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FYP REPORT
FAST-SCHOOL OF BUSINEES
NATIONAL UNIVERSITY OF COMPUTER & EMERGING SCIENCE MANAGEMENT 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
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 Contents
Table of Contents........................................................................................ 3 Chapter .01................................................................................................. 7 1. Introduction............................................................................................. 7 1.1 Overview of Topic..............................................................................7 1.2 Historical background........................................................................8 2. RISK......................................................................................................... 9 2.1. Defining Risk..................................................................................... 9 2.1.1. Definitions of risk......................................................................10 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............................................................................................. 13 3.4 Potential risk treatments..................................................................13 3.4.1 Risk avoidance...........................................................................13 3.4.2 Risk reduction............................................................................ 14 3
3.4.3 Risk retention.............................................................................14 3.4.4 Risk transfer...............................................................................15 3.5 Risk-management plan....................................................................15 3.6 Implementation................................................................................15 3.7 Areas of risk management...............................................................16 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.................................................................22 Chapter .02............................................................................................... 23 1. Literature Review..................................................................................23 1.1 Defining Risk.................................................................................... 23 1.2 Risk Management............................................................................ 24 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 1.6.2 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 4
1.8 Implications..................................................................................29 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.......................................................................................... 30 2.1 Overview.......................................................................................... 31 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 Overview.......................................................................................... 36 4.2 Measurement of Risk.......................................................................37 Chapter.03 ............................................................................................... 38 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:.............................................................................................. 40 8. Measurement Selection:....................................................................40 Chapter.04 ............................................................................................... 41 Data Analysis and Findings.......................................................................41 4.3 Analysis of Risk Management Practices at KSE...................................47 4.3.1 Eligibility of Listing:.......................................................................48 4.3.2 Products and services: .................................................................49 4.3.3 Netting: ........................................................................................ 50 4.3.3.1 Netting rules at KSE:...............................................................51 4.3.4 Mark to market procedures: .........................................................53 4.3.5 Clearing and Settlements:.............................................................54 4.3.5.1 Settlement and clearing for Deliverable Future Contracts:...........55 Daily Clearing: ....................................................................................... 55 5
Final Clearing ........................................................................................ 55 Special Clearing .................................................................................... 56 4.3.5.2 Settlement and clearing for Cash Settled Future Contracts:.........56 Daily Clearing ........................................................................................ 56 Final Clearing & Settlement ..................................................................56 4.3.5.3 Special Clearing ........................................................................57 4.4 Other initiatives by KSE:......................................................................57 4.5 Comparing KSE Risk Management Practices against Benchmark........58 Chapter.05................................................................................................ 61 Conclusion and Recommendations...........................................................61 5.1 Conclusion:.......................................................................................... 61 5.2 Future Outlook:................................................................................... 62 Bibliography.............................................................................................. 64 References................................................................................................ 65
Appendix... 44
Chapter .01
1. Introduction
1.1 Overview of Topic
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 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.
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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.
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 "", "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 Risk
Risk 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 organizations 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.
"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.
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.
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
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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.
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.
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.
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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)
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4. identify ways to reduce those risks 5. Prioritize risk reduction measures based on a strategy.
3.3 Process
1. Identification of risk in a selected domain of interest 2. Planning the remainder of the process. 3. Mapping out the following:
o o o
the social scope of risk management the identity and objectives of stakeholders 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.
Avoidance (eliminate) Reduction (mitigate) Transfer (outsource or insure) Retention (accept and budget)
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
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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
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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.
3.6 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.
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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
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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.
US newspaper, USA Today, termed Karachi Stock Exchange as one of the most excellent performing bourses in the globe.
6. Research Question
o Are Risk Management Practices in Pakistan Stock Market in line or align with the emerging Stock Markets (like Indian, Australian, and Russian etc)?
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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 actionsuch as changing their assessmentsuntil 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.
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Chapter .02
1. Literature Review
1.1 Defining Risk
For 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 companys ability to meet its business objectives. Such constraints pose a risk as these could hinder a companys 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 Management and some guiding principles to manage risks in organization (Ward 2003) Stephen Ward (2003
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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)
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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.
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.
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 organizations 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 companys 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 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 companys risk management practices (Chapman & Ward 2002). Managing Project Risk and Uncertainty Chris Chapman, Stephen Ward (2002)
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1.5 Misconception
A 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 accept credit risk but avoid interest rate risk, while an investment bank does the opposite
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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)
(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 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
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of the portfolio among different asset types provides an inexpensive and readily available means to mitigate risk (Federal Reserve Bulletin, June, pp. 36995).
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. 6276). 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)
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) 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,
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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).
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.
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
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upon assumptions such as normality, and have developed approaches that address model error (Journal of International Money and Finance, vol. 14, pp. 326).
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. 10620) That is, while hedging acts to reduce independent risk, it can enhance systemic risk. 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)
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2.1 Overview
The 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, 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
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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.
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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.
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
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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.
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 1987s stock market crash, the Kuwaits 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 cointegration 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 comovements 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
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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 longterm and short-term market efficiency/inefficiency in the region.
4. Calculating Value-at-Risk
4.1 Overview
In 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) 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
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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.
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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 humans entire economic behavior with the mode of over imagination. In early 1990s, 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.
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
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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.
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.
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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.
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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)
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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; 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.
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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 companys 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 ISOs 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 municipalitys 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 in multiple markets may find that it receives more netting benefits from InterISO/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.
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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 participants 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.
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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.
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.
Factor
Eligibility of Listing
Best practice
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 should net off their obligations cross markets. Valuing Investments at their current price to provide a realistic measure of portfolios true liquidation value. Over time, Reporting, standards for state and local governments investment portfolio have been enhanced so that
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Mark to Market
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. Diversifying the portfolio by investing it among different investment avenues like stocks, bonds and mutual funds etc.
Product Portfolio
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 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 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.
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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).
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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 companys ordinance 1984 and companys 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.
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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. 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 time basis. activities on real
4.3.3 Netting:
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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. Inter-ISO/Cross-Market Netting has a couple dimensions. First, it could include netting of transactions across multiple ISOs. A second dimension of the InterISO/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.
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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 Members 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).
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).
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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-thecounter (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).
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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 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).
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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).
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Moreover, investors guide is available and education seminars are also held on regular basis and investors 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.
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. 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
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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 investors 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, investors guide and educational seminars take place to help answer investors 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
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Chapter.05
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.
5.3 Recommendations:
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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 investors 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.
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