03 October 2004	Sunday	17 Shaban 1425

KARACHI, Oct 2: Financial derivatives are designed to manage overall risk profile and profitability of any business. But there are risks involved in the derivative products themselves which translates into "the gain of one is the loss of the other". Hedging against risks can also turn into speculative activity.

Yet, bankers are convinced that the derivative instruments improve the market efficiency by allowing for free trading of individual risk components. The popular variety are the futures, forwards, options and swaps.

In Pakistan, the derivatives market is in the nascent stage. It has just started to emerge with few contracts of forward trade agreements, plain vanilla swaps and currency options. The total volume of transactions is around Rs5 billion.

As the market is not fully developed to take large exposures, the State Bank says it "has been actively intervening in these riskier initiatives of the banks". All derivative agreements require formal approval of the central bank, given on a case-to-case basis, considering the concerned bank's potential of risk management.

Major foreign banks and multinationals have been exposed to risks of derivative products in a volatile global financial market and possess the knowledge and expertise in this area to manage the risks as well as gain by it. It is they who have been keen to develop a local derivative market. The State Bank acceded to their demand but is moving cautiously. It satisfies itself that parties to the agreement are fully aware of the risk of the derivative products. Local firms and banks need to be made aware of the downside or the risks in the hedging business.

Since derivatives package basic risks in combinations that can be quite intricate, bankers agree that they can also threaten the viability of the institutions if not clearly understood or properly managed.

Down the road, say SBP officials, the approvals may become institution-specific and only sound banks may be allowed to engage in derivative deals within defined parameters.

Sources here said the SBP is also preparing the risk management guidelines for derivatives. These derivatives, if used cautiously, are expected to be a positive step towards gaining economic efficiency. But the risk is that many want to become multi-millionaires overnight.

In Pakistani market, the entry of derivatives began in early 1990s with currency swaps called "dirty swaps" when foreign exchange reserves plummeted to low levels. Inter-bank players have also been carrying out swaps to square their daily currency exposures. But, to quote bankers, the market appetite for formal derivatives has risen from the need for risk management strategies, prevailing low interest rates and a relatively stable exchange rate.

"Some big players with overseas operations took the initiative and responded to the private sector's demands to lock in their liabilities and the future currency inflows at better prices," says an SBP report.

The implications of the derivatives have been also summed up by central bank as follows: Using financial derivatives brings up a number of concerns. In addition to risk sharing properties, derivative instruments facilitate information gathering.

The basic risks associated with derivative transactions are explicit market risks along with risks related to credit, liquidity, operations, legal and those stemming from information and functional characteristics of given financial market structure. Since they facilitate the specific identification and management of these risks, derivatives have the potential to enhance safety and soundness of financial institutions and to produce more efficient allocation of financial risks.