Derivatives:

Derivatives are complex financial instruments that are used by retail and institutional investors
for risk management. They derive their value from the ‘underlying’ source, such as financial
assets, commodities, currencies, or interest rates.

We deals derivative in two ways,

I. Over the counter ( High Risky)

II. Exchange Trade Derivative (Less Risky)

Introduction:
Some derivatives (futures and options) trade on organized exchanges, while others (forward
contracts, options, and swaps) trade on over-the-counter (OTC) markets.

The contracts on exchanges are characterized by standardization, high regulation, liquidity, no

default risk, and low transaction costs. On the other hand, OTC contracts are customized to the
needs of the parties involved, are less marketable with high counterparty default risk, and are
loosely regulated.

Types of derivatives:

1. Options

Options are financial derivative contracts that give the buyer the right, but not the obligation, to
buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific
period of time. American options can be exercised at any time before the expiry of its option
period. On the other hand, European options can only be exercised on its expiration date.

2. Futures

Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the
respective underlying asset at an agreed price on a specific date. The parties involved in a futures
contract not only possess the right but also are under the obligation, to carry out the contract as
agreed. The contracts are standardized, meaning they are traded on the exchange market.

3. Forwards

Forwards contracts are similar to futures contracts in the sense that the holder of the contract
possesses not only the right but is also under the obligation to carry out the contract as agreed.
However, forwards contracts are over-the-counter products, which means they are not
regulated and are not bound by specific trading rules and regulations.
Since such contracts are unstandardized, they are traded over the counter and not on the
exchange market. As the contracts are not bound by a regulatory body’s rules and regulations,
they are customizable to suit the requirements of both parties involved.

4. Swaps

Swaps are derivative contracts that involve two holders, or parties to the contract, to exchange
financial obligations. Interest rate swaps are the most common swaps contracts entered into by
investors. Swaps are not traded on the exchange market. They are traded over the counter,
because of the need for swaps contracts to be customizable to suit the needs and requirements of
both parties involved.

In Pakistan’s Practices

Domestic Derivatives Market

a. Current Derivatives Market:

State Bank has allowed limited number of derivative products (swaps and options) to the
derivative market participants with certain reporting and disclosure obligations and the market is
used only for hedging purpose.
State Bank of Pakistan allows four types of derivative instruments namely:

i. Interest Rate Swaps: An interest rate swap is an agreement between two parties where one
stream of future interest payments is exchanged for another based on a given principal amount.

ii. Forward Rate Agreements: A forward rate agreement (FRA) is an over-the-counter contract
between parties that determines the interest rate or exchange rate to be paid or received on an
obligation beginning at a future start date.

iii. Third Currency Options: they are used for exchange rate related risk hedging for trade
related transactions such as LC, exports, imports etc

iv. Cross Currency Swaps: A cross-currency swap is an over-the-counter derivative agreement

between two parties to exchange interest payments and principal on loans denominated in two
different currencies. In a cross-currency swap, a loan's interest payments and principal in one
currency would be exchanged for an equally valued loan and interest payments in a different
currency.
b. Authorized Derivative Dealers:

“Authorized Derivatives Dealer (ADD)” are institutions that are licensed by SBP to undertake
certain derivative transactions. There are currently the following 07 Authorized Derivative
Dealers in Pakistan:

1. Citibank N.A.

2. Deutsche Bank AG

3. Faysal Bank Limited

4. Habib Bank Limited

5. MCB Bank Limited

6. Standard Chartered Bank (Pakistan) Limited

7. United Bank Limited

c. Non-Market Maker Financial Institutions:

Non-Market Maker Financial Institutions are financial institutions that execute derivatives
transactions with its customers with the intention to make a spread. It does not undertake any
Market Making and covers the transaction on a back-to-back basis. There is currently only one
NMI I.e. The Bank of Tokyo-Mitsubishi UFJ, Ltd. (FX Options Only)

d. Financial Derivatives Business Regulations:

Financial Derivatives Business Regulation is a framework formulated to permit, regulate, and

supervise financial institutions entering into derivative transactions. Financial institutions are
required to obtain approval from the State Bank of Pakistan before engaging in derivatives and
would be subject to supervision and scrutiny from the State Bank of Pakistan as a supervisory
authority.

The State Bank of Pakistan may suspend or withdraw the status of a Financial Institution as an
NMI or an ADD to carry out Derivative Business if it finds that the financial institution is in
violation of these regulations. The FDBR discusses the permissible derivative transactions for
ADDs/NMIs.

Future Market (Contacts):

Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the
respective underlying asset at an agreed price on a specific date. The parties involved in a futures
contract not only possess the right but also are under the obligation, to carry out the contract as
agreed. The contracts are standardized, meaning they are traded on the exchange market

The Advantages of Future Contracts:

Opens the Markets to Investors:

Futures contracts are useful for risk-tolerant investors. Investors get to participate in markets they
would otherwise not have access to.

Stable Margin Requirements:

Margin requirements for most of the commodities and currencies are well-established in the
futures market. Thus, a trader knows how much margin he should put up in a contract.

No Time Decay Involved:

In options, the value of assets declines over time and severely reduces the profitability for the
trader. This is known as time decay. A futures trader does not have to worry about time decay.

High Liquidity:
Most of the futures markets offer high liquidity, especially in case of currencies, indexes, and
commonly traded commodities. This allows traders to enter and exit the market when they wish
to.

Simple Pricing:
Unlike the extremely difficult Black-Scholes Model-based options pricing, futures pricing is
quite easy to understand. It's usually based on the cost-of-carry model, under which the futures
price is determined by adding the cost of carrying to the spot price of the asset.

Protection Against Price Fluctuations:

Forward contracts are used as a hedging tool in industries with high level of price fluctuations.
For example, farmers use these contracts to protect themselves against the risk of drop in crop
prices.
Say for instance a farmer is planting wheat, and she expects to harvest 8,000 bushels of wheat
when the crop is ready. Unsure of the prices at the time of harvest, she can sell the entire crop at
a fixed price well before the actual harvest, with delivery to be made at a future date such as five
months from the date of agreement.
Although the farmer does not get the sale proceeds at the time of the agreement, the transaction
offers her protection against any possible fluctuations in currency exchange rates and price drops
in the wheat market.
Hedging Against Future Risks:
Many people enter into forward contracts for better risk management. Companies often use these
contracts to limit risk that may arise from foreign currency exchange.
Let's say for example, a U.S.-based company incurs labor and manufacturing costs in dollars but
exports its final products to the European market and receives payment in Euros. The company
supplies goods at a lead time of six months, which exposes it to the risk of exchange rate
fluctuations. To avoid this risk, the company can use a forward contract to sell its goods at
today's exchange rate although the delivery is to be made after six months.

The Disadvantages of Futures Contracts:

No Control Over Future Events:

One common drawback of investing in futures trading is that you don't have any control over
future events. Natural disasters, unexpected weather conditions, political issues, etc. can
completely disrupt the estimated demand-supply equilibrium.

Leverage Issues:
High leverage can result in rapid fluctuations of futures prices. The prices can go up and down
daily or even within minutes.

Expiration Dates:
Future contracts involve a certain expiration date. The contracted prices for the given assets can
become less attractive as the expiration date comes nearer. Due to this, sometimes, a futures
contract may even expire as a worthless investment.
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Forward Market:
Forwards contracts are similar to futures contracts in the sense that the holder of the contract
possesses not only the right but is also under the obligation to carry out the contract as agreed.
However, forwards contracts are over-the-counter products, which means they are not
regulated and are not bound by specific trading rules and regulations.
Since such contracts are unstandardized, they are traded over the counter and not on the
exchange market. As the contracts are not bound by a regulatory body’s rules and regulations,
they are customizable to suit the requirements of both parties involved.

Advantages & Diadvantages of Forwarded Market:

Advantages:
The following are the advantages of the forward market:

I. Customization- In the forward market, the parties on their own will, may enter and decide
the quantity, time, and rate at the time of delivery as per their need, requirement, and
specification. It is very flexible and convenient for both parties.
II. Offers full hedge- It is very advantageous for those parties who have certain commodities
that they need to exchange in future. The forward market provides the full hedge and tries
to avoid various uncertainties by which the party can secure their contracts.
III. Over-the-counter products- In the forward market the products are generally dealt with
over the counter. Most of the investor institutional wants to deal with them rather than
entering into the future contracts. Over-the-counter, products give them the advantage of
the flexibility to suit the duration, contract size, and strategy as per their requirements.
IV. Matching of exposure- Now the parties can match their exposure with the time frame of
the period according to which they can enter in the contract. On the basis of this, they can
customize to suit any party and modify the duration.

Disadvantages:
The following are the disadvantages of the forward market:

I. Cancellation problems- In the forward market if a contract is entered, it cannot be

canceled, and also being unregulated there are chances that parties become defaulters.
II. Finding counterparty- In the case of the forward market, there is very difficult to find a
counter party to enter into a contract.

What is Hedging:
Hedging in finance refers to protecting investments. A hedge is an investment status, which aims
at decreasing the possible losses suffered by an associated investment. Hedging is used by those
investors investing in market-linked instruments. To hedge, you technically invest in two
different instruments with adverse correlation.

Example:

The best example of hedging is availing of car insurance to safeguard your car against damages
arising due to an accident.
Types of Hedging Strategies

Hedging strategies are broadly classified as follows:

Forward Contract: It is a contract between two parties for buying or selling assets on a
specified date, at a particular price. This covers contracts such as forwarding exchange contracts
for commodities and currencies.

Futures Contract: This is a standard contract between two parties for buying or selling assets at
an agreed price and quantity on a specified date. This covers various contracts such as a currency
futures contract.

Money Markets: These are the markets where short-term buying, selling, lending, and
borrowing happen with maturities of less than a year. This includes various contracts such as
covered calls on equities, money market operations for interest, and currencies.

Country Risk & its Importance:

Country Risk:

Country risk refers to the uncertainty associated with investing in a particular country, and more
specifically the degree to which that uncertainty could lead to losses for investors. This
uncertainty can come from any number of factors including political, economic, exchange-rate,
or technological influences.

Different types of country risk

I. Political risk
II. Sovereign risk
III. Subjective risk
IV. Economic risk
V. Exchange risk
VI. Transfer risk