Performance of Futures Contracts: A Study of the Pakistan

Stock Exchange

by

MUHAMMAD NAEEM

A thesis submitted in partial fulfillment of the requirements for the degree of MBA

3.5 years (equivalent to MS)

Supervisor: Nadir Khan

Department/Institute of Management Sciences, University of

Balochistan, Quetta.

Session: 2012 to 2015

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Author’s Declaration

I ____________________________________________________ hereby state that

my MBA/MS thesis titled _______________________________________________

is my own work and has not been submitted previously by me for taking any degree

from UNIVERSITY OF BALOCHISTAN, QUETTA or anywhere else in the

country/world.

At any time if my statement is found to be incorrect even after my Graduate the

university has the right to withdraw my MBA/MS degree.

Muhammad Naeem
 iii

Acknowledgement

I would like thanks to many people who helped me, especially thanks to my family,

friends and my valuable supervisor Mr. Nadir khan for supporting me in the

completion of this thesis by providing guidance, important suggestions. I am very

obliged to all the fellows the way they have added to the improvement of my research.
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Abstract

Stock market scale is expanding very fast in Pakistan, investors are increasing

continuously to invest in stock market, to reduce the risk of loss they require better

methods for risk management. KSE 30 Stock/Sector Index Futures Contract was listed

firstly on Pakistan stock exchange on 2001. Due to the introduction of this missing

financial instrument the capital market of Pakistan got better response of the overseas

and domestic investors. Stock index market is defined then SIFC definitions related

information is described, the futures market of Pakistan relevant functions are

presented, futures market performance related information is reviewed, which

provides foundation for the empirical study. More over the progress of Pakistan

capital market, the indices information of stock markets is reviewed, regulations

governing SIFC are also defined and its index futures market are also studied. In last

the performance of KSE 30 index futures market is reviewed. The research problem is

that whether the introduction of KSE 30 stock index futures have been successful. To

see the performance of futures, the KSE 30 stock index futures will be investigated in

the procedure of empirical research. Then, the trend analysis is used to analyze the

performance of KSE 30 stock index futures, whether the futures contract have been

successful or not.

Key words: Pakistan Stock Exchange (PSX), KSE 30 index, Stock Index Futures

Contracts (SIFC), Security and Exchange Commission of Pakistan (SECP).

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Table Of Contents

Chapters Title Page No

1 Introduction 1
1.1 Background of the Study 1
1.2 Research Motivation 4
1.2.1 Theoretical Significance 4
1.2.2 Practical significance 4
1.3 Problem Statement 4
1.4 Limitations 5
2 Literature Review 6
3 Conceptual / Theoretical Framework 20
3.1 Related Theory of Stock Index Futures Contracts 20
3.1.1 Characteristics 23
3.1.1.1 Futures Characteristics 23
3.1.1.2 Special Characteristics 24
3.1.2 Functions 26
3.1.2.1 Hedging 26
3.1.2.2 Risk Aversion 26
3.1.2.3 Asset Allocation 27
3.2 Variable 27
4 Methodology 28
4.1 Research Design 28
4.2 Data Processing and collection 28
5 Result and Discussion 31
5.1 SIFC Price Movement (Returns) 32
5.2 Difference of the Natural Log 33
5.3 Autocorrelation Function (ACF) of Return 34
5.3.1 Partial Autocorrelation Function (PACF) of Return 35
5.3.2 Autocorrelation Function (ACF) of Log 36
5.3.3 Partial Autocorrelation Function (PACF) Difference
37
of Log
5.4 Stationary Test 38
5.5 ARIMA (0,0,0) Model 40
5.6 Results from Literature 41
6 Conclusion and Recommendations 43
APPENDIX
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1 INTRODUCTION

1.1 Background

During the last few decades’ dramatic changes have been experienced by the global

stock markets. The stock markets rose during few decades, due to economic recession

globally during the period of 2000 to 2002 in many countries the stock markets

declined nearly 40 to 50% (Ming Jing Yang & Yi-Chuan Lai, 2009). According to

different studies, the stock markets become more stable and the financial markets

performance has been improved due to the introduction of stock index futures

contracts, Futures contracts are said to be the type of contracts, that futures financial

agreement is standardized trade between parties to deliver or receive an identified

financial instrument at a stated amount for a specified price and date, Though, the

literatures have been reviewed are not newly findings. However, the theories and

models are already well established. The results of those researches are practical and

time tested, which can be adopted to study and analyze the newly launched KSE 30

stock index futures in Pakistan (Dubofsky & Miller, 2003).

Pakistan Stock Exchange (PSX), is one of the Pakistan most liquid and largest stock

exchange, and in the list of Pakistan Premier stock exchanges the Karachi Stock

Exchange (KSE) was one of the main stock exchange of Pakistan. PSX make

available an efficient and liquid digitized market place, which provides the facility for

investor to meet directly for trade of (sell and buy) listed companies’ common stock

and different type of securities (futures etc.). PSX has facilitated the formation of the

capital market, providing a service to a wide spectrum of contributors, including

institutional investors trading community, individuals, and listed companies. PSX

offers investors and companies transparent and an efficient securities market for

achieving investment objectives and raising capital (Bilal, 2013).

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“Futures Contract is a legally obligatory settlement to buy any underlying asset or sell

the asset on a future date”. These kinds of contracts are uniform contracts in terms of

its quality, quantity and transfer time for transection in future. These kinds of

contracts expire specified date or expiry date of the contract. Futures contracts can be

performed by transfer of the underlying asset or cash. Futures contracts in Pakistan

stock markets are of two types.

According to Dr, Sayani, (2016) In Monthly futures contracts the traders (buyers and

seller) should have to settle on transfer against payment basis. Monthly futures initiate

on each month first day and next to the last Friday.

The second type of the future contract in Pakistan is of the 90 days’ single stock

futures, this ninety days’ contracts is a uniform Contracts. These contracts are also

issued on first day of the month next to Friday and expire on the 3 rd month last Friday.

Regulations for Cash Settled Futures Exchange specifies a delivery of seven days’

cash settled futures, which will start from 1 st day of the week and maturity is on the

last day of the week, and Friday has been defined as a last day (maturity) of the

contract.

KSE 30 index futures delivers a new investment instruments with better risk

management tool, this financial instrument (futures contract) enriches the financial

products in the Pakistan futures market. This new concept leads towards diversity of

financial products and helps in investment strategies. Futures contract brings new

changes in stock market and connecting the futures markets with securities. KSE 30

index Futures helps investors to become more specialized in their investment

(portfolio) strategies (K. Alam, 2013).

Since KSE 30 stock index futures are introduced in 2001, the futures customers are

continuously increasing, the trading is active on Pakistan futures market with a steady
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growth of financial market, which shows a great potential for new investors in stock

markets. There is a good control of market risk in market, because the prices of

futures usually equal to the spot price. Monthly contracts are mostly active traded

futures contract in the capital market of Pakistan, this study shows that there is a good

momentum of expansion and great opportunity for investors to protect their

investments by futures contracts and achieving better profit from capital market of

Pakistan.

In the derivative segment of Pakistan capital markets there are two significant

products Stock Index Futures and single stock. The development is huge for the

potential of derivative segment. Derivative segment in Pakistan capital market is

hindered by two main issues, inexistent liquidity and the lack of knowledge about

existing derivatives. For flourishing derivatives market liquid and vibrant ready

market is an essential element. Moreover, a vibrant and liquid ready market is also an

essential element of a flourishing derivatives market, which cannot be achieved

without active participation of both speculators and hedgers. The term derivative has

no independent value; it is derived for the value of underlying asset. Underlying asset

can be bullion, currency, commodities, securities etc… (K. Alam, 2013).

Based on the above sited background related information of the Pakistan Stock Index

Futures Market, this study will provide a valuable information about the performance

of KSE 30 index futures market by analyzing it with quantitative method and using

the stock index futures market Seven and a half years trading data (Market fear

value), to achieve the objective of this thesis and will provide helpful information

about protecting investments with in capital market of Pakistan.

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1.2 Research motivation

1.2.1 Theoretical significance

In this research thesis, we combine both the literature about SIFC (KSE 30 index) and

the potential features of Pakistan Capital/Stock market, trend analysis has been used

as a tool to analyze the performance of KSE 30 index futures in a quantitative way.

The purpose behind this study is to provide insight for further research in the field of

Future market and will increase the interest of investors by literature related to (SIFC,

KSE 30 Index). Further this will promote the aim of risk management in portfolio and

improvement of stock index futures theoretical system.

1.2.2 Practical significance

In all over the world, everywhere there is a universal risk in the capital/stock market,

though Pakistan Capital/stock market cannot be separated from the universal risk,

therefore the risk can be reduced by better risk management (portfolio) to some extent

but it cannot be completely eliminated. The goal of every investor is to avoid the risk

and locking for greater returns by efficient investment. This study is based on

analyzing the Pakistan Stock index futures market, which will provide information

about the performance of KSE 30 Index Futures, and can help the domestic and

overseas investors to allocate their investment rationally for reducing their risk and

achieving better profit.

1.3 Problem Statement

The financial sector in the capital market of Pakistan is considered to be the key

sector in the process for development of SIFC (KSE 30 index) in Pakistan and

Introduction to KSE 30 Index and KSE 30 index futures. The overview of SIFC (KSE

30 index) growth & development of equity market, created a necessity to study the

performance of Stock Index Futures Contracts (KSE, 30 index) on Pakistan Stock

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Market. In this study a regression model has been adopted and ARIMA (0,0,0) model

to forecast the future behavior of the SIFC KSE 30 index on Pakistan Stock Market.

In order to fully understand the research purpose, a broad range of financial literature

has been studied in this Research paper, relevant knowledge of the Stock Index

Futures Contracts and derivative market is analyzed for smooth implementation of the

paper. For the Performance of the Pakistan Stock Index Futures this research paper

provides empirical research. For the sake of empirical analysis different statistical test

are used, it provides a rational assessment on the performance of Pakistan Stock index

futures. Meanwhile this paper delivers better recommendations for investors to

completely reflect the practical value.

1.4 Limitations

The time series data, which is used for research purpose is monthly fair value of the

SIFC (KSE 30 index), there is absence of particular analysis of Quarterly, Weekly and

daily high frequency data. In this study the performance of the stock index futures

contract has been reviewed by using unilateral process of analyzing the SIFC fair

value with time period, no other variables such as risk preferences of different

investors, inflation, interest rate, etc.. one used to investigate the trend. It ignores the

required margin and dynamic adjustment of hedging methods, and it has also ignored

the comparison between SIFC and other indices to analyze the performance in the

capital market of Pakistan. So, this leaves room for further research to analyze the

performance for SIFC in the capital market of Pakistan.

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2 LITERATURE REVIEW

In financial market the SIFC (KSE 30 index) is basically one of the main financial

instrument, in different countries the Stock index futures products are different, and in

different market environments the futures have different characteristics. It was the

first time on 2001, when Pakistan introduced the stock index futures contracts on

KSE. The investors in Pakistan relatively don’t have sufficient knowledge, therefore

to understand the subject matter and its trading system on KSE. The basket order

window was also available to facilitate small investors, financial institutions and high

net worth individuals for efficient hedging mechanism, the basket order window was

also available on Karachi Automated Trading System (KATS). The basket window

will show execution status once an order set is placed; hence basket stock may be

bought in smallest denomination of one stock that can be hedge by selling a similar

index futures contract (Ismail Dilawar, 2011). The growth of stock/capital market and

SIFC (KSE 30 index) in Pakistan will be focused in this chapter.

Pakistan is one of the biggest and high performer stock market in the world. Pakistan

has three stock Exchange companies limited by guarantee, which are operating under

the supervision of SECP. All transactions of futures within Pakistan are regulated by

Stock and Exchange commission of Pakistan, which is operating as an independent

agency of the government of Pakistan. The Commission has been completely

authorized (as a right) to handout punishments or charge fines for company or an

individual who breach any law or rules, The stock index futures prices have been

more volatile than the spot prices. Consequently, there exists arbitrage space in the

market price, which indicates the risk-averse ability of stock index futures need to be

further strengthened (Lu Zhang, 2014).

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According to Bilal, (2013), the purpose of the Pakistan Stock Exchange (PSX) is to

enjoy the full confidence of the investors, by offering fair, efficient and transparent

marketplace in the region and to be a leading financial institution. In the development

of Pakistan capital market the PSX remains the pioneer, through the improvement of

services and continuous assessment, catering according to segments of customer’s

needs, it strives to provide value added and quality services in the capital market with

orderly manners. And compatible with best practices and international standards.

Karachi Stock Exchange was established on 18th September, 1947. On 10 th march

1949, KSE was registered as a Limited company by Guarantee. Initially there were

only 90 members, in which half of them were active as stockbrokers. In KSE there

were only five companies having 37 million rupees of paid up capital were listed.

KSE 50 index was initially introduced in stock market, which was based on 50

companies. In 2002 Karachi Stock Exchange introduced automated trading system

also known as a computerized trading system having capability to make available

connectivity to limitless number of beneficiaries. Now Pakistan is one of the emerged

marked in the world, and KSE has key role in the capital market of Pakistan having

724 listed companies. On KSE there are 724 ordinary Share, 5 preference shares and

23 debt securities.

Lahore Stock Exchange Limited was introduced in October 1970, which is the 2nd

stock exchange of Pakistan and LSE was initiated under Securities and Exchange

Ordinance, 1969. The purpose behind the establishment LSE was to support the stock

performance of the capital of the Punjab. There were only 83 members, which are

increased during the period of 25 years from 83 to 150.

The Islamabad Stock Exchange another stock exchange of Pakistan was established

on 25th October, 1989 in the capital city (Islamabad) of Pakistan. The aim of ISE was
 8

to strengthen the transaction and clearing infrastructure, information system,

availability and a fair and organized market place in the world, and to help the less

developed northern area of Pakistan. There are 103 Members, in which 29 are

corporate organizations (banks, DFIs and brokerage houses) and the remaining 74

Members are general public.

In the capital market of Pakistan, the mutual funds were permitted in 2001, by

Securities and Exchange Commission of Pakistan (SECP), as a derivative for the sake

of providing the missing tool (hedging). By Investing in SIFC the mutual funds can be

duplicate the possessions for underlying index. While encouraging the AMCS and the

Brokers for trading in Stock Index Futures Contracts, the Naqvi stated that in India

the cash settled futures are derivative product which are performing well, then why

Pakistan cannot be champion in cash settled futures derivative product, he also stated

that in Pakistan the derivative market has not worked. Stock index futures market has

incredible benefit of inferior costs, therefore by choosing underlying stock the

investors may hedge the positions in their portfolio, using stock index futures

contracts, Increases in futures market trading activity has an impact on the equity

volatility of the underlying stocks by using a measure of daily stock return volatility

by following a procedure suggested by (Kazim Alam, 2013).

All over the world the capital markets are strictly regulated and monitored, because

they are considered as the reflection of the stability of economy and also measured as

a backbone of the economy. The aim of these governance is to protect investors from

deception and fraud, safeguard the capital markets, provide the stability in the

economy, reducing the financial losses. For the development of Pakistan stock and

capital market the Securities and Exchange Commission of Pakistan resolve the

institutional problem and brings reform in the structure of shareholder. If the closing
 9

price of the contract (Stock Index Futures Contracts) from the previous day is traded

beyond the boundary of 5% (five percent), in the Stock Index Futures Market the

market Halt shall be announced by Exchange and all outstanding losses should be

collected and the time for market halt shall be for at least 30 minutes. If such losses

accrue and the situation of default in payment take place, then defaulting broker

should be charged for breaching the law/contract and default proceedings shall be

initiated. The circuit breaker will not be applicable on the last day trading in a SIFC

but in the circumstance when the movement is of 7.5% below or above or from the

previous day closing price the circuit Breaker may also be practicable in Stock Index

Futures Market. When (SIFC) contract is traded on first day, the circuit breaker shall

be applicable on movement of 7.5% below or above the opening price of the day as

identified through the pre-open session. These empirical results for the Pakistan’s

equity market support theories implying that equity derivatives trading improves

liquidity provision and depth in the equity markets, and appear to be in contrast to the

theories implying that equity derivatives markets provide a medium for destabilizing

speculation (Safi ullah Khan, 2006).

For the Pakistan capital market, 2014 was high spirits and growth year. In 2014

Pakistan stock market was ranked third among world top ten best performing markets.

Stock market performed outstanding throughout the year, with historical levels.

Number of market reforms took place in 2012-13, and were implemented, which

results in to a bullish trend. To build credibility and transparency in the markets, the

SECP strengthening its risk management, and introduced structural and legal changes.

Most revolutionary reforms of 2012 was the demutualization and corporatization of

the stock exchanges in Pakistan, by SECP. Which projected into a positive image and

greater governance internationally, led toward segmentation, attracting global

 10

investors, separation between trading and ownership rights. Pakistan Mercantile

Exchange (PMEX) was also initiated to enhance the product suite, in the commodity

market for various investors which provides the hedging facility.

In the Capital market of Pakistan, the introduction of Pakistan Stock Exchange (PSX)

is a positive step for financial sector reform and marks the second phase completion

of the Stock Exchanges Demutualization and Integration Act 2012. KSE, LSE and

ISE, these three stock Exchanges were previously trading separately, their

Management, trading structure even indexes were different from each other. There

three stock exchanges were performing their activities as non-Profit Organization. In

the month of January 2016, Government of Pakistan implemented the Stock Exchange

Act 2012, Known as “Demutualization Act” and introduced Pakistan Stock Exchange

(PSX). Due to implementation of this Act, now all three exchanges which were

operating separately, now they are merged and functioning under one management,

trading structure, listing criteria and they are working under the title of PSX. In

Pakistan Stock Exchange (PSX) there are total 581 companies are listed having Rs.

6798.21 rupees. These companies are categorized on the basis of sectors, in which 35

sectors in PSX are contributing towards markets capitalizations and remaining sectors

are allocated for index futures etc, because these remaining sectors are not

contributing in market capitalization. The futures companies and brokers internal

control mechanism has been perfected, for stock index futures introduction these

advantages have provided favorable environment. As information gathers, a plethora

of different findings leads to greater understanding of the current, future, or past state

of affairs. A general misconception amongst market participants in Pakistan is that

futures trading leads to increased volatility in cash markets. This view must be
 11

dispelled from the market if we wish to achieve any significant advancement in our

capital markets (Kim, A. (2015)

According to Ming Jing Yang & Yi-Chuan Lai, (2009) in the recent years’ stock

markets have experience dramatic changes internationally. Risk management for

investments become more and more important, since investors have acknowledged

that they are unprotected to a high level of uncertainty in stock markets. For the

protection of international portfolios for investors, different hedging strategies have

been designed and used, but the financial derivatives, especially SIFC is one of the

utmost effective hedging instrument and most widely used to protect (hedge) the

investment.

The futures market is invented some 150 years ago, at that time farmers produce the

crops and bring them to market to sale their inventory. But due to lack of demand, the

supply increases which causes excesses of inventory, therefore the unpurchased crops

were left to rot. In the mid of 19th century the central grain markets were introduced;

it was a better marketplace where farmers bring their inventory to sell them for speedy

transfer or for forward transfer. These previous contracts (forward contracts) were the

indications to futures contracts. This concept helped them to hedge their risk of loss

and gain better profit in the off season. Therefore, it is easier to describe the

performance of futures contract between parties who are involved in the trade (sale

and purchase) of futures contracts, at expiration date (maturity) of a futures contract,

the value converges to the value of that specific underlying asset which has to be

supplied (Frederic, S. Mishkin, 2013, financial markets and institutions).

Futures on stock, in Pakistan was introduced in July 2001, at the Karachi Stock

Exchange (KSE) Market. The basic purpose behind the introduction of futures in

Pakistan was to offer several assistances to investors, for hedging, speculation,

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arbitrage, leveraged trading, and lower operation costs. It has been over a decade

subsequently Futures on stock were introduced in Pakistan at the Karachi Stock

Exchange, and now in this study we are going to see the performance of futures

market on KSE, whether these futures have been successful or not. It is the time to see

whether Futures have been performing at desired level to satisfy the investors.

(https://www.dawn.com/news/61576/have-futures-been-successful-at-kse).

A standardized benchmark by that the Stock Index Futures Market performance can

be matched (measure) over period of time, this is one of the main objective of the

KSE 30 Index. In Pakistan equity market the KSE-30 Index is aimed to help the

investors and speculators by delivering information with a sense of how enormous

companies are performing. Therefore, other factors which track the different sectors

of the country economic activities (consumer price index, etc...) are similar to the

KSE-30 Index. For the calculation, the KSE 30 index the free float capitalization

procedure is used, for the purpose of index calculation the free float approach refers to

index construction by free float shares of a company total market capitalization (Bilal,

2013).

According to Kazim Alam (2013), the Representatives of Pakistan stock market

signed an agreement in 2013 to initiate trading formally in Stock Index Futures

Contracts, oil and gas, KSE 30 index as underlying indices and with banking. In

India’s capital market the 70 percent (%) of the total trading volume is constituted by

derivatives market, but in Pakistan’s capital market the constitution of derivative

market is less than 5 percent (%) and if the deliverable market is also combined, still

it is less than 10 percent (%). According to Sani-e-Mehmood Khan, the General

Manager for New Products and Market Development, that the performance of the

KSE 30 Index will be tracked by the stock index futures typical exchange-traded
 13

product. This will provide protection from adverse market movement to the investors,

because it is imagined as a vital leveraged product.

Now-a-days futures market is not only limited to agricultural inventories, but it is a

universal marker place for different financial instruments, currencies, T-bonds,

securities futures. This is the place where different type of beneficiaries (farmers,

exporters, importers, manufacturers, speculators) take the advantage of futures to

hedge the risk. Garbade & Silber, (1979-1982) stated that in the process of price

discovery of cash market, the futures markets make an important contribution but

only if futures markets lead the spot market, Information gathered from the study

explain why stock index futures provide a different trading mechanism for liquidity

traders who wish to transact large portfolios of stocks. Those investors can minimize

their transaction cost by implementing index trading strategies instead of transacting

in the markets for individual securities. To avoid loss of assets it provides better

hedging tool to the investors, it increases the market liquidity, also attracts the hedgers

and arbitrageurs to participate. The overall situation of the Pakistan Capital/Stock

Market is positive and Stock Index Futures Contracts presented a steady growth

during the last decade, therefore there is a need of repeatedly improvement and strict

regulations for better financial environment.

Within the capital market of Pakistan, the Pakistan Stock Exchange (PSX) is

sustaining five indices i.e. KSE 30 Index, All Share Islamic Index, KSE 100 Index,

KMI 30 index and KSE All Share Index. The KSE 100 Index firstly was initiated in

November, 1991, in KSE 100 index the one hundred (100) companies are nominated

on the foundation of sector representation and highest market capitalization, these 100

listed companies almost capture 80 percent (%) of the whole market capitalization. In

September, 2006, the KSE 30 Index was introduced, in September, 2008, the KMI 30
 14

Index was announced, The All Shares Islamic Index of Pakistan was introduced on

November 18, 2015, and in 1995, the KSE All Share Index was introduced.

The main purpose of introducing KSE 30 Index in September, 2006 was to have a

benchmark by which over a period of time the stock price performance can be

compared. The KSE 30 index is providing a sense in that how large companies are

performing in the equity market of Pakistan. The KSE-30 Index is also comparable to

other indicators, which track the country’s different sectors economic activities such

as the consumer price index, gross domestic product, gross national product etc.

Rather than paid up capital, the calculation of KSE 30 Index is grounded on free float

of shares. The variance between other indices and KSE 30 index is that, total return on

the market is represented in other indices and top 30 companies participates in KSE

30 Index, in Pakistan stock Exchange the total return of the market is represented by

other indices. When dividend is announced that amount of dividend (cash or bonus)

are not adjusted/ reduced, but dividends and right shares are adjusted in KSE 30

Index. At the time when Karachi Stock Exchange formally implemented from Friday,

September the KSE 30 index 10,000 points was its base value. Below table shows the

five-year progress of Pakistan stock market indices from 2012 to 2016, the trend

analysis of all indices shows growth and good performance. As shown in table below

the KSE 30 index in 2012 was 13764 points, and now it has increased to it high level

of 22758 in 2016.
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Stock Market five years progress 2012-2016

up to up to up to Up to up to
31.12.2012 31.12.2013 31.12.2014 31.12.2015 27.07.2016
No. of Listed Companies 573 560 557 554 560
Market Capitalisation - Rs. 4,242,278 6,056,506 7,380,531 6,928,497 7,862,911
Listed Capital - Rs. 1,094,367 1,129,787 1,168,484 1,269,703 1,291,696
KSE-100™ Index 16905 25261 32131 32811 39434
KSE-30™ Index 13764 18808 20771 19309 22758
KMI-30 Index 29125 42431 50735 55647 70078

KSE All Share Index 11964 18664 23397 22868 26236

All Shares Islamic Index of Pakistan - - - 15448 18305

New Companies Listed during the year 4 3 6 8 3
New Debt Instruments Listed during

the year 5 6 6 2 1
Listed Capital of New Companies - Rs. 8,161 4,545 26,973 29,941 4,240
Listed Capital of New Debt

Instruments - Rs. 5,254 9,779 15,000 25,000.00 10,000

Average value of daily turnover - Rs. 4,675 7,603 9,401 11,465 9,367
Average Daily Turnover - Shares in
million 196 238 218 258 198
Average Daily Turnover (Future™)
YTD 12 22 24 36 39
Average Value of Daily Turnover -

YTD 862 1,868 2,205 3,142 2,715

Source: Progress report is generated from Pakistan Stock Exchange website (https://www.psx.com.pk/)

In the capital market of Pakistan Stock Index Futures Contracts (KSE 30 index) is an

index which consists of largest market capitalization and liquidity. The price of

futures contract is determined via arbitrage arguments, when the product exists in

abundant supply, or freely created. In the case when arbitrage cannot be fixed the

price for futures then there is only one force to set the price is demand and supply for

the asset in the future. The KSE 30 Index with bases point at 1000 was created on

September, 2006. The candidate components of KSE 30 index must have decent

performance without breaching the laws and regulations without serious financial
 16

problems and with no high price volatility, which can characterize solid evidence of

manipulation (Lu Zhang, 2014).

According to CME GROUP (2013) In an Index futures contract the parties and binds

for underlying index agreed value at a specified future date. It is a zero-sum game like

any derivative, one party is short and the other is long and the winner must be paid by

loser the difference between the index closing value and index futures price at

expiration. The difference between theoretical futures prices and spot index values is

often referred to a fair value, this provides the level at which futures are expected to

trade. The futures prices are greater than spot prices, therefore the fair value of a stock

index futures is normally expected to be positive. Only at the expiration the index

futures price should equal the underlying index value. An investor in index futures

does not owe of receive dividends on the stocks, albeit the underlying index and index

futures are closely correlated. The futures contract has a fair value at any other time

relative to the index, which reflects a deduction from the index value (expected

dividends forgone) and the financing cost for the difference between the principal

amount and the initial margin of the contract between the expiration and the trade

date. The fair value for the index futures is lower than the index value when the

interest rates are low, and the adjustment of dividend offsets the financial cost.

(http://www.investopedia.com/articles/active-trading/070113/using-index-futures-

predict-future.asp)

All futures contracts transactions in the Pakistan are regulated by Stock & Exchange

Commission of Pakistan (SECP), therefore commission has a right to charge fines or

other punishments by company or an individual who breach any rules or law which is

regulated by commission on all transaction. The SIFC is offering opportunities to

investors who are wishing to gain exposure, actually in specific sector without buying
 17

share in that sector, investors who are interested to take positions in an entire sector

can use Stock Index Futures Contracts to sale and purchase easily and inexpensively.

In a given benchmark index it provides investors the way to see the performance of

securities. Market losses are paid and collected daily, with Rs 5 per index point

movement of cash settlement without delivery requirement. It is also indicated that

Stock Index Futures Contracts agreements on tradable point of reference indices are

standardized value of tradable sector index. In Karachi Automated Trading System

(KATS) the basket order window was also available to facilitate small investors,

financial institutions and high net worth individuals for efficient hedging mechanism.

Within a tradable sector index the basket order window allow investors in a ready

market to place multiple market orders through a single mouse click with same time

priority for all stocks. Small investors with reduced lot size of 1 (one) which can be

hedge by selling a similar index futures contract, it is more practicable to gain

exposure of leading stock from a cumulative value of Rs 100,000 by Paying 12.5%

margin minimum of Rs 12,500 (Ismail Dilawar, 2011)

Whereas at the Pakistan Stock Exchange for the introduction of Stock Index Futures

Contract, it is necessary to formulate and implement some important regulations, that

will regulate stock index futures contracts. The proposed regulation governing stock

index futures (SIFC) has formally permitted by the Securities and Exchange

Commission of Pakistan. It is stated that through Karachi Automated Trading System

(KATS), all the trading in SIFC shall take place. Therefore, under section 34(1) of

securities and Exchange ordinance, 1969, with the previous endorsement of Security

and Exchange Commission of Pakistan the Pakistan Stock Exchange hereby makes

the following regulations.

 18

Through Karachi Automated Trading System (KATS), all the trading in SIFC shall

take place, subject to prior notification in writing any broker/agent of the exchange

can enter SIFC (KSE 30 index) as basic deposit with Rs 250,000 of payment in cash

to exchange, the exchange keep separate the deposit and any other return which is

earned on it. Broker making an offer bid or all offers bids for or up to the limit made

may be accepted and shall be bound by the contracts. The exchange shall notify upon

opening of any contract, date for the settlement & other relevant details, the date of

closing and opening of such contract and name of the contract. When an offer/bid of a

contract is accepted by buyer/seller, as specified according to these regulations shall

have believed to taken place as per format.

In Stock Index Futures Contracts, there is no adjustment for Right Issue in SIFC,

Bonus and cash Dividends, only 90 days standardized contract which would be issued

following last Friday of every month and on the first trading day, therefore third

month last Friday shall be the expiration day for the contract, if it is trading holiday

on the last Friday then previous trading day will be the expiration day.

The broker is liable to pay the deposit against exposure at flat 12.50% of the total

exposure in Stock Index Futures Contracts, the variation against exposure in the

percentage would be matter to endorsement of the commission, 50 % Deposit will be

charged in cash against exposure and the remaining of the rest in any 25 top securities

which would be selected on the criteria of lowest impact cost and highest average

daily turnover during the period of last 6 months. Netting is only permitted in losses

and profits for investors (broker or client) having positions with different expirees in

different SIFC, but no other losses and profits netting arises having position in SIFC

across futures contracts, different clients, different markets, based on different indices.
 19

When circumstances warrant is determined by exchange the pre-close of contracts is

necessary for the best interest of participants in the market and for market, then

special clearing may be announced by the exchange in the following manner.

With prior approval of board the special clearing will be announced by the exchange

for the interest of market & participants in the market. Fair value of the contract as a

reference price will be calculated by the exchange for the purpose of outstanding

SIFC settlement, through this method all outstanding contracts will be settled.

Fair value will arrive as a function of underlying index value plus function of Kibor

rate (financing charges) minus any dividends which will accrue with carry and

acquisition of all Index essential until the final settlement date. For stock index

futures contracts to calculate the fair value the following formula shall be used where

x number of days to maturity and r Rate of interest (Underlying index [1+r(x365)] –

dividends) in respect of an SIFC a member shall liable to pay the Special margin if the

difference between the first day’s daily clearing price and daily clearing price for the

contract either side downward or upward is greater than 20 %, and when the contract

daily clearing price is outside the band of 15 % of the underlying Index. (A special

margin will be determined by higher amount from above calculations).

In the case of unidirectional price movement when it is upwards each client of a

member who is a net buyer of the contract is liable to pay cash equal special margin.

In the case of downward unidirectional price movement each client of a member who

is a net seller will be liable to pay cash equal special margin.

(http://aaj.tv/2008/02/stock-index-futures-contract-regulations-issued/)
 20

3 CONCEPTUAL / THEORETICAL FRAMEWORK

3.1 Related theory of stock index futures

According to Reem Heakal, (2002) the futures are financial contracts, which are also

called derivative instrument. In future contract the two or more than two parties agree

to perform a set of financial agreement for the specific financial instruments or any

tangible commodities for future transfer at a specific value. (Jeff Madura, 2010-2008

financial markets and institution) stated in his book, that financial future contract is a

uniform agreement between parties to trade (deliver or receive) a stated amount of an

identified financial instrument at a specific date and Price. The Future contract is a

uniform shape of the forward contract which is simply transacted between parties

other than the two initial parties to the contract. The future contracts are basically

derivative products.

Any underlying asset which creates legal obligations for the settlement to buy or sell

on a future date is called Futures Contract. These kinds of contracts are uniform

contracts in terms of its quality, quantity and transfer time for transection in future.

These kinds of contracts expires on specified date or after expiry date of the contract.

Futures contracts can be performed by transfer of the underlying asset or cash.

Dubofsky & Miller, (2003) stated in his study that the futures contracts are practiced

from long time but stock index futures have very short trading history. Stock index

futures cannot be replaced because it is most important component of financial

derivatives, to avoid the market risk in the financial system stock index futures are

vital organized arrangements.

According to Hull, (2011) investors are compensated to analyze the investment

decisions for tracking the portfolio management. Value line, value weighted average

and price weighted index are used to construct the stock market index in three
 21

different ways. Stock index futures are helpful for investors to predict and analyze the

stock price and its future measure. Future Contracts contains sale and purchase of

financial securities for a price today and at some future date. Based on the eligibility

standards which has been approved by Security and Exchange Commission of

Pakistan, the companies by name & numbers which are to be traded on futures

counter, they are determined every six months. Under the rules and regulations of

SECP, governing stock index futures contracts and futures contracts, that for the

period of one-month transaction costs the contract is fixed. Between the client and the

negotiator, the brokerage on transactions is freely negotiable. Under the physical form

of transfer 1.5% of the face value of the share is charged as stamp duty. All the

transfers are free from stamp duty which are settled by central depositary system, but

at the time of deposit of securities in the central depositary system one paisa per share

one-time stamp duty is charged. Seller and the buyer born the stamp duty (Bilal,

2013).

Future contracts are said to be one of the best contract for hedging risk and get better

profit from investment, and encourages the investors to invest in future market

without any fear of lose, In the month of March 2005 when stock market crashes, the

investors even analysts were also blaming the crash of stock market was due to

financial futures markets. They were blaming the high instability in stock prices was

caused by trading in future contracts, therefore they were demanding a ban on futures

contract (Safi ullah Khan, 2006). In the result of stock market crash which was

blamed on futures markets, stock exchange commission of Pakistan acted on future

market and KSE publicized the stimulating of sanction from September 2006 on short

selling in futures contract.

 22

The ban on short selling in futures contract take place due to an emergency meeting

which was called by KSE board, the board identified different methods to stabilize the

Stock market volatility. The KSE board decided to take a step to lift a ban on futures

contracts, because there was a demand from investors and members for lifting the ban

on future contract short selling. In the result of this trick the KSE-100 index recovered

by high points on the very next day.

Safi ullah Khan, (2006) also stated that the researches have low level of agreement

among them about the volatility of stock market relationship with futures contracts,

that the stock market is effected by futures contracts. There is a universal opinion

about the instability of stock market which has been increased due to the introduction

of derivatives. But there is no realistic confirmation concerning the volatility of stock

price due to future contracts. There is conflict between perception and empirical

result, which led researchers far from conclusion that why future contracts influence

the world stock market.

The stock index futures contracts play a vital role in the development process of stock

market. Stock index futures contracts are basically used for reduce the systematic risk

in the market which is produced by fluctuation of spot price. The high correlation

between spot market and stock index futures market provide basis for recognition of

hedge function. Stock Index Futures market is influenced by different factors such as

transaction system, traders, trading mechanism, market influencing behavior, holding

cost, market demand & supply, etc… Investors having overconfidence, and respond to

specific related evidence and stock price changing, be likely to manage the portfolio

for their investment. Overconfidence refers when investors overvalue the level of their

knowledge, accuracy and capability of the information. In other words, we can say
 23

about the future that, investors are excessively confident, therefore they have

capability to control the future (Shao-gang Chen, 2014).

In derivative trading, a contract derives its value from prices of underlying securities

or index of prices is permissible for any stock exchange. Securities and Exchange

Commission of Pakistan act as top regulator in Pakistan whereas stock exchanges act

as frontline regulators. In the trades of derivatives, the settlement and clearing is

settled through National Clearing Company of Pakistan, which is performing

independent in governance and membership from stock exchanges.

Stock index futures is a useful financial tool for investors to reduce the stock market

expected risk to the futures market. Stock index futures are specially designed for

bring about the stock market price risk. Futures are also used to meet the needs of risk

aversion, like other futures (commodity futures, interest rate futures, currency futures,

etc...). Now-a-days futures market is not only limited to agricultural inventories, but it

is a universal marker place for different financial instruments, currencies, T-bonds,

securities futures. This is the place where different type of beneficiaries (farmers,

exporters, importers, manufacturers, speculators) take the advantage of futures to

hedge the risk.

3.1.1 Characteristics

Stock Index Futures Contracts are basically underlying asset of the financial futures

contract. Futures index futures have both the characteristics of specific features and

the futures, but also has the Stock characteristics.

3.1.1.1 Futures characteristics

According to Zhang, (2014) the futures characteristics of commodity and stock index

futures dealing are mostly the same. Futures system balance the position of the traders

every day, to stabilize the market the stock index futures can be helpful. These
 24

previous contracts (forward contracts) were the indications to futures contracts. This

concept helped investors to hedge their risk of loss and gain better profit in the off

season. Therefore, it is easier to describe the performance of futures contract between

parties who are involved in the trade (buy & sale) of futures contracts, at expiration

date of a futures contract, the value converges to the price of the that specific

underlying asset which should supplied (Frederic, S. Mishkin, 2013, financial markets

and institutions). (Kolb, 1999) stated that stock index futures transactions are also like

other futures, having the system of daily settlement.

3.1.1.2 Special characteristics

Stock index futures as an investment instrument has different features from other

futures contracts, which helps investors to speculate on stock market’s performance.

Underlying asset Stock index futures’ stock index represent the underlying asset.

Contract multiplier (with prior approval of the commission the Rs. 5.00 per index

point or exchange may determine any other amount with commission approval from

time to time) multiplied by the index value provide the value of the contract. Stock

Index Futures Contract daily settlement Value is determined by Last half hour of

trading for cash settlement in the relevant stock index futures contracts volume

weighted average value.

Delivery Method, future delivery for stock index futures contracts is a stated value of

the underlying asset. The futures of a stock index, have a range of contract periods.

Traders who wants to take long term position on stock index the select to invest in

Equity futures, which have a year's worth of quarterly contract. The futures contract

value will be cash settled based. This cash settlement system feature makes stock

index futures special. On the time of delivery, it produces cost because of the

underlying asset ownership to transfer.

 25

High Leverage in futures market, an investor with small levels of capital having

control over large cash amounts of commodities, in this type of contract the investor

does not pay full value, certain percentage is only paid for trading. Having small

amount of cash investor can enter into a much worthier futures contract, these

contracts are said to be highly leveraged. A smaller change in the price of futures can

result in a huge loss or gain. Futures market is very risky but also useful, futures are

highly leveraged because its initial margins are relatively small compared to the

contracts cash value. Futures market can be extremely risky for investments because

due to highly leverage it can produce greater losses of great profits.

Low Transaction Cost Relate to spot trading, cost of the transactions is lower than

spot trading. Transaction cost comprises of the bid ask spread, commission, possible

taxes, and the opportunity cost of the initial margin. This transection cost of trading in

stock is much higher than the transaction cost of futures contract. The number of

contracts determine the calculation of to the cost to trade index futures. And the stock

market costs are calculated by the volume of stock traded.

Easy Short Selling, Zhang, (2014) stated in his study that in most of stock exchanges

there is a short-selling mechanism. But there are very strict limiting conditions for

short selling. In china, the investors don’t have the facility of short selling. When

shares, prices are dropping, the short selling mechanism helps investors to reduce the

loss. Stock Index Futures Contracts are more attractive due to having this features.

Liquidity of stock market is lower than Stock index futures market. It decreases the

transaction costs, due to margin trading system. The investors are more attracted to

the stock index futures, because of this feature. Having the features of defined

maturities and standardization provides the facility to hedge their positions. Therefore,
 26

Stock index futures contracts are said to be one of the utmost dynamic investment

tools, based on these features all over the world.

3.1.2 Functions

Stock index futures gives a new choice for managing the risk to the investors. In

financial markets the stock index futures are the most important investment tool. The

liquidity of the market is also improved and futures enhances the vitality.

3.1.2.1 Hedging

Hedging in futures trading is one of the most important function. Over the time as

expiration nears the basis is decreases (Cusatis & Thomas, 2005). Basis helps the

investors to make the rational asset allocation, change in basis provides important

criteria for investment.

According to Zhang, (2014) most of the investor instead of getting greater profit, they

want to set off their gains against losses in the portfolio. A systemic risk which is

caused by stock price cannot be reduced completely but it can be reduced to some

extent by better portfolio. The result is time tested and practical, therefore it can be

accepted for learning and analyzing the stock index futures contracts in the capital

market of Pakistan.

3.1.2.2 Risk aversion

The risk aversion is a basic function in stock index futures contracts, in capital market

the SIFC is a standardized trading. For better risk management in the portfolio the key

tool are financial derivatives. It cannot be assumed that investors are absolutely risk

averse, but it helps investors for managed reallocation of their portfolios. Different

investors are facing different type of risks, generally the process of indices and Stock

Index Futures Contracts are usually behaving in the similar direction. The loss and

profit can be partly or full offset, investors invest in two markets with opposite
 27

positions, if he loss in one market then he will benefit from another market, due to

changes in the stock price. In order to obtain profits, there are large number of

speculators, with the help of frequent and rapid trading, these speculators can easily

transfer the price risk from stock holders.

3.1.2.3 Asset allocation

Asset allocation is a portfolio strategy; it is an investment strategy implementation to

attempt balance reward versus risk. Every investor is facing the problem of better

asset allocation to control their risk to some extent. That is the reason nowadays,

investors have different investment selections, for instance commodities, bonds, real

estate stocks and so on. These investments are not free of risk. The example is the

crash of KSE stock market in 2005, when the environment for investment was bad,

investors were facing grater loss, but in futures market having short positions were in

high profit. In strategic portfolio, the allocations depend upon risk tolerance of

different type of investor’s time horizon and investor’s investment objectives.

According to Bodie, Kane, and Marcus, (2011) many investors are considering the

futures as a flexible asset allocation tool, because the liquidating futures positions and

their establishing costs are much lower. Stock index futures contracts can modify the

portfolio with combination of several categories of assets, it improves the efficiency

and increase the capital marketplace liquidity. Investors can sell or buy SIFC

corresponding to the asset for decrease or increase the financial assets holdings.

3.2 Variable

The monthly fair value return is use as a variable of the study,

Where Rf ,t represents the logarithm of the SIFC fair value return at time t , Ft is the

Natural logarithm futures price at time t, and Ft−1 is Natural Logarithm futures price

at time t −1.
 28

4 METHODOLOGY

4.1 Research Design

Time series data and secondary data has been used to analyze the performance of

Stock Index Futures Contracts.

4.2 Data processing and collection

Time Series Data

The monthly fair value of the Stock Index Futures Contracts (KSE 30 index) data has

been adopted in this study. There are four kinds of contracts which are traded on PSX,

i.e. Current month contract, the next month contract and the next two calendar

quarterly month contracts. The data is obtained from SIF Market, for time series test

to achieve the maximum frequent return observation.

All the data is collected from the Pakistan stock exchange (Stock index futures

market), covering the eight years’ series data (January 1, 2009 (authoritatively

released) to December 1, 2016). For the whole sample the time series data consists of

96 observations. For empirical analysis, the time series data are non-stationarity time

series therefore these price series are transformed into natural logarithms, and to

stabilize the data in stationarity time series the difference of natural logarithms are

used to analyze the information for most accurate result. The SIFC (KSE 30 index)

time series data are analyzed by using R studios.

Returns Calculation

When futures contracts approach their settlement days, the trading volume of

contracts decreases sharply. Therefore, to analyze the performance of stock index

futures market, the monthly fair value is used in this research thesis and the theory of

return is applied. The returns of SIFC (KSE 30 Index) are defined as follows:
 29

Return f, t = =ln F t__

F t-1

The above equation shows calculation of the returns for SIFC, where Rf ,t represents

the logarithm of the stock index futures contracts fair value return at time t , Ft is the

Natural logarithm of SIFC (KSE 30 index) futures price at time t, and Ft−1 is Natural

Logarithm of SIFC (KSE 30 index) futures price at time t −1.

Statistical test

Using the ADF (augmented Dickey-Fuller) test for empirical analysis of the fair value

returns and returns difference of the Stock Index Futures Contracts to test the null

hypothesis and alternative hypothesis of a unit root which is present in a time series

data.

Stationarity

The data which are used for analysis in finance and economics are mostly non-

stationary time series data. Therefore, the transformation process is applied for this

time series data to stabilize variance. By differencing and removing the changes in the

level of a time series can help to stabilize the mean of a time series and so eliminating

trend and seasonality. The ACF and PACF function is also used, it is useful for

identifying non-stationary time series. For a non-stationary time series, the ACF will

decreases slowly while for stationary time series the ACF will drop to zero relatively

quickly.

Regression Analysis

Using the ARIMA (p, d, q) model to calculate the evaluation indicators of Stock Index

futures contracts (KSE30 Index) performance on Pakistan Stock Market. Whereas P is

the order of the autoregressive part, d is the degree of first differencing involved and

the q is order of the moving average part. Brandt and Bessler, (1984) stated that for
 30

better predicting the price changes over the time period the variety of ARIMA models

and other autoregressive models are used in terms of forecasting accuracy but no one

has dominated the other. For autoregressive and moving average models, the same

inevitability and stationarity conditions are applied to this ARIMA model. Basically,

the selection of the appropriate values of p, d and q can be difficult for selection of

ARIMA model, therefore the auto ARIMA function in R will do it for selection of

appropriate ARIMA model automatically.

 31

5 RESULT AND DISCUSSION

Time Series Monthly Return

The statistical features of the SIFC (KSE 30 index) fair value return, the monthly

return time series of the futures can be analyzed subsequently.

Table 5.1 discriptive statistics of the monthly returns

As
Daily Mean Maximum minimum Std. Dev.

Return
Rx 14930 22980 5199 5093.75
D log 0.01520 0.24470 -0.13030 0.05487924
seen from the above table. The mean, median and standard deviation of the stock

index futures contracts returns are positive. Both the means of SIFC (KSE 30 index)

return and difference of Log are positive, which is representing that within the period

of analysis, SIFC Futures fair value returns showed an upward trend.

The Stock Index Futures Contracts price returns standard deviation is larger. This

situation is mainly because the transaction cost is lower in futures market and the

reaction of information is sensitive.

The range for Stock index futures contracts (KSE 30 index) is from -0.13030 to

0.24470. Which indicates that, the volatility in Pakistan Stock Index Futures Market is

reasonably high.
 32

5.1 SIFC Price Movement (Returns)

The above table shows the price movement of the Stock Index Futures Contracts

(KSE 30 index) returns over the time period of 2009 to 2016. The technical Analysis

of SIFC forecasting is based on returns movements of past fair value. The above

graph is showing positive (upward trend) movement over the time, which provides

basis for prediction about the future. Technical analysis (forecasting) helps investors

(stake holders) to anticipate about the price movement over the time in near future,

but forecasting from the above graph does not result in absolute prediction about the

future. The fair value returns series trend is non-stationary, because in maximum

circumstances, the economic and financial time series data are non-stationary, it may

lead us to false regression and unacceptable assumptions by using non-stationary time

series data. To prevent the spurious regression problems, it is necessary for time series

data that the mean and the co-variance of a series are time-independent or series

involved are stationary. Therefor the Natural Logarithm is used to transform the

returns of SIFC from non-stationary to stationary form.

 33

5.2 Difference of the Natural Log

In figure 5.1, notice how the price movement of stock index futures contracts was

non-stationarity, to stabilize the time series data compute the differences between

consecutive observations, this is one way to make a time series stationary. Therefore,

the differencing method is applied on the time series data and we got difference of the

N-log returns, by removing changes in the level of a time series the differencing helps

in stabilizing the mean of a time series. To stabilize the variance of time series the

logarithms can help to make it stable. The above figure (5.2) shows that the time

series date is stationary. Now the graph show that the statistical properties such as

variance, mean, autocorrelation, all are constant over time. Through mathematical

transformations a stationarity time series is relatively easy for the prediction of near

future that will be same as they have been in past.

 34

5.3 Autocorrelation Function (ACF) of Return

Autocorrelation Function and Partial Autocorrelation Function is adapted to test the

stationarity and non-stationarity of the SIFC time series data. At different points in

time the autocorrelation is also known as correlation of a signal with itself and serial

correlation. It is the relationship between observations as a function of the time lag

between them. The mathematical tool is adapted to see the stationarity and non-

stationarity of the returns and difference of the returns of Stock Index Futures

Contracts.

The above figure 5.3 of SIFC time series data provides strong indications of non-

stationary, but the autocorrelation function helps us ascertain this indication. The

above ACF for the simple returns of the Stock Index Futures Contracts is showing

tell off movement in the graph, it is decreasing very slowly and remains well above

the significance range. This is indicative of a non-stationary series, On the other hand,

observe the ACF of a stationary series:

 35

5.3.1 Partial Autocorrelation Function (PACF) of Return

In time series analysis, the partial autocorrelation function (PACF) in time series

analysis, gives partial correlation between time series with its own lagged values. It

contrasts with the autocorrelation function, which does not control for other lags.

PACF is a conditional correlation. It is correlation between two variables, we take in

to account other set of variables values, in which we assume that we know some other

set of variables. In the above figure (5.4) it is the sample PACF for this series, which

indicates that the first lag value is statistically significant, whereas partial

autocorrelations for all other lags are not statistically significant. And the Ljung-Box

Q* statistic has p-value of < 2.2e-16 and X-squared = 90.626, df = 1.

 36

5.3.2 Autocorrelation Function (ACF) Difference of Log

The ACF of the SIFC Difference of log returns looks just like that from a white noise

series there is only on autocorrelation lying just outside the 95% limits. You can see

from the SIFC difference of log returns that the autocorrelation at lag 6 is just

touching the significance bounds.

 37

5.3.3 Partial Autocorrelation Function (PACF) Difference of Log

In data analysis PACF function plays an important role aimed at identifying the extent

of the lag in an extended ARIMA model. The partial autocorrelation function is used

for difference of log returns.

From the above Partial ACF figure (5.6) of SIFC difference of log returns shows that

there is only one autocorrelation at lag 6, you can see from the above graph (5.6) that

the autocorrelation at lag 6 the significance bounds lying just outside the 95% limits

and the Ljung-Box Q* statistic has p-value = 0.7782 and X-squared = 0.079343, df =

1. In R test the Ljung-Box test statistic is 0.079343, and the p-value is 0.7782, so in

the sample forecast errors at lags 1-19, there is evidence of non-zero autocorrelations.

To check whether the forecast errors are normally distributed with constant variance

and mean zero. It is also good idea to be sure that the predictive model cannot be

improved upon.
 38

5.4 Stationary test

The cotter and Hanly, (2006) stated that in most of the scenarios the economic and

financial time series data are non-stationary. Analyzing the non-stationary time series

data and estimating optimal hedge ratio may lead us to the false regressions and

invalid assumptions.

For technical analysis, it is essential to reduce/prevent false regression problems,

therefor it is necessary that the series used are stationary. Stationary suggest that the

time series data will remain steady at different time points, i.e., in stationary time

series the covariance and mean of a series are time-independent. Augmented Dickey

Fuller test unit root test is applied on each of the sample series to test the stationarity,

the outcomes of the series Rx, Rdlog are given in Table

Table 5.2 Augmented Dickey Fuller (ADF) Test

Null Hypothesis: Rx

Augmented Dickey-F

Null Hypothesis: Rdl

Augmented Dickey-F

In ADF. Test (dlog): P-value is smaller than printed P-value

The above Table (5.2), shows that the t-statistics of ADF test for Rdlog at critical

standards of 1% level, 5% level and 10% level is smaller. In the above series table the

1% significance level means that to reject the null hypothesis we can have at least

about 99% confidence level. Therefore, the result stat that, the SIFC (KSE 30 index)

series data don’t have a unit root. In other words, the time series data of monthly fair

value returns shows stability in the trend. Application of the ADF test on the monthly
 39

returns series of SIFC (KSE 30 Index) indicates that the series are stationary at levels.

ADF test on KSE 30 index also indicate that the P-value is smaller than printed P-

value.
 40

5.5 ARIMA (0,0,0) MODEL

As long as the development of an autoregressive model, the moving average (MA)

process is invertible it is good estimate of ARIMA model. According to Kohzadi and

Boyed, (1995) the Autoregressive models are simple to estimate, require limited

pretesting and have well-developed model selection criteria, they are the procedure of

ARIMA which is used for estimation. On the basis of AIC and BIC we select the

ARIMA model, here the result shows that, AIC and BIC are lowest (AIC= -281.87

AICc=-281.74 BIC=-276.74), and we also applied the auto ARIMA Selection

method therefore on the basis of both AIC and Auto ARIMA method we select the

ARIMA (0,0,0) model to forecast the future behavior of the SIFC KSE 30 index on

Pakistan Stock Market.

From the above figure (5.7) forecasts from ARIMA (0,0,0) with non-zero mean, we

have forecasted the future value of the Stock Index Futures Contracts (KSE 30 Index)

on Pakistan stock market. Across time the errors are uncorrelated because an ARIMA
 41

(0,0,0) model is white noise. In this case the sigma^2 estimated as 0.003012 this is

very small number and log likelihood=142.94, yes the model fits well. And standard

error is 0.0056 is the indication of positive movement in the future values of the SIFC

(KSE 30 index) difference of Log returns. The intercept using ARIMA (0,0,0) model

is 0.0152 which shows the next forecasted value of SIFC (KSE 30 index) difference

of Log returns.

5.6 Results from literature.

The results of various papers that examine the impact of stock index futures on

underlying markets, the conclusion is reached that futures markets never have a

destabilizing effect on underlying markets. The volatility impact of stock index

futures on cash markets and the lead- lag relationship between futures prices and cash

prices supports the intuitive hypothesis that futures trading acts as a stabilizing

influence. The theoretical model provided a strong corroborative element and proved

to be comprehensively applicable to real life scenarios, (Safi ullah Khan, 2006).

According to the empirical findings, the new stock index futures market in China still

does not function well in the price discovery procedure; yet strong bidirectional

volatility feedbacks are found between the spot and futures markets. Other studies

explore the impact of introducing stock index futures (i.e., CSI 300) on the volatility

in the spot market (Chen, H., Q. Han, Y. Li, & K. Wu. 2013).

From the perspective of the development, index future has maintained a steady

growth during its initial of operation. Which confirms the existence of a long-term

equilibrium relationship between the index and index futures through the co-

integration test. This conclusion demonstrates the existence of co-movement between

the stock market and the stock index futures market. This long-term equilibrium

relationship provides a prerequisite for hedging. The stock index futures prices have
 42

been more volatile than the spot prices. Consequently, there exists arbitrage space in

the market price, which indicates the risk-averse ability of stock index futures need to

be further strengthened (Lu Zhang, 2014).

 43

6 CONCLUSION AND RECOMMENDATIONS

The data for this thesis are collected from Stock Market of Pakistan, to see the

performance of Stock Index Futures Contracts, monthly fair value of the SIFC, (KSE

30 index) data has been adopted. The data is obtained from SIF Market of Pakistan,

for time series test to obtain the possible most frequent return observation.

The price movement of SIFC (KSE 30 index) over the time period of 2009 to 2016 is

used to analyze the performance, which shows the positive (upward trend) movement

over the time. Technical analysis (forecasting) helps investors (stake holders) to

anticipate about price movement over the time in near future, but it does not result in

absolute prediction about the future. The time series trend is non-stationary, because

in maximum circumstances, the economic time series data are non-stationary, using

this kind of financial data may lead us to invalid conclusions and spurious regressions.

To prevent the false regression problems, the data is used to transform from non-

stationarity to stationary. Therefore, the data is transformed into Natural Logarithm

and then the differencing method is applied on the time series data and we got

difference of the N-log returns, which helps in stabilizing the mean of a time series.

The partial autocorrelation function is used for difference of log returns, the

autocorrelation at lag 6 the significance bounds lying just outside the 95% limits and

the Ljung-Box Q* statistic has p-value = 0.7782 and X-squared = 0.079343, df = 1.

In R test the Ljung-Box test statistic is 0.079343, and the p-value is 0.7782, so in the

sample forecast errors at lags 1-19, there is evidence of non-zero autocorrelations.

Based on AIC and BIC we select the ARIMA model, here result shows that, AIC and

BIC are lowest (AIC= -281.87 AICc=-281.74 BIC=-276.74), and we also applied the

auto ARIMA Selection method therefore on the basis of both AIC and Auto ARIMA

method we select the ARIMA (0,0,0) model to forecast the future behavior of the
 44

SIFC KSE 30 index on Pakistan Stock Market. And the result of the technical analysis

show that the Pakistan stock market is performing well over the time period of 2009

to 2016, which indicts better opportunity for domestic and international investors to

invest in Pakistan stock market and grab better opportunity for their growth.

Based on above point of view, the subsequent assumptions can be attained:

The statistical analysis of the SIFC (KSE 30 index) fair value time series shows the

features of fat tail, which is describing volatility clustering and non-normality in the

data. According to the Augmented Dickey Fuller test, the Alternative Hypothesis of

SIFC (KSE 30 index) return series are stationary time series. And Null Hypothesis

state that the time series data are non-stationary. These results suggest that on the

return series regressions can be applied.

Correlation between Pakistan stock market and the futures market (KSE 30 Index) in

Pakistan has positioned the basis for the recognition of hedging function. Therefore,

we expect the SIFC (KSE 30 index) be an effective tool in spot market of Pakistan for

hedging risk.

There is absence of particular analysis of Quarterly, Weekly and daily high frequency

data. This paper is focusing at macro level but not enough at a micro-level, the

performance of SIFC is analyzed by using Fair value trend with time period, no other

variables such as risk preferences of different investors, inflation, interest rate, etc..

Are used to investigate the trend. It has ignored the comparison between SIFC, it also

ignores the required margin and dynamic adjustment of hedging methods, and other

indices to analyze the performance in the capital market of Pakistan. So, there leaves

room for further research to analyze the performance for SIFC.

 45

APPENDIX

PSX Pakistan Stock Exchange

KSE Karachi Stock Exchange

SIFC Stock Index Futures Contracts

Board means the Pakistan Stock Exchange (PSX) Limited Board of Directors.

Broker is basically any member/participant of the Pakistan Stock Exchange, and

registered with Commission (SECP) under the Agents & Brokers Registration Rules,

2001, and also involved in performing the transactions in derivatives (securities) for

his own account and the account of others.

Contract Is a Standardized Sector/Stock Index Futures Contract.

Contract Multiplier means that the value of Contract Multiplier shall be Rs. 5.00 or

any other sum for Sector/Stock Index Futures Contract, the Exchange may determine

the other amount from time to time having the previous endorsement of the

commission.

Contract Unit means that the value of contract unit must be in the numerical form of

the underlying stock index.

Daily Settlement Value for the Stock Index Futures Contracts is the last half hour of

trading in the relevant Sector/Stock Index Futures Contracts for cash settlement

Volume Weighted Average value, multiplied by the contract multiplier and must be

provided in Pakistani Rupees.

Stock Index Futures Contracts Final Settlement Price is the set of one hundred &

twenty-one readings of 15 second intervals (price points) of the underlying index

levels price calculated based on interval of the last half an hour of transactions. The

closing price is calculated based on as an average of 81 price point and that will be the
 46

Final Clearing Price for the settlement of contract and highest & lowest the remaining

20 price points will be ignored.

Index means, Sector Index or KSE-30 Index for the purpose of trading may be

defined by the Board in Stock Index Futures Market.

The Stock Index Futures Contract Open Interest is the total value of Contracts of

clients of his Broker in stock index futures contract, which has not been closed and

offset at any point in time by an opposite transaction. At any point in time the open

interest per product (KSE 30 index) of a broker in the Stock Index Futures Market

shall not exceed 1 percent (%) of the total open interest or 1000 contracts (whichever

is higher) in the SIFC, any change in this limit would be made with prior approval of

the commission or on recommendation of the Board with written approval of the

Commission.

Stock Index Futures Market means that, for execution of Stock Index Futures

Contracts and subject to the Regulations a Market which is made accessible by the

Exchange.
 47

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