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ISSN 2229-5518
Impact of Derivatives on Efficiency of Stock
Market: Evidence from Karachi Stock Exchange.
Ali Raza M.Shaf i (M.S., Department of Commerce, University of Karachi), Syed Shabib ul Hassan (Assistant Professor, Department of Public Administration, University of Karachi), Ayesha Fareed (Lecturer, Department of Commerce, University of Karachi)
Abstract—Through the proper us e of derivatives, a f irm, even c ountry c an hedge, manag e and transf er the s ys tem atic and uns ys tematic ris ks. Many studies have been c onducted f or determination of the f ac tors whic h inf luenc es the reluctant and us age of f inan cial derivative ins truments & ris k manag em ent prac tic es of financ ial c orporations and non-financ ial c orporations , have built a lot of materials to the literature. In Pakistan s uc h studies enc ompass the driving f ac tors like history of derivative in Pakistan, meas urement of ris ks (es pecially interest rate and f oreign exc hange risks ), and knowledg e of f inanc ial manag ers of Pakistani c orporation towards modern finan cing. Financ ial derivatives bus iness regulations (FDBR) have been c reat ed and allowed by State Bank of Pakistan to regulate and handle the derivative dealings in Pakistan. To enhanc e the liquidity and flow the c apital to the right path f or ec on omic growth, the introduction of derivative market in Pakistan c ould be a pioneer s tep. T he purpos e behind this study is highlighting the impact of derivatives on the effic ienc y of Karac hi stoc k exchang e of Pakistan. T he study f irst f ocus es on the c onc ept of the derivative market, products, and participants and s ec on dly, it provid es auxiliary f or devel opment of an effic ient derivati ve m arket in Pakistan.
Index Terms— Derivatives , Hedge, Pakistan, Sys tem atic ris ks, Uns ystem atic risks .
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Interest rate risk and foreign exchange rate risk are frequently facing risks among all types, for- eign exchange rate risk is only bear by organiza- tions having their operations in more than one country (MNCs), while almost every organiza- tion faces the interest rate risk to stable it’s short and long term financial requirements. Misunderstanding and mismanagement of risks (especially foreign rate and interest rate risks) by financial managers can hurt the value of share- holder’s wealth, the loss in shareholder’s confi- dence is the result, and in last the performance of stock market minimized.
Derivative (instrument for risk reduction) is a
written contract between two parties, it doesn't have its own value, but its value derived from and depend on some other underlying assets, the values of both derivative contract and the underlying assets are closely related. In the de- rivative market normally the physical delivery of above listed (underlying) assets is not in prac- tice. OR it is a financial instrument or contract consisting three conditions. 1) Derivative value changes by the changing of underlying assets. 2) The initial investment is not necessary here. 3) A future settlement date is an essence of this con- tract.
All companies, especially multinational are fac- ing the interest rate and foreign exchange rate risks. Karachi Stock Exchange (KSE)’s efficiency
obviously disturbs by levels of reluctant and usage of derivative instruments. A rational in- vestor always seeks the hedging of risk in the shape of investment in derivatives, when he ana- lyzes the financial statements. Especially for KSE listed companies, due to unfavorable circum- stances, the proper use of derivative instruments invites to hedge systematic and unsystematic risks to get the sufficient financing by giving more confidence to the investors.
Many studies have been conducted determina- tion of factors which influences the reluctant and usage of financial derivative instruments, risk management practices by the financial cor- poration (e.g. jack W.Dorminey and Barbara
2012. highlighted the hedging derivatives in the
banking industry) and non-financial corporation
(e.g. Bodnar, G. M. and Gebhardt, G. 1999. High-
lighted the derivative usage by nonfinancial firms in the US and German) have built a lot of materials to the literature.
This study will provide help for all KSE listed companies to enhance their efficiency and per- formance by using derivative instruments to hedge the interest rate and foreign exchange rate risks. The study will be helpful to motivate the financial managers to start or increase the deriv- ative use; economic revival is the basic aim be- hind these efforts.
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In the discussion of economic revival, among other factors the stock market is considered as an important driving force. When we talk about the stock exchange, its efficiency comes auto- matically in our debate as a crucial topic.
An efficient market can lead their competitors at national and international levels, meaning of efficient market can learn better with the Effi- cient Market Hypothesis (EMH) and Miller & Modigliani (M&M) Theorems. M & M theory and EMH argue that the changes in stock price depend upon public information. Efficiency in information is the base of strongest relationship between stock price and information. Three cat- egories of market efficiency; weak, semi and strong forms were also introduced by FAMA (1970) on the basis of efficiency of information.
In a rational decision making regarding invest- ment portfolio and their analysis can do easily in an efficient financial market by an investor, it means only an efficient market can permit their investors to make decisions quickly.
The derivative market is new for Pakistan stock exchange; Investors in Pakistan have not aware- ness (information) regarding the use of deriva- tives.
Investigation for building an efficient derivate market is the purpose of this study in order to put more efficiency in the Karachi stock ex- change market. In the under developing econo- mies like Pakistan the research area for “deriva- tive impact on stocks” is now waiting for re- searchers and it can play a valuable contribution in economic growth also. For Pakistani envi- ronment where more volatility, more inflation, security threats, terrorism and energy crises are considered as extra challenges for an investor, this study could be a sign of prosperity in the Karachi stock exchange market. After publica- tion of this study, these papers could be helpful for further researches. The derivative market has been captured more attention after global finan- cial crises of 2008 and Asian crises of 1995 and
1996. This crisis vividly reveals that the financial
institutions were not able to capture the risk
through their instruments and model; these
were unable to protect investment regarding
sudden abrupt and quantum fluctuation in asset
prices. For emerging economy like Pakistan, a
healthy derivative market facilitates economic
growth and development and also can develop
the bond, foreign exchange, real estate markets.
Why KSE listed companies do not use deriva-
tives? And what type of instruments are they
using in alternate of derivatives? Are the big
research areas of this study.
The study has been divided into five sections. The first section focuses to facilitates to under- standing of the derivative market, products and participants, the second section draws light on the scope of the study, The methodology stated in the third section, the forth section highlights the impact of derivatives on Karachi Stock Ex- change (KSE) market, and finally fifth section emphasizes the conclusion and recommendation remarks to the concern authorities to make some necessary steps in developing a potential deriva- tive market in Pakistan.
(Hedging device for investors to safe their in- vestments from dropping their worth):
Derivative (instrument for risk reduction) is a written contract between two parties, it doesn't have its own value, but its value derived from and depend on some other underlying assets, the values of both derivative contract and the underlying assets are closely related.
Underlying assets consists
In the derivative market normally the physical delivery of above listed (underlying) assets is not in practice.
It is a financial instrument or contract consisting
three conditions
1) Derivative value change by the chang-
ing of underlying assets
2) Initial investment is not necessary here
3) Future settlement date is an essence of this contract
1) Operational risk; uncertainty of failure
to operate the system.
2) Market risk; uncertainty about unfavor- able movement of market prices.
3) Legal risk; uncertainty of legal bounda-
ries disrupts your activities.
4) Liquidity risk; risk of slowness in pace of trading an asset or security.
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5) Counterpart (default) risk; uncertainty of involved party or parties that might default.
Players / Participants of Derivative Market: This study tries to fill the following gaps
1. Scope of derivative market in Pakistan.
2. Impact of derivative on efficiency of Ka- rachi stock exchange.
3. Basics of derivatives consisting market, products, and participants.
4. What barriers are in the use of deriva-
tives?
5. How to overcome these barriers.
6. What the responsibilities of concern au- thorities are being ignored to promote derivative market in Pakistan?
1) To mobilize the capital at right direction to
generate the employments and income by using
derivatives, 2) to enhance the transparency and
security for financial instruments and risks, 3) to
explain the meaning, products and participants
of derivative market, are also can be consider as
an important purpose of this study due to intro-
ductory period of derivative market in Pakistan.
Importance of derivative market in emerging
economies for economic growth, impact of de-
rivatives market on the efficiency of Karachi
Stock Exchange (KSE), identification of factors
that contributes to rapid growth of derivatives
market are also the scope of this study. In addi-
tion, in the Pakistan the investors have not ade-
quate awareness regarding derivative products
and its use. Therefore the investors and financial
institutions, both are not contributing their real
potential in the development of derivative mar-
ket, ultimately the pace of economic growth is
not quite differ before and after global financial
crises, this study could be an integral material to
fill these gaps.
The stubby is mainly based on secondary data;
collected from official websites and publications
of KSE, and from other related literatures.
In addition, relevant literature is also reviewed
to enhance the quality of this study. The use in
the vital range of secondary data is responsible
for this study because the derivative market in Pakistan is quite new. Derivate market is a broader market and it almost cover all of the integral financial market of the economy, includ- ing insurance companies, broking services, and funds& portfolio management, and also in- cludes banks and housing societies, credit un- ions, and micro financing facilitation institu- tions.
Indeed the KSE listed companies are using de-
rivatives to the insufficient extent, more than
50% firms are minimizing their risks by hedg-
ing, while less than 30% firms are using deriva-
tives for speculation. These insufficient levels
are the result of the risk averse nature of finan-
cial managers; affecting the efficiency of KSE.
Although some of the KSE listed companies
have been agreed upon the development of a
fully active derivative market in Pakistan, but
majority of them are using only one or two types
of instruments where the future is more pre-
ferred than forward.
The derivatives are quietly new instruments for
the investors of Pakistan, but currently many
financial institutions, including banks, credit
unions and mutual funds, institutions are deal-
ing the derivative transactions with various
types of use. Karachi Stock Exchange is now
working to introduce the Islamic derivatives in
contrast of preventing selling and buying of de-
rivative transactions in the existing derivative
market. 2001 was the year when first time the
one month future derivative introduced in Kara-
chi stock exchange, but now various other in-
struments are available like cash settled futures,
and index futures etc.
Despite these developments the Pakistan deriva-
tive market has not in a better position as com-
pared to Indian derivative market (which started
in 2000) and other developing countries.
Markets for derivatives started in Pakistan in the
year 2003. The first transaction was the coupon
swap by National Bank for PARCO. At that time
the market was very thin and uneducated. Cli-
ents were not sophisticated enough to handle
the transaction. Moreover, there were not
enough transactions taking place in the market.
After PARCO, forward rate agreement took
place in 2004 which were apparently termed as
the first derivatives in the market done by UBL.
2004 was the year in which State Bank of Paki-
stan focused on derivatives. SBP gave approval
for FX options, interest rate swaps on a case to
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International Journal of Scientific & Engineering Research, Volume 5, Issue 7, July-2014 108
ISSN 2229-5518
case basis. At that time there used to be four ac- tive players in the market, Standard Chartered Bank, Citi Bank, ABN Amro and Deutsche Bank. In November, 2004 SBP introduced the concept of the Authorized Derivative Dealer (ADD). In
2005, the license was given out to Banks for
ADD.
Underdeveloped derivative market in Pakistan
is due to the bad performance of the whole
economy, consequently the presence of a vital
range of risks makes market maker unable to
attract the foreign even local investors. Basically,
through the proper use of derivative, a weak
party can prevent his self from bearing risk and
can able him to transfer the risk to other strong-
er and willing party who can handle it better
than first one. An effective derivative market in
Pakistan economy can generate an efficient stock
market where a rational investor can manage
their risks not only regarding inflation, but as
well as for trade deficit, foreign policies, curren-
cies and interest rates. An efficient derivative
market provides auxiliary to attract foreign in-
vestments; can reduce our debt burden.
Investors know that a security has higher the
risk invites higher the return, but investor wants
to place some blocks to the extent possible be-
tween risk their investments.
Concept of derivative securities starts from for-
eign currency contracts, then grew into interest
rate and now famous in the world and make
investors able to deal in risky investments or
securities.
As at the initial stage of derivative market in
Pakistan is facing a number of challenges and
concern & responsible authorities try to intro-
duce this derivative market to individual inves-
tors and participants for example, state bank of
Pakistan decided to allowing the banks to carry
out the derivatives transactions. These authori-
ties are seeing a bundle of challenges and it is
also known by these authorities that the devel-
oped economy of Pakistan demands the proper
management of financial commodity risk.
I think that the major problem in the develop-
ment of derivative markets of Pakistanis is the
lacking of knowledge of derivatives, and its ad-
vantages in today complex investment decision
making.
I hope that the well educated people in this field
can minimize the barriers and maximize the in-
terest, and speed of growing of that market. The
less educated investors and participants are the
main reasons still under development stage of
derivative market in Pakistan.
If we draw some light on other challenges, the deregulation of financial markets in Pakistan is another major constraint.
Underdeveloped market, the interest level of derivative concern authorities, and its dealers are still too low, and constraints of unavailability of market data regarding derivatives are the main responsible blocks in development of de- rivatives.
Low level of market liquidity is also may be re- sponsible for underutilization of derivative risk protector’s instruments, a large capacity market can overcome this liquidity problem, because more the participants invites high liquidity. The state bank of Pakistan is responsible to provide surety to the participants (individual investor and institutions like old age benefit fund, and national investment trust etc.) regarding proper supervision and trading of derivative transac- tions.
Derivatives can help to our investor in calcula- tion of opportunity cost and also help in better understanding regarding the operations of money market
If the Pakistani derivative concern authorities and other responsible sectors increase their at- tention towards the development of derivatives, then the increasing domestic saving, continuous development, sustainable development of econ- omy, increase in FDI, and resolution of interest rate fluctuation problem will be ready in the weak economic umbrella to make it strong.
I hope that in coming days the concern authori- ties will be successful with the help of an edu- cated framework to make a developed deriva- tive market in Pakistan.
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