Derivatives Market of Pakistan

ASIGNMENT # 2
Derivatives Market of Pakistan
Fixed Income and Derivative Analysis
Name :

Daood Abdullah
Fozia Asghar
Farah Islam

14209003
13109002
13119001

Submitted To:
Sir Faisal Munir

School of Accounting and Finance

Gujranwala

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Assignment 1

Derivatives Market of Pakistan

Introduction

Single Stock and Stock Index Futures are the two significant Products in the
Derivative Segment of Pakistani Capital Markets. The potential for derivative
segment development is huge. However, the lack of knowledge about existing
derivatives, and inexistent liquidity therein, are the two key issues hindering the
development of the Derivative Segment in Pakistan. Moreover, a vibrant and liquid
ready market is also an essential element of a flourishing derivatives market, which
can be accomplished by the active participation of both hedgers and speculators.

The term "Derivative" indicates that it has no independent value, i.e. its value is
entirely "derived" from the value of the underlying asset. The underlying asset can
be securities, commodities, bullion, currency, livestock or anything else. In other
words, Derivative means a forward, future, option contract of pre-determined fixed
duration, linked for the purpose of contract fulfillment to the value of a specified
real or financial asset or to an index of securities.
A Derivative includes: A. A security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of security;
B. A contract which derives its value from the prices, or index of prices, of
underlying securities; Derivative trading is permissible for any stock exchange. The
stock exchanges act as frontline regulator whereas SECP acts as apex regulator in
Pakistan. The clearing & settlement of all trades of Derivatives is settled through
National Clearing Company of Pakistan, which is independent in governance and
membership from Stock Exchanges.

Development of derivatives market in Pakistan

Entry of derivatives began in early in 1990 with currency swaps called dirty swaps. Few banks are
allowed by SBP to deal in derivatives securities.

SBP regulate the OTC market for

1. Foreign currency option
2. Forward rate agreements
3. Interest rate swaps

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Derivatives Market of Pakistan

All derivatives agreements require formal approval of the central banks. In 2011 the Securities
and Exchange Commission in Pakistan allowed mutual funds to use derivatives for Hedging
purpose. With Leverage Market Rules 2011 (Second Amendment in 2012) the Margin
Trading System (hybrid derivative) defined procedures for Extension and
maintenance of credit towards purchase of securities, which was earlier prohibited
under section 16 of SECP Ordinance 1969.

Key Concepts in Derivatives

Volatility: Derivatives feed on volatility!
Liquidity: Derivatives markets cannot function properly w/o sufficient
Liquidity - easy entry and easy exit
Hedging: Risk-avoiding strategy to protect position values
Speculation: Risk-taking, dynamic investing strategy to generate high returns
Arbitrage: Risk free, profit-seeking strategy from temporary price distortion
Symmetry: Long Vs. Short - A Zero-sum Game!
Leverage: Small Commitment - Large Consequence
Fungibility: Substitutability of assets/contracts (Money - Commodity)

Derivatives users in Pakistan

Following are the users of derivatives instruments in Pakistan
1. Hedgers, speculators, Arbitrageurs
2. Individuals
3. Institutional investors
4. Banks, others financial intermediaries

Derivatives are derived from the following products:

Shares

Debentures

Mutual funds
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Derivatives Market of Pakistan

Gold

Steel

Interest rate

Currencies.
Derivatives are financial contracts of pre-determined fixed duration, whose values are derived
from the value of an underlying primary financial instrument, commodity or index, such as:
interest rates, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes
in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.
Hedging is the most important aspect of derivatives and also its basic economic purpose. There
has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives
as means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in
pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are
essential.

Benefits of derivatives
Following would be the benefits of derivatives market
1.
2.
3.
4.

Price discovery
Risk management
Improve market efficiency for underlying assets
Reduce market transaction costs

Understanding the types of derivatives market

1. Forward
This is a form of contract wherein two parties agree on buying or selling an asset at an agreed
price. The actual exchange then happens on a future date, thus the term forwards. The contract
happens among the parties themselves without an outside party interfering. The contract in a
forward type of financial derivative is non-standardized. It is subject to the choices of the
parties engaged in a forward contract.
2. Futures
A futures contract is similar in some manner to the forward type. It also involves an
agreement on sales of an asset on a future time. However, financial derivatives contracts of
this category have a standardized contract form. The terms and conditions of the contract are
arranged by a third party called a clearing house.
3. Options
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Derivatives Market of Pakistan

This type of contract allow the person involved to have the option of exercising his right on
the assets. Transactions start at a specified price called a strike price. A maturity date is then
set for the owner to exercise his option of buying or selling the asset. The owner has the
option of using his right on the exact date of maturity and not before in a European option.
The American option allows the owner to exercise his right on or before the maturity date.
4. Swaps
Contracts involving swaps allow transactions to occur before a future date. Like all financial
derivative types, swaps derive their financial value based on the underlying asset.
The above examples are the most common forms of contracts on financial derivatives. There
are many other types that could be made out of a combination of the above examples. When
these forms are combined, the contract takes on new features or characteristics that are unique
and different from the other forms.
Knowing the types of financial derivatives makes it easier to understand how it works. Now
that you know the different contracts involved in financial derivatives, it will be easier to
choose an option that suits your need. The concept of financial derivatives may operate on an
abstract level but its applications and impact are definitely felt in the real world.

Types of Derivatives available in Pakistan

Cash-Settled Futures (CSF) at the KSE Yet to Gain Popularity
Introduced early in 2007. Not gained popularity at all. Presently 15
companies are available for these cash-settled futures.
Standard contract is of 30, 60 and 90 day duration, with daily marked-to
market of losses & gains. There is necessarily an equal number of buyers and
sellers in the market and thus smooth settlement on the last day of the
contract is ensured.
Mutual fund are not allowed to trade in future as per Section 58 of NBFC
regulation
Not gaining popularity because of the availability of other resembling
leveraging instrument of CFS and also because of liking for deliverable
futures for various reasons.
However, on the recommendation of the committee CFS MK II and
deliverable futures have been discontinued recently.
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Types of Futures
Stock futures Tracks the performance of a SCRIP
Stock Index futures Tracks the performance of an INDEX
Both can be further classified into two types:
Cash Settled Futures
Deliverable Futures
Internationally cash settled futures are more popular. (Available in Pakistan)

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