The change from fixed to flexible interest rates and the often unpredictable volatility of Rupee-Dollar parity was creating problems for investors and borrowers because these developments were sometimes too rapid for the comfort of many of them.

Introduction of floating interest rates which, at least theoretically, affords borrowing at the going market rates, softened the blow a bit but the dearth of credible yardstick market rates (to which floating rates must be pegged) undermined the benefit of borrowing on floating rates.

The key role of yardstick market rates in quoting floating rates necessitates institutionalising credible yardstick rates. However, the money market relied largely on SBP Discount Rate as the yardstick distorting the floating rates because this rate is based on macroeconomic considerations rather than free flow of demand and supply that determines credible yardstick rates.

Some banks offered floating rates pegged to rates on gilt-edged securities but that too did not serve the purpose because periods (such as the last year) during which these rates rose too sharply, borrowers and lenders found themselves in trouble because interest costs changed too sharply for the borrowers to withstand.

Introduction of KIBOR (Karachi Inter-bank Offer Rate) too didnt help because, given the wide disparity in the sizes of the banks, this rate (supposedly based on free demand and supply) continues to be distorted.

Thus, in spite of the availability of floating interest rates neither borrowers nor investors were able to satisfactorily manage risks arising from rate volatility nor benefit from the opportunities the scenario offered unless the market was permitted to deal in risk hedging instruments.

Without this help, businesses were finding it hard to undertake even short-term financial planning to face up to fierce competition from sharper adversaries at home and abroad.

For Pakistan, where businesses tend to be highly leveraged, this scenario implied containing very substantially their borrowing costs if they were to remain competitive.

Beginning 2005, this scenario was posing more troubles for businesses because the new WTO regime increased the premium on price efficiency many fold. Responding to this scenario, on November 17, SBP finally permitted banks to deal in three financial derivatives viz.

Forward Rate Agreements, Interest Rate Swaps and Foreign Currency Options that can contain risks arising from interest and exchange rate volatility. Buying Forward Rate Agreements (FRA) allows fixing now the interest rate on term borrowings to be undertaken at future date.

At the borrowing commencement dates banks selling FRAs compensate their borrowers for any increase in interest cost over the agreed rate. The reverse applies if, at the future borrowing commencement date, interest rate falls below the rate agreed in the FRA and the borrower is required to compensate the bank for loss of potential earning on the contract amount.

Borrowers buy FRAs to hedge against a rise in interest rates and lenders sell FRAs to hedge against a fall in interest income. FRAs thus provide for compensating the party that stands to lose due to interest rate movement. FRAs therefore have a stabilizing influence on markets.

Besides, the bank selling the FRA is not obliged to lend to the contract buyer implying no credit risk for the bank and affords borrowers the flexibility to borrow from any source. Selling FRAs thus has minimal adverse effect on the contract seller who only carries the interest rate risk.

In developed markets this risk is covered in a Futures Market. In Pakistan, that does not have a Futures Market, the risk will have to be covered in the inter-bank market by buying an opposite FRA or the seller can take a view on interest rates (if it has the requisite predictive expertise) and carry the risk itself.

A secondary risk is that if market rates move in the contract sellers favour, the contract buyer may not be there to pay the compensation. In essence, the FRA is a forward-forward rate contract because it fixes a rate that will apply to a loan or deposit beginning on a future date and mature on a second future date.

It is also the implied future interest rate derived from current market rates. For a financial institution wherein natural forward-forward positions being created in the normal course of its business FRA can be a particularly useful product to sell.

Hedging future loans, or mismatches in interest rate sensitive instruments, should be the primary consideration from a business point of view. But FRAs can be traded like other instruments in a deepening market.

For example, position taking by going long on FRAs if an interest rate rise is expected, trading just on the spread, or perhaps arbitraging contracts where conditions allow for earning an arbitrage spread all speculative activities.

Increased interest rate volatility gives rise to opposing views on future trend of interest rates. After borrowing on floating rates, borrowers may expect a rise in interest rates that would proportionally increase their interest cost. They would look for arrangements whereby their floating interest payments can be replaced with fixed payments.

Such borrowers would look for borrowers who have fixed rate borrowing but hold an opposite view on future trend of interest rates, and want to replace their fixed interest payments with floating rate payments. The mechanism of Interest Rate Swap can remedy their fears by changing the basis of interest rate payments according to their perceptions.

In Interest Rate Swaps, an exchange of principal is not involved; only the interest rate payments need to be met by the parties on each others behalf at their respective payment dates.

It is unlikely that parties to the transaction will put such a complex deal in place themselves; a financial intermediary a bank will be involved and will be responsible for facilitating the deal and its implementation over extended time periods.

Foreign Currency Option contracts assure the contract buyer about the availability of an agreed amount of a foreign currency at an agreed future date at an exchange rate to be agreed now without the compulsion of fulfilling the contract.

On the one hand it assure the contract buyer of a firm future exchange rate and on the other allows the buyer to take advantage of the moving market if the market exchange rate is more favourable than that agreed in the option contract.

The contract seller, however, must be prepared to deliver should the option buyer exercise the option of taking delivery of the currency, which will certainly be the case if the market exchange rate rises above the rate agreed in the option contract.

Thus, selling these contracts is extremely risky unless the seller off-loads the risk by buying an opposite option contract from another market player. The new concepts of competition, economic progress and profitability make market stability look like a stumbling block.

But de-regulation of interest and exchange rates is creating new risks that could exercise a dramatic influence on the fortunes of business and industry. Given the rapid changes in Pakistans financial markets as a result of de-regulation, the key area that must be focused on is the risk management capability of the market players.

While the introduction of these hedge contracts must be welcomed, the knowledge and skill needs of bankers must be addressed now if the market is to remain risk averse after their introduction.

In the report on the winding up of BCCI, Lord Bingham attributed the banks failure to incompetence and errors by unsophisticated amateurs venturing into highly technical and sophisticated markets.

Scenario such as this must not be allowed to develop in any institution that decides to trade in these instruments. Although these contracts afford greater flexibility to the parties thereto, the risk involved in the selling mismatched Interest Rate Swaps contracts and Foreign Currency Option Contracts could be very high.

SBP has taken this aspect into consideration by insisting that the contract sellers the banks must keep themselves fully covered by simultaneously entering into opposite cover contracts with other market players but it is yet to be seen whether banks will abide by this golden principle and SBP will be able to verify it credibly.

Then there will be operational problems to face up to. Firstly, SBP has forbidden dealing in Rupee-Dollar currency options, which implies entering into option contracts in other currencies with the Rupee as the counter-currency.

But the possibility of foreign banks quoting Rupee cross-rates option rates is remote. Practically all such contracts will have to be against US Dollar but with dealing in Rupee-Dollar option contracts forbidden these contracts will expose the contract seller enormously to exchange risk as far as the Rupee-Dollar leg of the transaction is concerned.

Secondly, allowing trading in Interest Rate Swaps may help very little. Although the process appears simple implying that parties to the transaction alter their borrowing cost according to their choice and the bank arranges and implements the deal in letter and spirit, this is not the case.

For a bank to act as the intermediary it must find two borrowers who have an opposite view on interest rate, have borrowings of the same amount, in the same currency and for the same period and, above all, the risk associated with both parties must also be identical.

In reality, setting up long-term contracts of this nature brings with it two basic risks. Firstly, any of the parties may fail to honour their commitment (unable to meet periodic interest payment commitments of the other party) forcing the bank to take over the failed partys liability.

Secondly, the agreed swapping of interest payments may take place but not on their respective due dates. Both risk types are real and can lead to substantial losses for the bank.

The longer the swap period, larger could the possibility of loss over the life of the swap contract. Finally, for selling these sophisticated contracts Pakistani banks need to make extensive efforts for developing the expertise for selling, booking and managing the risks under these contracts.

They would be at a disadvantage (at least in the initial phase) compared to foreign banks that can conveniently copy these arrangements from their offices in major markets and get a head start.

It would have been better if banks were advised to make these preparations until June 30, and all banks were allowed to commence selling the contracts from July 01, onwards.

For a while, the move will render the playing field uneven for Pakistani banks. But this could be justified by the benefits it may offer to Pakistans business and industry. The real test will lie in how much this move helps business and industry in financial planning and cost control.