Chapter-I Introduction

CHAPTER-I

Introduction

1.1 Foreword

The chapter provides an insight into the rationale of this study and Pakistan’s

market potential. Further it looks into the research question and its objectives

and briefly states the methodology, scope and scheme of study.

1.2 Rationale of Study

Global economies have evolved greatly in the present times and in the process

the risks associated with the economic system also evolved. Such risks

instigated the introduction of modern day sophisticated financial instruments for

efficient risk management. These dynamic in economic systems facilitated the

development of derivative securities like swaps, options, forward and future

contracts which are deemed to be the specialized treatment of specialized risks.

(Whatsham, 1992).

This growth in derivative trade started in the western developed economies like

America and Europe and now expanding the outreach to the developing

economies like Asian emerging markets which includes Korea, India, China,

and Malaysia etc. This study initially overviews the impact of derivatives trade

on these Asian economies and its financial markets which started to expand in

the later part of twentieth century (Fratzscher, 2006).

Chapter-I Introduction

Exploring the positive outcome of derivative trade on these emerging Asian

markets the study moves on to establish the need for introduction of these

specialized financial instruments in Pakistan listed exchanges. Derivatives trade

and its concept are still juvenile in Pakistan where it has been introduced in over

the counter markets lately and no such trade takes place in its listed exchanges.

The financial market in Pakistan is deemed highly volatile (World Bank, 2006).

Amongst other factors contributing towards this volatility, one major factor is low

availability of efficient risk management instruments. Therefore the introduction

of formal exchange traded derivatives in Pakistan will help strengthening its

financial market and contribute towards its economic growth.

1.3 Pakistan’s Market Potential

Geographically Pakistan with an area of about 803, 904 square kilometres lies

at a strategic location which joins South Asia with Central Asia and Middle East

and neighbouring economic giants like India and China. It has a population of

170,430,000 which is 2.48% of the world’s population as per consensus in Sep,

2010 and makes it the 6th largest country in terms of population. At present it is

a developing country but with its strategic location and population capacity it is

an attractive market and grasps the interests of many worldwide (Ahmad,

1969).

The country has 4 states which also represents the major cultures in the

country. They include Punjab with the largest population and agricultural land,

Sindh with the largest financial city also considered as the financial capital of
Chapter-I Introduction

Pakistan i.e. Karachi which also have the Arabian Sea port, Khyber

Pakhtunkhwa in the north attracting tourists due to its immense natural beauty

and mountain ranges like Karakoram and world’s 2 nd tallest peak K-2,

Baluchistan largest state by area and 2nd largest provider of natural gas in

Pakistan. In addition to that there is Pakistan’s administered part of Kashmir

which is still under dispute with the neighbouring country India. Islam being the

principal religion with 96.3% population as Muslims (CIA World fact book).

According to Economic Survey of Pakistan 2008-2009 published by Ministry of

Finance the following statistics shows economic activity:

Economic Survey Pakistan 2008-2009 (Growth Rate in Percentage)

Overall Growth Rate (GDP) 2% Money Supply (M2) (4.37%)

Manufacturing Sector (7.7 %) Inflation 12%

Agriculture Sector 4.7% Sensitive Price Indicator (SPI) 9.9%

Services Sector 3.6 % Exports (3%)

Finance and Insurance (1.2%) Imports (9.8%)

SME Sector 7.5% Real Private Consumption 5.2%

Total Investments 19.7% External Debt Liabilities 2.1%

Mining and Quarrying 1.3% National Savings 0.8%

Foreign Direct Investment (13.8 %) Public Sector Investment 1.6%

Table-I Economic Survey Pakistan 2008-2009 Source: Ministry of Finance official website

(http://finance.gov.pk/survey/index.htm)

According to Ministry of Finance Pakistan’s economy has gone through booms

and slumps due to political instability, law and order situation, rising demand
Chapter-I Introduction

with low level of supply causing increased inflation but still is resilient enough to

show constant growth which also concurs to the argument of Ex-country

Director World Bank Pakistan John Wall, (2006). (Ministry of Finance Pakistan)

According to Ex-Governor State Bank of Pakistan Shamshad Akhtar, the GDP

is mainly dependent upon 3 major sectors including Agriculture, Manufacturing

and Services. Finance sector in Pakistan constitutes Banks and Non-Banking

Finance Corporation (NBFC’s) and banking sector owes 70% to the growth of

this sector (Akhtar, 2006). Though the manufacturing sector suffered seriously

due to the current financial crisis throughout the globe.

Capital markets in Pakistan have shown significant potential in the recent past,

Karachi stock exchange (KSE) with its indices of 100 companies, the largest in

Pakistan went up to 23.5% to 12360 points in April, 2007 with Market

Capitalization going up from USD 46.4 Billion to USD 59.3 Billion. But this

growth had very little impact on the overall economy (Ministry of Finance

Pakistan, 2007).

Financial Sector in Pakistan is going through an evolution process as State

Bank of Pakistan in cooperation with Securities and Exchange Commission of

Pakistan (SECP) are introducing measures to restructure the market via

improvement of legislative infrastructure, market infrastructure, technological

advancements, amendments in Prudential Regulations which shall help in the

reinforcement of Pakistan’s financial markets (Akhtar, 2006). Though the

evolution process is sluggish and little implementation has been seen till date.
Chapter-I Introduction

Pakistan is classified as a low-income economy by World Bank regardless of its

growth and assigns it factors like macro-economic instability, political

turbulence, exposure to internal and external shocks, economic sanctions,

military disputes with neighbouring country India, the 9/11 dogma, 2005

massive earthquake, military interventions in the government, investors safety

etc (World Bank, 2009).

1.4 Research Problem

The research question is:

 To determine whether there is a need for introduction of Listed Exchange

Traded Derivatives in Pakistan’s Financial Market?

1.5 Research Objectives

Key objectives of this research are given below:

 Examining the role of derivatives trade in Pakistan’s financial market from

future point of view and to see whether they can effectively perform in this

market.

 To find whether exchange traded derivatives are needed in the current

market scenario.

1.6 Research Methodology

The research commence with review of the extant literature on the role of

derivatives trade in emerging Asian markets and its development in the context

of Pakistani market until now. Secondary data is collected through articles/e-

Chapter-I Introduction

articles, books, business and finance journals/newspapers, previous researches

on subject matter and internet etc in order to formulate a structure and identify

the factors to be considered for the semi-structured questionnaire (See

Questionnaire) and later the responses of the interviewers were matched with

the literature for analysis. Primary data via telephonic interviews with 30

respondents from various backgrounds relevant to the field was collected

making use of the semi-structured questionnaire. The respondents belonged to

brokerage houses, regulatory authorities, Investment banks, individual investors

and local academe. Qualitative research methodology is applied for the purpose

of analysis.

1.7 Scope of the Research

This research explains the major features and applications of derivative

securities and is particularly related to future of derivatives in Pakistan’s

financial market. The research investigates various aspects that are deemed to

be of much significance for derivatives to perform well in the financial markets.

This research will facilitate individuals with keen interest in derivatives and its

applications to financial markets and investors who are considering an

investment in Pakistan as the research provides an overview of this market.

Chapter-I Introduction

1.8 Scheme of the Research

The research follows the following scheme:

Chapters Title of Chapter

Chapter-II
Literature Review: Efficacy of derivatives in Emerging Asian Economies

Chapter-III Research Methodology

Chapter-IV Identifying need for Exchange traded derivatives: Analysis of Interviews

Chapter-V Conclusions and Recommendations

Table-II Scheme of research