This article is an in-depth look at the state of the equity derivative market in Pakistan. It examines the current market state, compares its performance with those of India, and offers explanations for the problems faced by the market. In the end, the writer offers several recommendations on how the various regulatory bodies and institutions can seek to improve the state of the derivative market.
We start of by defining exactly what a derivative is. A derivative is a financial instrument whose value and cash flows depend on the value and cash flows of an underlying asset. Examples of such instruments are forward and future contracts, options, swaps etc. However, in this presentation we only consider the equity derivative market of Pakistan.
The derivatives market in Pakistan was started in 2001, with the introduction of single stock deliverable futures. Since then, various other instruments have been introduced, such as cash settled futures, index futures (based on KSE 30 index) and 7 day cash settled futures.
However, despite these developments the performance of the Pakistan equity derivatives market remains poor, as compared to India (which started its derivatives market in 2000), and other developing countries. The trading volume is 3-4% of the spot market volume, which is very low. Also, most of the investors in this market are individual and small investors. Institutional participation is very subdued, and only limited number of banks, NFBCs, and companies take part in this market. Further, the single stock deliverable future remains the most popular instrument traded, with almost 100% volume attributed to this. Other instruments like cash settled futures and index futures are traded minimally, despite their myriad advantages.
The author bases her reasons on a survey she conducted on reasons for the low participation of institutions in the market. According to her, the major reason for low institutional involvement is the lack of knowledge and technical expertise, along with internal policies prohibiting investment in derivatives. Further, the lack of liquidity is another factor, and the fact that due to technological improvements, the margin calls of derivative investments now come directly to institutions.
The author finally gives some recommendations, which include increasing investor knowledge and human capital development to increase expertise, as well as developing clear and string risk management policies for institutions. Finally, she recommends that public sector get more involved in these markets to improve liquidity.
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