27 November 2004	Saturday	14 Shawwal 1425

KARACHI, Nov 26: The State Bank has allowed banks and development finance institutions or DFIs to issue financial derivatives after meeting the criteria set for this purpose.

This means the banks and DFIs will no longer be required to secure prior permission of the central bank to transact financial derivatives business on case by case basis. All they need to do is to become an authorized derivative dealer (ADD) or non-market maker financial institution (NMI) after fulfilling some formalities laid down in Financial Derivatives Business Regulations or FBR.

Financial analysts say this decision of the central bank will, over the years put Pakistan's financial market at par with those of the developed countries in terms of availability of financial products.

A circular issued by the State Bank says the FDBR has become effective from November 26. "Any financial derivative transaction approved by the State Bank prior to the issuance of these regulations shall be deemed to be executed within these regulations," it adds.

"Financial institutions desiring to enter into derivative transactions, which do not fall within the scope of these regulations, will be required to obtain specific approval from the State Bank prior to entering into such transactions," it adds.

The proposed regulatory framework stipulates necessary operational and risk management standards for derivatives business, keeping in view the higher level of inherent risk.

The SBP has recently allowed Over the Counter or OTC financial derivatives in Pakistan, under which banks were permitted to undertake Interest Rate Swap IRS, Foreign Currency or FX Option and Forward Rate Agreement or FRA on the basis of transactional approval from the SBP.

"Such prior approvals will no longer be needed for the vanilla IRS, FX Options and FRAs once a bank or DFI is granted an ADD or NMI status by the SBP," says a press release issued by the central bank.

The OTC financial derivatives has undergone tremendous growth throughout the world during the last decade as the derivatives have become extremely popular for hedging risks as well as for profit-making.

"The State Bank's decision to allow banks/DFIs to undertake the financial derivatives business is to concurrently develop the FX market in Pakistan and to provide a risk hedging mechanism to the market participants," the release adds.

Foreign Currency (FX) options are contracts that give the buyer the right, but not the obligation, to buy or sell one currency against the other, at a predetermined price and on or before a predetermined date.

The buyer of a call (put) FX option has the right to buy (sell) a currency against another at a specified rate. If this right can only be exercised on a specific date, the option is said to be European, whereas if the option can be exercised on any date prior to its maturity, the option is said to be American.

All ADDs and NMIs are permitted to carry out derivatives business in Foreign Currency Options as follows: Dealing in FX options is permitted in G-7 currencies only. No entity may offer any PKR / USD or PKR / Other Currency option unless specifically permitted by State Bank of Pakistan.

There is no restriction on the minimum or maximum size of 'notional principal' amounts of FX options. Maximum tenor of the Option may not exceed 1 year. Any transaction, which exceeds this tenor, would require separate approval from relevant approving authority. Risk Management

All FX option transactions will be covered by ADD and NMI on a back-to-back basis and financial institutions will not be allowed to carry any market risk in this respect. Authorized Derivative Dealer must cover all exposures on a back-to-back basis from a foreign bank or their branches abroad.

ADDs, which have their Head Offices in Pakistan, may cover their position with their branch abroad; however they must ensure that their branch also covers its position on a back-to-back basis offshore.

An ADD, which has its Head Office outside Pakistan, will be required to cover their exposure with their branch outside Pakistan. ADDs, in order to cover its long/short FX position may purchase Vanilla FX Options with a maximum maturity of 6 months.

Such FX options will be reported on a net delta weighted basis in the net foreign exchange exposure reporting. Banks may enter into packaged products involving cost reduction structures for customers provided the structure does not involve customers receiving a premium.

Banks may quote the option premium in US Dollars or in the currency of the underlying option and will be allowed to remit abroad the premium required to cover the transaction on a back-to-back basis.

Hedges entered against a particular exposure or part thereof for a given time period should not exceed the total principal / duration of the underlying exposure. A customer may enter into FX Option hedge with any Financial Institution irrespective of the exposure being booked in that Financial Institution or not.

ADDs/NMIs must ensure that its customer has Board/Head office /senior management approval to enter into derivative contracts for hedging. Settlement Option contracts may be settled on maturity either by delivery on spot basis or by net cash settlement as specified in the contract. In case of unwinding of a transaction prior to maturity, the contract may be cash settled based on the market value of an identical offsetting option.

Options can be booked against all existing FX exposures arising out of trade transactions and loan exposures. In cases where exposures are against PKR, the customer will either run their USD/PKR exposure or cover this separately in the inter bank forward market.

Interest Rate Swap: This swap is a financial contract between two parties exchanging or swapping a stream of interest payments for a 'Notional Principal' amount on multiple occasions during a specified period. The swap is usually "fixed to floating" or "floating to floating" exchanges of interest rate.