KARACHI, Dec 1: In the eyes of local companies seeking to hedge interest rate and currency risks, the recent launch of a formal derivatives market in Pakistan comes at an opportune time, bankers said.

While derivatives have long been traded in Pakistan, these are done over the counter, meaning that each interest rate swap, foreign currency option, or forward rate agreement needs central bank approval before they are allowed for sale.

With a formal market in place, contracts will be standardized, meaning transactions will be faster and easier. Banks will also have a framework to increase their products.

"If you just look at the borrowing side, large companies that are carrying term-rupee debt - payable over many years - they have a wider range of instruments to address their risk-related debt," said Zubyr Soomro, managing director Citigroup Pakistan.

"Given the expansion we have seen in plant and equipment, there will be a large number of borrowers who would be carrying these risks ... the introduction of these derivatives on a wider scale is an appropriate step."

In an announcement last week, the State Bank of Pakistan said it will let banks offer financial derivatives for hedging against interest rate and foreign exchange risks. The move couldn't have come at a better time.

The economy is growing briskly and is expected to exceed the government's 6.6 per cent target in the current fiscal year, up from 6.4 per cent in the last fiscal year. Textile and automobile companies are leading the expansion and are increasing capacity so that they can capitalize on the rebound in domestic and export demand. Textile firms too are hoping to take a bigger slice of the global export market after textile quota barriers are lifted by the US and Europe next year.

At the same time, interest rates in Pakistan, like most places elsewhere, are on the rise. The central bank shifted to a tighter monetary policy stance in July to counter inflationary pressures, making companies wary of borrowing at floating rates, favoured over the past two years.

Until recently, companies were borrowing at rates linked to the Karachi Inter-bank Offered Rates (Kibor) to take advantage of low interest rates. Rates started to rise in early 2004, and the six-month Kibor - the benchmark inter-bank money market rate that is used to price loans - has shot up to 5.72 per cent from 2.74 per cent in early July.

Experts expect interest rate swaps and short-term foreign exchange options to grab the bigger slice of the derivatives market as manufacturers hedge against volatility in interest rates, and importer and exporters protect themselves against exchange rate fluctuations.

The rupee has been volatile since July mostly due to a widening trade deficit, likely to reach $4 billion in the fiscal year June 2005, beating a government forecast of $3 billion.

"We are already seeing more demand from companies seeking interest rate swaps for floating loans. Banks will now be doing interest rate swaps with these companies, offering them fixed rates and getting floating rates," said a treasury official at a European bank.

He said the large buildup of government bonds by the banking sector can also be used by banks to hedge their own exposure in the derivatives market. Banks hold up to Rs250 billion worth of long-term bonds.

The banker said forex options are also in demand for companies that are hedging against exposure in currencies such as the euro and yen or other than the US dollar for large capital expansion.

Bankers say the rising level of international trade - expected to gain 15 per cent to $30 billion - also shows the level of corporate exposure to foreign exchange risk. Asif Qureshi, research head at AMS Securities, said the market still lacks the adequate level of expertise to launch these products.

Few banks are prepared to deal with the rising level of risk, as are brokerage industry and the end-users who also need to be educated on managing their risks. Zubyr Soomro said the central bank has opened up the derivative market "in a structured, orderly way" to ensure prudent management of risk.

"There are two protective features that stand out. One feature is that this should only be used for hedging purposes - to hedge existing risks as opposed to taking speculative positions. The second element is the need to emphasize back-to-back coverage," he said.

Mr Soomro said authorized dealers will be allowed to undertake positions in derivative instruments, as well as market-making. However, other financial institutions will need to ensure any positions they have taken are properly hedged.

"It is important that all the players fully understand the risk that they are undertaking. This will impact the growth of the market in the future," he said. -Dow Jones Newswires