Potters. 2003. Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management. Cambridge, UK: Cambridge University Press 4. Financial Derivatives Business Regulations (FDBR), announced by State Bank of Pakistan.