RISK MANAGEMENT PRACTICESRISK MANAGEMENT PRACTICES

A CASE OF PAKISTAN STOCK MARKETA CASE OF PAKISTAN STOCK MARKET

FYP REPORTFYP REPORT

Submitted by:

SANDEEP KUMAR

09-3306(MBA)

Supervised by:

MR. SYED BABAR ALI

Program:

Master of Business Administration (MBA)

FAST-SCHOOL OF BUSINEESFAST-SCHOOL OF BUSINEES

NATIONAL UNIVERSITY OF COMPUTER & EMERGING SCIENCENATIONAL UNIVERSITY OF COMPUTER & EMERGING SCIENCEMANAGEMENT SCIENCE DEPARTMENT, KARACHMANAGEMENT SCIENCE DEPARTMENT, KARACH

ACKNOWLEDGMENTS

All praises and thanks are for

Almighty ALLAH Who is the source of

all knowledge and wisdom endowed

to mankind and to the humanity as a

whole. I would particularly like to

thanks Mr. Syed Babar Ali (Course

Supervisor & PROFESSOR NU: FAST)

and Mr. Zaki Rashidi (Course

coordinator & PROFESSOR NU: FAST)

for many insights he provided us

throughout this FINAL YEAR PROJECT

report. Discussions with them have

also proven most helpful.

The encouragement and assistance of

our parents and friends are gratefully

acknowledged. Most of all, I wish to

thank Mr. Nadeem Yaseen and Mr.

Jamil Ahmed Mehar who provided me

the important and relevant

information to complete this report.

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In the end, I express my deep

appreciation to all the people who

share their experience and knowledge

with me. I am grateful for the

inspiration and wisdom of them.

Table of ContentsChapter .01...............................................................................................................................7

1. Introduction..........................................................................................................................7

1.1 Overview of Topic 7

1.2 Historical background 8

RISK........................................................................................................................................9

2.1. Defining Risk 9

2.1.1. Definitions of risk...................................................................................................9

2.2 Types of Risks 10

2.2.1 Fundamental Types of Risks.................................................................................10

2.2.2 Specific Types of Risks.........................................................................................10

3. Risk management...............................................................................................................12

3.1 Introduction: 12

3.2 Methodology 12

3.3 Process 12

3.4 Potential risk treatments 13

3.4.1 Risk avoidance......................................................................................................13

3.4.2 Risk reduction.......................................................................................................13

3.4.3 Risk retention........................................................................................................14

3.4.4 Risk transfer..........................................................................................................14

3.5 Risk-management plan 15

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3.6 Implementation 15

3.7 Areas of risk management15

3.8 Financial risk management 16

4. The Stock Market...............................................................................................................17

4.1 HISTORY OF STOCK EXCHANGES 17

4.2 PAKISTAN STOCK MARKETS 18

4.2.1 Lahore Stock Exchange.................................................................................................18

4.2.2The Islamabad Stock Exchange (ISE)............................................................................18

4.2.3 The Karachi Stock Exchange........................................................................................19

5. Objective of the Study........................................................................................................20

6. Research Question..............................................................................................................20

7. Issues behind the Study......................................................................................................20

8. Limitations and Scope........................................................................................................20

9. Background and Justification.............................................................................................21

Chapter .02.............................................................................................................................23

1. Literature Review...............................................................................................................23

1.1 Defining Risk 23

1.2 Risk Management24

1.3 Levels of Risk Management Activities.....................................................................24

1.3.1 Strategic level........................................................................................................25

1.3.2 Macro Level..........................................................................................................25

1.3.3 Micro Level:..........................................................................................................25

1.4 Risk Evaluation/Measurement 26

1.5 Misconception 26

1.6 Issues in Risk Measurement 27

1.6.1 Are Returns Normally Distributed.........................................................................27

1.6.2 Serial Correlation..................................................................................................27

1.6.3 Correlation among Outcomes................................................................................27

1.6.4 Risk Ignorance.......................................................................................................28

1.7 Risk Mitigation.........................................................................................................28

1.7.1 Risk Migration.......................................................................................................29

1.8 Implications..............................................................................................................29

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1.8.1 Implications for Managers.....................................................................................29

1.8.2 Implications for Regulators...................................................................................30

2. The Influence of Enterprise Risk Management on Stock Market performance 31

2.1 Overview31

2.2 Purpose of Enterprise Risk Management 32

2.3 Illustrating Some Major Events 32

3. Stock Market Volatility and Risk Management..................................................................34

4. Calculating Value-at-Risk..................................................................................................36

4.1 Overview36

4.2 Measurement of Risk 37

Chapter.03..................................................................................Error! Bookmark not defined.

Research Methodology...........................................................................................................38

1. Overview: 38

2. Research Design: 38

3. Procedure: 38

4. Software employed: 39

5. Research Schedule: 39

6. Population: 39

7. Sample: 39

8. Measurement Selection: 40

Chapter.04..............................................................................................................................41

4.1 Analysis of Risk Management Practices at KSE:.............................................................41

4.1.1 Eligibility of Listing: 41

4.1.2 Products and services: 43

4.1.3 Netting:45

4.1.3.1 Netting rules at KSE:..........................................................................................45

4.1.4 Mark to market procedures: 46

4.1.5 Clearing: 47

4.2 Settlement and clearing for Deliverable Future Contracts:...............................................48

4.2.1 Daily Clearing: 48

4.2.2 Final Clearing 49

4.2.3 Special Clearing 49

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4.3 Settlement and clearing for Cash Settled Future Contracts:..............................................49

4.3.1 Daily Clearing 49

4.3.2 Final Clearing & Settlement 50

4.3.3 Special Clearing 50

4.4 Other initiatives by KSE:.................................................................................................51

4.5 KSE Risk Management Practices:....................................................................................52

Chapter.05..............................................................................................................................54

Conclusion and Recommendations........................................................................................54

5.1 Conclusion:......................................................................................................................54

5.2 Future Outlook:................................................................................................................55

Bibliography...........................................................................................................................55

References.............................................................................................................................55

Appendix...………………………………………………………………………… 44

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Chapter .01

1. Introduction

1.1 Overview of TopicRisk management is the identification, assessment, and prioritization of risks

followed by coordinated and economical application of resources to minimize,

monitor, and control the probability or impact of unfortunate events. The risk can

come from hesitation in monetary market, project failure, legal liability, credit risk,

accident, natural cause and disaster.

Risk Mitigation Practices as well faces difficulties to allocate capital. This is the

scheme of opportunity cost. Resources depleted on risk management could have been

spent on more profitable activities. Again, ideal risk management minimizes spending

while maximizing the reduction of the negative effects of risks.

Understanding risk in emerging markets is a critical success factor for management

today. Risk management is about prohibited decision making rather than risk evading.

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Corresponding risk and reward is increasingly important but return does not come

without risk. Risk Management in rising markets is mainly concerned with the risks

facing long-term investors who deposit their money in real assets rather than financial

ones such as investing in stock markets.

Risk management Practice basically Financial Risk Management practice is the

practice of creating economic value in a firm by using financial instruments to

manage exposure to risk, particularly credit risk and market risk. Additional types

include foreign trade, outline, Volatility, region, Liquidity, price increases risks, etc.

Risks can appear from ambiguity in financial markets, project failures, legal liability,

credit risk, accidents, innate causes and disaster as well as deliberate attacks from an

opposition.

Due to dynamic market environment of Stock markets the investors are more exposed

to the Risk and this is the most important reason of paying so much attention to the

risk management practices by the regulatory bodies of stock markets. Pakistan stock

market is one the growing stock market in its region and but it is also very much

exposed to the risk in fact Pakistan stock market is even more uncertain because

political instability in the country. So Risk Management has become a vital to

everyone who is directly or indirectly engages in stock market.

1.2 Historical backgroundThe term risk may be traced back to classical Greek rizikon (Greek ριζα, riza),

meaning root, later used in Latin for cliff. The term is used in Homer’s Rhapsody M

of Odyssey "Sirens, Scylla, Charybdee and the bulls of Helios (Sun)" Odysseus tried

to save himself from Charybdee at the cliffs of Scylla, where his ship was destroyed

by heavy seas generated by Zeus as a punishment for his crew killing before the bulls

of Helios (the god of the sun), by grapping the roots of a wild fig tree.

Niklas Luhmann - the Sociologist said that the term 'risk' is a neologism which

appeared with the transition from traditional to modern society. "In the center Ages

the term riscium was used in highly explicit contexts, over all ocean trade and its

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ensuing authorized problems of loss and spoil." In the vernacular languages of the

16th century the words rischio and riezgo were used, both terms derived from the

Arabic word "رزق", "rizk", meaning 'to seek prosperity'. The introduction of this

happened in continental Europe, during interaction of Middle Eastern and North

African Arab dealers. The term risk in the English words emerged only in the 17th

century, and "looks to be brought in since continental Europe." When the terminology

of risk took ground, it replaced the older notion that thought "in terms of good and

bad fortune." Niklas Luhmann (1996) seeks to explain this transition: "Perhaps, this

was simply a loss of plausibility of the old rhetorics of Fortuna as an allegorical

figure of religious content and of prudentia as a (noble) virtue in the emerging

commercial society."

2. RISK

2.1. Defining RiskRisk is a concept that denotes the precise probability of specific eventualities. In

principle, the term of risk is autonomous as of the notion of value and, as such,

eventualities may have both helpful and unfavorable cost. Though, in common usage

the convention is to focus only on likely pessimistic impact to some trait of value that

may occur from a prospect event.

Risk can be definite as “the warning or likelihood that an action or incident will

negatively or constructively affect an organization’s capacity to accomplish its

objectives”. In easy terms risk is ‘Uncertainty of results’, either from pursue of a

prospect optimistic chance, or an accessible negative threat in trying to attain a

present goal.

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2.1.1. Definitions of risk

"Risk is a Combination of the likelihood of an occurrence of a hazardous event or

exposure(s) and the severity of injury or ill health that can be caused by the event or

exposure(s)" OHSAS 18001:2007

"Risk is the unwanted subset of a set of uncertain outcomes” (Keating)

Qualitatively, risk is proportional to both the expected losses which may be caused by

an event and to the probability of this event. Superior loss and superior event

probably result on the whole in a greater risk.

Regularly in the theme of literature, risk is defined in pseudo-formal form where the

mechanism of the description are unclear and distracted, for instance, risk is measured

as an sign of threat, or depends on coercion, vulnerability, impact and uncertainty.

2.2 Types of Risks

2.2.1 Fundamental Types of Risks

2.2.1.1Systematic Risk

Systematic risk influences a large number of assets. An important political occasion,

for instance, might affect quite a few of the resources in your portfolio. It is almost

impractical to protect yourself against this kind of risk.

2.2.1.2Unsystematic Risk

Unsystematic risk is at times referred to as "explicit risk". This class of risk affects a

very little amount of assets. An illustration is rumor that affects an explicit supply

such as an impulsive strike by workers. Diversification is the only way to protect you

from unsystematic risk.

2.2.2 Specific Types of Risks

2.2.2.1. Credit Risk

Credit risk is the risk that a company or individual will be unable to pay the

contractual interest or principal on its debt obligations. This type of risk is of

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particular concern to investors who hold bonds in their portfolios. Government bonds,

especially those issued by the federal government, have the least amount of default

risk and the lowest returns, while corporate bonds tend to have the highest amount of

default risk but also higher interest rates. Bonds with a lower chance of default are

considered to be investment grade, while bonds with higher chances are considered to

be junk bonds.

2.2.2.2. Country Risk

Country risk refers to the risk that a country won't be able to honor its financial

commitments. When a country defaults on its debt, this can harm the performance of

all other financial instruments in that country as well as other countries it has relations

with. Countryside risk is relevant to stocks, bonds, mutual funds, options and futures

that are issued within a particular country. This sort of risk is most frequently seen in

rising markets that have a severe debit.

2.2.2.3. Foreign-Exchange Risk

When spending in foreign countries you must think about the piece of information

that currency exchange rates can vary the price of the asset as well. Foreign-exchange

risk relates to all financial instruments that are in prevalence other than your local

currency. As an example, if you are a resident of America and invest in some

Canadian stock in Canadian dollars, even if the share value appreciates, you may lose

money if the Canadian dollar depreciates in relation to the American dollar.

2.2.2.4. Interest Rate Risk

Interest rate risk is the risk that an investment's value will change as a result of a

change in interest rates. This risk affects the value of bonds more directly than stocks.

2.2.2.5. Political Risk

Political risk represents the financial risk that a country's government will suddenly

change its policies. This is a major reason why developing countries lack foreign

investment.

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2.2.2.6. Market Risk

This is the most well-known of the entire risks. Also referred to as volatility, market

risk are the day-to-day fluctuations in a stock's price. Market risk concerns primarily

to stocks and options. As a whole, stocks are likely to achieve well during a bull

market and poorly in a bear market - volatility is not so much a cause but an effect of

certain market forces. Instability is a determinant of risk as it refers to the

performance, or "nature", of your speculation rather than the grounds for this

behavior. Because market movement is the reason why people can make money from

stocks, volatility is essential for returns, and the more unstable the investment the

more chance there is that it will experience a dramatic change in either direction.

3. Risk management

3.1 Introduction:Risk management is the identification, assessment, and prioritization of risks

followed by coordinated and economical application of resources to minimize,

monitor, and control the probability and/or impact of unfortunate events. The risk can

come from hesitation in monetary market, project failure, legal liability, credit risk,

accident, natural cause and disaster. The strategy to deal with risk contain transferring

the risk to a different party, avoiding the risk, dropping the pessimistic effect of the

risk, and tolerant a little or all of the cost of a particular risk.

3.2 Methodology

For the most part, these methodologies consist of the following elements, performed,

more or less, in the following order.

1. identify, characterize, and assess threats

2. assess the vulnerability of critical assets to specific threats

3. determine the risk (i.e. the expected consequences of specific types of attacks

on specific assets)

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4. identify ways to reduce those risks

5. Prioritize risk reduction measures based on a strategy.

3.3 Process1. Identification of risk in a selected domain of interest

2. Planning the remainder of the process.

3. Mapping out the following:

o the social scope of risk management

o the identity and objectives of stakeholders

o The basis upon which risks will be evaluated, constraints.

4. T o Define a structure for the activity and a schedule for identification.

5. Develop a study of risks concerned in the procedure.

6. Improvement of risks using accessible scientific, human and

organizational capital.

3.4 Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall

into one or more of these four major categories:

1. Avoidance (eliminate)

2. Reduction (mitigate)

3. Transfer (outsource or insure)

4. Retention (accept and budget)

3.4.1 Risk avoidance

It includes none performing an activity that could carry risk. An example would be

not buying a property or business in order to not take on the liability that comes with

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it. Another would be not flying in order to not take the risk that the air-planes was to

be hijacked. Avoidance possibly will appear the counter to all risks, but avoiding

risks also means down out on the probable increase that accepting the risk may have

permissible. Not entering an industry to keep away from the risk of failure also avoids

the likelihood of earning income.

3.4.2 Risk reduction

It involves methods that reduce the severity of the loss or the likelihood of the loss

from occurring. For example, sprinklers are designed to put out a fire to reduce the

risk of loss by fire. This means may origin a bigger loss by stream damage and as a

result may not be apt. Halon fire suppression systems may mitigate that risk, but the

cost may be prohibitive as a strategy. Risk management may also take the form of a

set policy, such as only allow the use of secured IM platforms (like Brosix) and not

allowing personal IM platforms (like AIM) to be used in order to reduce the risk of

data leaks.

Outsourcing could be an example of risk reduction if the outsourcer can demonstrate

higher capability at managing or reducing risks. In that situation companies

subcontract only some of their departmental requirements. For instance, a business

may outsource only its software advance, the developer of hard goods, or client

support needs to another company, while treatment the business organization itself.

This technique can focus more on business development exclusive of having to worry

as much about the manufacturing process, managing the development team, or

decision a physical position for a call center.

3.4.3 Risk retention

It involves accepting the loss when it occurs. True self insurance falls in this category.

Risk retention is a feasible policy for little risks where the price of insuring against

the risk would be greater over time than the total wounded constant. All risks that are

not avoided or transferred are retained by default. This includes risks that are so large

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or disastrous that they either cannot be insured against or the premiums would be

infeasible.

This may also be satisfactory if the possibility of a very large loss is small or if the

price to cover for greater reporting amounts is so great it would hold back the goals of

the organization too much.

3.4.4 Risk transfer

In the terminology of practitioners and scholars alike, the purchase of an insurance

contract is often described as a "transfer of risk." However, technically speaking, the

buyer of the contract generally retains legal responsibility for the losses "transferred",

meaning that insurance may be described more accurately as a post-event

compensatory mechanism. For example, a personal injuries insurance procedure does

not relocate the risk of a car mishap to the insurance business.

3.5 Risk-management plan

Select appropriate controls or countermeasures to measure each risk. Risk

improvement desires to be accepted by the proper level of supervision. The risk

management plan should propose applicable and effective security controls for

managing the risks. For instance, an experiential high risk of computer viruses could

be mitigated by acquiring and implementing antivirus software. A high-quality risk

executive plan is supposed to contain a plan for control implementation and

responsible persons for that trial.

3.6 Implementation

Follow all of the planned methods for mitigating the effect of the risks. Acquire

insurance policies for the risks that have been determined to be transferred to an

insurer, evade all risks that can be avoided without sacrificing the entity's goals,

diminish others, and hold the rest.

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3.7 Areas of risk management

As applied to corporate finance, risk management is the technique for measuring,

monitoring and controlling the financial or operational risk on a firm's balance sheet.

See value at risk.

The Basel II framework breaks risks into market risk (price risk), credit risk and

operational risk and also specifies methods for calculating capital requirements for

each of these components.

3.8 Financial risk managementFinancial risk management is the practice of creating economic value in a firm by

using financial instruments to manage exposure to risk, particularly credit risk and

market risk. Further type include Foreign trade, Shape, Volatility, region, Liquidity,

price increases risks, and so on. Parallel to broad risk management, monetary risk

management requires identify its sources, measuring it, and device to deal with them.

Financial risk management be capable of be qualitative and quantitative too. As in the

field of risk management, financial risk management focuses on when and how to

evade using financial instruments to supervise costly exposures to risk.

In the banking segment globally, the Basel Accords are usually adopted by

internationally lively banks for tracking, coverage and revealing operational, credit

and marketplace risks. The concepts of financial risk management change

dramatically in the international realm. Multinational Corporations [[MNC}] s are

faced with many different obstacles in overcoming these challenges.

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4. The Stock Market

4.1 HISTORY OF STOCK EXCHANGESIn 11th century France the courtiers de change was concerned with managing and

regulating the debts of agricultural communities on behalf of the banks. As these men

also traded in amount outstanding, they might be called the first broker.

Nevertheless, it is more probable that in the overdue 13th century goods traders in

Bruges gathered within the residence of a man called Van der Burse, and in 1309 they

institutionalized this until now informal meeting and became the "Bruges Bourse".

The plan reach rapidly in the region of Flanders and neighboring counties and

"Bourses" soon opened in Ghent and Amsterdam. The house of the Beurze family on

Vlaamingstraat Bruges was the site of the world’s first stock Exchange, in 1415. The

term Bourse is believed to have derived from the family name Beurze.

In the middle of the 13th century, Venetian bankers began to trade in government

securities. In 1351, the Venetian administration outlawed spreading rumors proposed

to inferior the price of government resources. There were people in Pisa, Verona,

Genoa and Florence who also began trading in government securities during the 14th

century. This was only likely since these were free city states lined by a council of

significant citizens, not by a duke.

The Dutch later started joint stock companies, which let shareholders invest in

business ventures and get a share of their profits - or losses. In 1602, the Dutch East

India Company issued the first shares on the Amsterdam Stock Exchange. It was the

17

first company to issue stocks and bonds. In 1688, the trading of stocks began on a

stock exchange in London.

o Corporate governance

o Creating investment opportunities for small investors

o Government capital-raising for development projects

o Barometer of the economy

4.2 PAKISTAN STOCK MARKETSPakistan has a total of 3 stock exchanges that are given below:

o Karachi Stock Exchange - KSE

o Lahore Stock Exchange – LSE

o Islamabad Stock Exchange – ISE

4.2.1 Lahore Stock Exchange It was established in October 1970 and is the second largest stock exchange in the

country with a market share of around 12-16% in terms of daily traded volumes. LSE

has 519 companies, across 37 sectors of the financial system, that are listed on the

Exchange with total scheduled capital of Rs. 555.67 billion having market

capitalization of approximately Rs. 3.64 trillion. LSE has 152 members of whom 81

are business and 54 are individual members.

4.2.2The Islamabad Stock Exchange (ISE) It was incorporated as a guarantee limited Company on 25th October, 1989 in

Islamabad Capital territory of Pakistan with the main object of setting up of a trading

and settlement infrastructure, information system, skilled resources, accessibility and

a fair and orderly market place that ranks with the best in the world. The reason for

institution of the stock exchange in Islamabad was to provide to the needs of less

urbanized areas of the northern part of Pakistan. At present there are 118 members

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out of which 100 are corporate bodies including commercial and investment banks,

DFIs and brokerage houses.

The supplementary 18 Members are individual persons who are well

learned, enterprising with progressive minded. At the moment there are 247

companies/securities listed including 6 Open- End Mutual Fund and 4 TFCS on the

Exchange with an aggregate capital of Rs. 526,487.571 million. The market

capitalization was at Rs. 358, 0474.104 million as on 30-04-2008. The pace of listing

has remained slow as the economy of the Country is under consistent pressure due to

internal as well as external factors.

4.2.3 The Karachi Stock ExchangeThe oldest exchange in Pakistan was established in 1947 and became a registered

company limited a few years later. Since then it has experienced a remarkable

progress with only 5 companies listed and 90 members on the Exchange in the 1950s

and 663 listed companies and 200 members in 2006.

In 2002, the Karachi Stock Exchange was renowned globally by the journal 'Business

Week' as one of the best performing stock markets in the globe.

The association in the Karachi Stock Exchange is restricted. Just 200 individual and

business entities can list as members in the KSE. In 2005, 162 members traded

dynamically on the Exchange. In addition, overseas business entities may also happen

to the members of the KSE with the state that the candidate member of the company

is a resident of Pakistan.

Karachi Stock Exchange is the major and most liquid trade and has been affirmed as

the “most excellent Performing Stock Market of the globe for the year 2002”. As on

December 31, 2007, 654 companies were listed with the market capitalization of Rs.

4,329,909.79 billion (US $ 70.177) having listed capital of Rs. 671.269 billion (US $

10.880 billion) The KSE 100 Index closed at 14075.83 on December 31, 2007.

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KSE has been well into the 6th year of being one of the Best Performing Markets of

the world as declared by the international magazine “Business Week”. Likewise the

US newspaper, USA Today, termed Karachi Stock Exchange as one of the most

excellent performing bourses in the globe.

5. Objective of the Studyo To determine the Effectiveness of the Risk Management Practice in Pakistan

Stock Market.

6. Research Questiono Are Risk Management Practices in Pakistan Stock Market in line or align with

the emerging Stock Markets (like Indian, Australian, and Russian etc)?

7. Issues behind the StudyThe emerging stock markets are very expose to risks and risks can be of various type

like credit risk political risk etc and risk can be of volatility of returns or it can

changing market conditions, uncertainty and dynamic business environment. That is

why it has been very important to manage the risk so that the uncertainty can be

minimized. Investors are seeking value on their investment but due to the volatile

market condition they are exposed many potential losses and this is the main issue

behind the study of risk management around the world in many different aspects to

minimize the risk through quality risk management practices.

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8. Limitations and Scope

Risk management is simply a practice of systematically selecting cost effective

approaches for minimizing the effect of threat realization to the organization. All

risks can never be fully avoided or mitigated simply because of financial and practical

limitations. Therefore all organizations have to accept some level of residual risks. If

risks are improperly assessed and prioritized, time can be wasted in dealing with risk

of losses that are not likely to occur. Spending too much time assessing and managing

unlikely risks can divert resources that could be used more profitably. Unlikely events

do occur but if the risk is unlikely enough to occur it may be better to simply retain

the risk and deal with the result if the loss does in fact occur. Qualitative risk

assessment is subjective and lacks consistency.

In the years leading up the financial crisis, some regulators identified weaknesses in

the risk management systems of large, complex financial institutions. Regulators told

us that despite these identified weaknesses, they did not take forceful action—such as

changing their assessments—until the crisis occurred because the institutions reported

a strong financial position and senior management had presented the regulators with

plans for change. Moreover, regulators acknowledged that in some cases they had not

fully appreciated the extent of these weaknesses until the financial crisis occurred and

risk management systems were tested by events.

In several instances, regulators identified shortcomings in institutions’ oversight of

risk management at the limited number of large, complex institutions we reviewed

but did not change their overall assessments of the institutions until the crisis began.

Risk evaluation and risk management instruments are difficult to use and monitor.

Understanding them often requires a good grasp of mathematics and statistics. It is,

consequently, not clear that audit-committee members without specialized training

would be up to monitoring the in-and-outs of coverage and even speculations

presented to them, often in rapid and very summary fashion.

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9. Background and JustificationThe primary justification for a formal risk assessment process is legal and

bureaucratic. Prioritizing too highly the risk management processes could keep an

organization from ever completing a project or even getting started. This is especially

true if other work is suspended until the risk management process is considered

complete. It is also important to keep in mind the distinction between risk and

uncertainty. Risk can be measured by impacts x probability.

Financial institutions need systems to identify, assess, and manage risks to their

operations from internal and external sources. These risk management systems are

critical to responding to rapid and unanticipated changes in financial markets.

Risk management depends, in part, on an effective corporate governance system that

addresses risk across the institution and also within specific areas of risk, including

credit, market, liquidity, operational, and legal risk. The board of directors, senior

management (and its designated risk-monitoring unit), the audit committee, internal

auditors, and external auditors, and others have important roles to play in an

effectively operating risk-management system. The different roles that each of these

groups play represents critical checks and balances in the overall risk-management

system, Regulators also have a role in assessing risk management at financial

institutions. In particular, oversight of risk management at large financial institutions

is divided among a number of regulatory agencies.

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Chapter .02

1. Literature Review

1.1 Defining RiskFor the purpose of these guidelines financial risk in organization is possibility that the

outcome of an action or event could bring up adverse impacts. Such outcomes could

either result in a direct loss of earnings / capital or may result in imposition of

constraints on company’s ability to meet its business objectives. Such constraints

pose a risk as these could hinder a company’s ability to conduct its ongoing business

or to take benefit of opportunities to enhance its business (Guidance for practitioners

2007).

Management of Risk (2007 Edition) Guidance for Practitioners

Regardless of the sophistication of the measures, companies often distinguish

between expected and unexpected losses. Expected losses are those that the bank

knows with reasonable certainty will occur (e.g., the expected default rate of

corporate loan portfolio or credit card portfolio) and are typically reserved for in

some manner. Unexpected losses are those associated with unforeseen events (e.g.

losses experienced by companies in the aftermath of nuclear tests, Losses due to a

sudden down turn in economy or falling interest rates). Companies rely on their

capital as a buffer to absorb such losses (Chapman 2004). Project Risk Management -

Processes, Techniques and Insights Chris Chapman, (2004)

” Risks are usually defined by the adverse impact on profitability of several distinct

sources of uncertainty. While the types and degree of risks an organization may be

exposed to depend upon a number of factors such as its size, complexity business

activities, volume etc, it is believed that generally the companies face Credit, Market,

Liquidity, Operational, Compliance / legal / regulatory and reputation risks. Before

overarching these risk categories, given below are some basics about risk

23

Management and some guiding principles to manage risks in organization” (Ward

2003) Stephen Ward (2003

1.2 Risk Management

“Risk Management is a discipline at the core of every financial institution and

encompasses all the activities that affect its risk profile. It involves identification,

measurement, monitoring and controlling risks to ensure that (Well-Stam, Lindenaar

& Kinderen & Bunt 2004): D. van Well-Stam, F. Lindenaar, S. van Kinderen, B.P.

can den Bunt (2004):

a) The individuals who take or manage risks clearly understand it.

b) The organization’s Risk exposure is within the limits established by Board of

Directors.

c) Risk taking Decisions are in line with the business strategy and objectives set by

BOD.

d) The expected payoffs compensate for the risks taken

e) Risk taking decisions are explicit and clear.

f) Sufficient capital as a buffer is available to take risk”

“The acceptance and management of financial risk is inherent to the business. Risk

management as commonly perceived does not mean minimizing risk; rather the goal

of risk management is to optimize risk-reward trade -off. Notwithstanding the fact

that companies are in the business of taking risk, it should be recognized that an

institution need not engage in business in a manner that unnecessarily imposes risk

upon it: nor it should absorb risk that can be transferred to other participants” (Vose

2008).

Risk Analysis: A Quantitative Guide David Vose (2008)

24

1.3 Levels of Risk Management Activities

In every financial institution, risk management activities broadly take place

simultaneously at following different hierarchy levels (Crouhy & Galai 2000). Risk

Management Michel Crouhy, Dan Galai, Robert Mark (2000)

1.3.1 Strategic level

It encompasses risk management functions performed by senior management and

BOD. For instance definition of risks, ascertaining institutions risk appetite,

formulating strategy and policies for managing risks and establish adequate systems

and controls to ensure that overall risk remain within acceptable level and the reward

compensate for the risk taken.

1.3.2 Macro Level

It encompasses risk management within a business area or across business lines.

Generally the risk management activities performed by middle management or units

devoted to risk reviews fall into this category.

1.3.3 Micro Level:

It involves ‘On-the-line’ risk management where risks are actually created. This is the

risk management activities performed by individuals who take risk on organization’s

behalf such as front office and loan origination functions. The risk management in

those areas is confined to following operational procedures and guidelines set by

management.

“Expanding business arenas, deregulation and globalization of financial activities

emergence of new financial products and increased level of competition has

necessitated a need for an effective and structured risk management in financial

institutions. A company’s ability to measure, monitor, and steer risks

comprehensively is becoming a decisive parameter for its strategic positioning. The

risk management framework and sophistication of the process, and internal controls,

used to manage risks, depends on the nature, size and complexity of institutions

25

activities. Nevertheless, there are some basic principles that apply to all financial

institutions irrespective of their size and complexity of business and are reflective of

the strength of an individual company’s risk management practices” (Chapman &

Ward 2002). Managing Project Risk and Uncertainty Chris Chapman, Stephen Ward

(2002)

1.4 Risk Evaluation/Measurement“Until and unless risks are not assessed and measured it will not be possible to control

risks. Further a true assessment of risk gives management a clear view of institution’s

standing and helps in deciding future action plan. To adequately capture institutions

risk exposure, risk measurement should represent aggregate exposure of institution

both risk type and business line and encompass short run as well as long run impact

on institution. To the maximum possible extent institutions should establish systems /

models that quantify their risk profile, however, in some risk categories such as

operational risk, quantification is quite difficult and complex. Wherever it is not

possible to quantify risks, qualitative measures should be adopted to capture those

risks. Whilst quantitative measurement systems support effective decision-making,

better measurement does not obviate the need for well-informed, qualitative

judgment. Consequently the importance of staff having relevant knowledge and

expertise cannot be undermined. Finally any risk measurement framework, especially

those which employ quantitative techniques/model, is only as good as its underlying

assumptions, the rigor and robustness of its analytical methodologies, the controls

surrounding data inputs and its appropriate application” (Borge 2001) The Book of

Risk Dan Borge (2001)

1.5 MisconceptionA popular misconception is that the objective of risk management is to eliminate risk.

In fact, firms appear to pick and choose among the types and degrees of exposures,

assuming those that they believe they have a competitive advantage in managing and

laying others off into the capital markets, or accepting small or moderate exposures

while insuring against catastrophic ones (Stulz 1996). Thus, a commercial bank may

26

accept credit risk but avoid interest rate risk, while an investment bank does the

opposite

1.6 Issues in Risk Measurement

1.6.1 Are Returns Normally Distributed?

Using the distribution of potential outcomes to measure risk is a great conceptual

advance, but it is a difficult one to implement. Estimation of a potential return

distribution is usually based on historical data, but the availability of such data is

often limited, and even when available, older data may have little forecasting value

because of institutional or structural changes in the environment. In particular,

estimation of the tails of the distribution, the area of special interest for risk managers,

is difficult, since by definition the number of observations in the tails is limited

(Shanley 1996). (Mark Shanley. 1996)

1.6.2 Serial Correlation

An attractive simplification when analyzing risk is to assume serial independence,

that is, that outcomes are not correlated over time, so that the outcome next period

does not depend on the outcome this period. The assumption of serial independence

has two major implications. If outcomes are serially independent, then the standard

deviation of returns increases with the square root of time. That is, daily data can be

used to estimate weekly, monthly, or annual volatility by multiplying the standard

deviation of the daily data by the square root of the number of trading days in the

longer period (Frederic 1999). (Frederic M. 1999)

1.6.3 Correlation among Outcomes

(William R. Nelson. 1999) Nelson (1999) explained that in measuring the risk

exposure of a firm or financial institution, the estimation of the correlation among

27

asset returns is as important as or more important than the estimation of the

distribution of the individual asset returns. This is so because the risk of a portfolio of

assets depends not only on the stand-alone risks (standard deviations) of the

individual assets but also on the correlation (covariance) among them (Antulio 1999).

Bomfim, Antulio(1999) Unless the different assets are perfectly positively correlated,

then the assets will act as partial natural hedges for each other, so that diversification

of the portfolio among different asset types provides an inexpensive and readily

available means to mitigate risk (Federal Reserve Bulletin, June, pp. 369–95).

1.6.4 Risk Ignorance

Merton H. Miller. (1995). Miller (1995) in his studies said that assumptions of

normality, serial independence, or non-varying return correlation are all examples of

“model error.” Model error occurs when the potential exposure is recognized but

misestimated because some parameter of the distribution of outcomes is

misestimated, or because the correlation between different risks is misestimated.

Journal of Model error often results either because managers make inappropriate ex

ante assumptions concerning the shape of the distribution, or because the conceptual

models fail to capture some important aspect of reality (Applied Corporate Finance,

Winter, pp. 62–76).

But a second and extreme form of risk measurement error occurs when the firm fails

to recognize it has any exposure whatsoever. Such a case might be termed “risk

ignorance (Christopher 1995). Culp, Christopher (1995)

1.7 Risk Mitigation

“A firm does not necessarily have to accept a particular distribution of outcomes, but

often can modify the probability of adverse outcomes through its own efforts. These

efforts to alter the distribution of outcomes can be termed “risk mitigation.” To the

extent that a firm successfully mitigates its risks, then its distribution of outcomes will

be less extreme, and it will require less equity capital than if it had undertaken no risk

mitigation (Pan 1997). Jun Pan (1997)

28

Duffie, Darrel (1997) Darrel (1997) explained that risk mitigation can take a number

of different forms. Perhaps the two most obvious are the purchase of insurance, where

the firm pays an unrelated third party to assume the exposure, and hedging, where the

firm takes an offsetting position in a security, commodity, or currency that is closely

correlated with the exposure it wishes to mitigate. But firms also employ a number of

other measures to mitigate exposures, including market research, geographic and

product line diversification, screening and monitoring of customers, outsourcing,

imposing risk premiums in pricing products, carrying inventories or slack in

productive capacity, and imposing defined procedures designed to minimize

operational risks (The Economist 1996). (The Economist 1996 “Coming A Cropper in

Copper)

Eugene F. (1965) According to Eugene (1965), Risk mitigation efforts may be

ineffective for a number of reasons. Perhaps the best known is agency risk, the risk

that a manager or employee, inadvertently or purposefully, will fail to follow the

policies or procedures designed to mitigate risk. For example, a rogue trader whose

compensation or tenure is dependent upon his trading results may fail to abide by

position limits or hide cumulative losses, or maintenance personnel may overlook an

incipient equipment failure. Agency risk has been responsible for a number of

notorious episodes, including the bankruptcies of Orange County and Barings, and

the large losses of Sumitomo (Fama 2000).

1.7.1 Risk Migration

But risk mitigation efforts can also fail for more subtle and indirect reasons (Stephen

1994). The first is the tendency for risk to shift or change form. While an individual

firm may mitigate its risks by purchasing insurance or hedging, these actions do not

reduce systemic risk in the economy, but only transfer it elsewhere ( Figlewski- The

Journal of Derivatives). Moreover, in many cases hedging or purchasing insurance

does not really transfer risk, but merely transforms the nature of the exposure.

29

1.8 Implications

1.8.1 Implications for Managers

Longin & Solnik (1995) explained the existence of non-normality in returns, positive

serial correlation and state-sensitive correlation in returns means that managers must

view their ability to forecast the distribution of future outcomes with some

skepticism. Use of simplifying assumptions such as normality is likely to result in

significant underestimation of the probability of seriously adverse outcomes. Many

institutions have recognized the danger of building their risk management processes

upon assumptions such as normality, and have developed approaches that address

model error (Journal of International Money and Finance, vol. 14, pp. 3–26).

1.8.2 Implications for Regulators

As noted above, risk tends to migrate in the financial system. In particular, hedging

does not reduce systemic risk, but only transfers the exposure elsewhere or transforms

the type of the exposure (Rol & Richard 1988). Thus, risk migration has three

important implications.

First, because risk mitigation activities such as hedging do not reduce the amount of

systemic risk in the system, they also do not reduce the aggregate amount of equity

capital needed to absorb this risk (Parsons 1995). J. E. Parsons. (1995) That is, the

amount of equity capital needed system wide is independent of the amount of risk

mitigation that is undertaken.

Second, the greater the amount of risk mitigation undertaken through hedging or the

purchase of insurance, the more likely that unforeseen losses will migrate quickly

from one market to another, or from one country to another. Journal of Applied

(Corporate Finance, Spring, pp. 106–20) That is, while hedging acts to reduce

independent risk, it can enhance systemic risk.

30

Finally, as risk migrates through the system, it tends to emerge in its most basic form,

as credit risk. This tendency for errors in risk management to ultimately emerge as

credit exposures means that those institutions that specialize in managing and

absorbing credit risks, that is, commercial banks, play a special role (Mello 1991).

Mello, A. (1991)

2. The Influence of Enterprise Risk Management on Stock Market performance

2.1 OverviewThe performance of ERM of the financial sector is limited within hedging activities

of the firm (Stulz 1996; Nacco & Stulz 2006). (Stulz, R. M., 1996; Nacco, B. W., &

Stulz, R. M., 2006) The financial literature suggests that firms should hedge based on

the understanding of efficient market hypothesis of finance. In practice, market is not

efficient and shareholders, at least in theory, do not value firms risk management

initiatives. They can manage their unsystematic risk through diversification. In

contrast, the strategic management literature argues that risk management provides

competitive advantage (Collins & Ruefli, 1992; Miller 1998). However, such

theoretical perspectives about the performance of risk management always remain

inconsistent and mutually exclusive.

In fact, the understanding of risk management could provide contrasting views if

analyzed either from management theories or finance theories. Notwithstanding,

ERM should the theorized by integrating these two matured disciplines while giving

appropriate weights considering the purpose and resource of the specific organization.

Despite several attempts of academics e.g., (Hoyt & Liebenberg 2008) the ultimate

question that still remains unanswered whether ERM above disciplinary silos add

value to the firm. Notwithstanding, all the previous studies were unable to provide a

single indicator in measuring firms risk management capabilities. In such incomplete

theoretical foundation, the study, in line with the asymmetric information theories,

31

accepts insurers’ stock market performance as the ultimate indicator of the

combination of both perspectives.

In line with the conclusion of Mehr & Forbes (1973) the study assumes that the

increase of shareholder value (i.e., finance theory expectation) and achievement of

competitive advantage (management theory expectation) is truly reflected in insurers’

superior stock market performance. Alternatively, the performance of ERM has been

aligned with the overall performance of the organization in the stock market.

Consequently, the hypothesis of the study is that in normal situation insurers’ stock

market performance is positively correlated with the performance of ERM. It is

further hypothesized that if the stock market performance of the insurer maintains an

increasing trend then it can be assumed that the ERM is functioning well. In other

words, ERM practicing insures will demonstrate superior stock market performance.

If the trend is negative then the performance of ERM is not up to the industry level.

2.2 Purpose of Enterprise Risk ManagementLiebenberg & Hoyt (2003), Beasley et’el (2005) suggested the purpose of ERM is to

achieve and balance between the three key objectives. They are

1. Optimization of the risk-adjusted returns for investors;

2. Maintenance of the capital strength required to support firm’s businesses and

future growth opportunities; and

3. Maintenance of capital and risk governance requirements of regulatory and

rating agencies.

2.3 Illustrating Some Major Events

1. September 11 incident: World Trade Center losses in 2001 impacted the insurance

industry over USD 21bn (Swiss 2004). As a result the economy experienced

strong rate increase in the reinsurance market despite government’s bailout to

risky by the insurance industry, in particular, insurance.

32

2. 2001-2002 credit crises: Following the long bull market from 1982 to 2000 the

world stock market crashed in 2002. The market capitalization plunged by billions

of dollars where price losses in the US capital market was calculated at USD

7,000 billion since March 2000.

3. 2004 US Hurricanes: In 2004 the capital losses from hurricane Charley, Frances,

Ivan and Jeanne were priced at USD 28 billion and the economic losses were

calculated at USD 56billion (Swiss 2005).

4. 2005 KRW worst ever insurance loss: The equity market losses from hurricane

Katrina, Rita and Wilma (KRW) in 2005 are estimated at USD 65 billion and total

damage to the economy is calculated at USD 170bn (Swiss 2006). A recent study

conducted by Aon stock price reaction to KRW found that the stock price of

insurance companies were more sensitive to a single large loss rather than to an

aggregation of loss events. The study concludes that companies can illustrate

better stock market performance if they introduce an ERM to manage the

catastrophic losses.

5. 2002 D&O related losses from Enron & WorldCom: Several in settled substantial

amount of losses for D&O related losses arising from the collapse of Enron and

WorldCom. Thereafter the cost of D&O insurance went up 260% from mid-2001

to mid-2003, driven by the lawsuits that arose from the wake of accounting

scandals of these companies.

6. 2007-2008 subprime mortgage crisis and subsequent financial meltdown: The

subprime mortgage crisis threatens some well ranked institutional investing

companies those have exposure on the structured financial products (e.g., CDOs).

Although the insurance industry as a hold does not hold large exposure on the

financial market due to that crisis the life insurance industry are much affected by

interest rate falls.

33

In addition, the industry is affected by 2008 equity market disruption which

eroded their investment income and reduced their capital reserves. There is no

enough information about the ERM initiatives of insurance companies. Although

several insurers realized the need of ERM, there is no consistent understanding

and framework of ERM in the global insurance industry (Acharyya & Johnson

2006). In addition to the industry recognition, the regulators and rating agencies

emphasis on the holistic management of insurers risk. Some rating agencies, in

particular S&P and A.M. Best, take insurers’ ERM initiatives on their financial

strength rating process. Despite the initiatives of several parties it is not still clear

which insurance company is practicing ERM, in particular, what is the correct

structure of their ERM and how are they implemented and how are the

performance of their ERM is evaluated.

In this circumstance, it is difficult to research on the ERM initiatives of insurers

from an empirical perspective. With these limitations the study hold the view that

ERM is the management of all risks irrespective of type whether it comes from

financial and non-financial activates of the insurer. Indeed, such concept is purely

theoretical and difficult to formulate in mathematical terms. The selection of

performance measurement criteria of ERM is even difficult in the lack of market

consistent infrastructure and understanding.

3. Stock Market Volatility and Risk Management

The existence of uncorrelated returns in international stock markets is fundamental in

a context of global portfolio diversification. In presence of high stock market

volatility, risk management represents the main aim for portfolio managers and

international diversification is the key to achieve it. Since the first work by Solnik

(1974) up to some recent papers such as Heston and Rouwenhorst (1994) and Gri¢ n

and Karolyi (1998), evidence on the advantages of cross-country diversification has

been the focus of extensive research.

34

Many investors believe that cross-border diversification increases risk while most of

the literature on this topic provides evidence of its value as a risk reducer. Numerous

studies have investigated international diversification using various methodologies

and dataset. Starting from the early studies by Grubel (1968) and Levy and Sarnat

(1970) ending with the work by Longin and Solnik (2001) have shown different

results on this issue. The early works in the 70s witnessed that correlations among

national stock market returns were low and national markets were largely responding

to domestic economic fundamentals. In the eighties the use of stochastic calculus to

analyses financial markets brought evidence of high and statistically significant level

of interdependence between national markets.

The hypothesis that global markets were becoming more integrated could be verified.

In the last decade, recent studies using larger data set have shown some interesting

results, supporting partially both findings. The main assumption is that certain global

extreme events, i.e. the 1987’s stock market crash, the Kuwait’s invasion by Iraq, the

terrorisms attack in 2001, tend to move world equity markets in the same direction,

thus reducing the effectiveness of international diversification. On the other hand, in

the absence of global events national markets are dominated by domestic

fundamentals and international investing increases the benefits of diversification. In

this paper we want to investigate this assumption using the common trend and

common cycle methodology (Vahid & Engle 1993).

The idea of testing if a set of economic variables move together and identifying

possible co-movements among time series has a long history in economics. Recent

econometric application study the common components in time series using co-

integration and common trends as in Granger (1983) Engle and Granger (1987),

Stock and Watson (1988), common features (Engle & Kozicki 1993) and

codependency (Gourieaux et al. 1991). Co-movements among time series indicate the

existence of common components which would imply a reduction to a more

parsimonious and probably more informative structure. An indicator of co-

35

movements among non stationary variables is co-integration, when the variables are

co-integrated they share some common stochastic trends that drive their long run

swings and at least one linear combination of them exists which has no long swings,

i.e. it is stationary. This methodology has been widely applied to understand the

dynamic of macroeconomic phenomena, i.e. to investigate to what extent business

cycles are transmitted from one country to another, while, in our knowledge, little

evidence of its application to financial data could be found. Hecq (2000); Mills

(2002) and Sharma et al (2002) are the only examples of application of such

methodology to decompose a financial time series using the Beveridge-Nelson

approach. Hecq studies the nature of the relationship between five major international

stock market indices trying to identify a long run component and a cyclical

component, and controls the presence of external shocks using dummy variables. He

uses quarterly data in real US dollars taking the third observation of monthly data in

order to avoid conditional heteroskedasticity problem.

Mills sets up a VECM framework to investigate the presence of common trend and

common cycles of the UK financial markets. He uses weekly data for the period

1969-95. Sharma et al. analyze the degree of long term and short term co-movements

in the stock markets of five Asean countries trying to shed some light on the long-

term and short-term market efficiency/inefficiency in the region.

4. Calculating Value-at-Risk

4.1 OverviewIn volatile financial markets, both market participants and market regulators need

models for measuring, managing and containing risks. Market participants need risk

management models to manage the risks involved in their open positions. Market

regulators on the other hand must ensure the financial integrity of the stock exchanges

and the clearing houses by appropriate margining and risk containment systems

(Varma 1999).

Prof. Jayanth R. Varma (July 1999)

36

The market risk of a portfolio refers to the possibility of financial loss due to the joint

movement of systematic economic variables such as interest and exchange rates.

Quantifying market risk is important to regulators in assessing solvency and to risk

managers in allocating scarce capital. Moreover, market risk is often the central risk

faced by financial institutions. Investment and commercial banks, as well as treasury

operations of many corporations, hold portfolios of complex securities whose value

depends on exogenous state variables such as interest and exchange rates. To allocate

capital, assess solvency, and measure the profitability of different business units

(ranging from individual traders to the entire bank), managers and regulators quantify

the magnitude and likelihood of possible portfolio value changes for various forecast

horizons. This process is often referred to as “measuring market risk”, which is a

subset of the risk management function.

4.2 Measurement of RiskVAR can be derived by placing assumptions on each of these two elements (Garbade

1986; Morgan 1994; Hsieh 1993 & Wilson 1994).

(1) The portfolio function approximation method.

(2) The state variable approximation method.

Garbade (1986), J.P. Morgan (1994), and Hsieh (1993) assume that changes in the

portfolio function can be well-approximated by the delta3 of the portfolio, but differ

in how changes in the state variables are modeled. Garbade (1986) assumes that

changes in the state variables over the forecast period can be modeled as a

multivariate normal (the delta-normal model) J.P. Morgan (1994) refines the

modeling of the changes in the state variables to reflect non-linearity’s by weighting

the residuals in computing the variance (the delta-weighted normal model). Hsieh

(1993) further generalizes the modeling of the evolution of the state variables with an

EGARCH model (the delta-GARCH model). Wilson (1994) enhances the modeling of

the portfolio function but reverts to the Garbade (1986) assumptions on the state

37

variables. Wilson (1994) models the convexity of the portfolio by explicitly

incorporating the gradient and Hessian of the portfolio function (the gamma-normal

model).

Chapter.03

Research Methodology

1. Overview: Financial risk management is always one of the important topics either in theory or in

practice. In the last 25 years, international financial market has developed greatly, and

financial storms have much influence on human’s entire economic behavior with the

mode of over imagination. In early 1990’s, a kind of new risk management

methodology was developed, which is VAR methodology. Value at Risk

methodology is becoming to be the international standard of risk measurement.

The market risk of a portfolio refers to the possibility of financial loss due to the joint

movement of systematic economic variables such as interest and exchange rates.

Quantifying market risk is important to regulators in assessing solvency and to risk

managers in allocating scarce capital. Moreover, market risk is often the central risk

faced by financial institutions.

2. Research Design: It will be both qualitative and quantitative study because the study “Risk management

Practices” is basically focused on the system, policies and measures taken to

minimize the risk faced by investors in stock markets and the analysis will be done on

the basis of both market data and risk management practices guidelines therefore,

study is both Qualitative and Quantitative.

38

3. Procedure: The Steps in which study will be completed:

Step .01 The policies and guidelines of Risk Management from sample stock market

will be collected for analysis. Following are some of the factors on the basis of that

risk management analysis will be done based on the comparison of effectiveness and

efficiency of these factors in Pakistan stock Market and the emerging stock market

(Australia, India and Russia).

o Eligibility of Listings

o Clearing

o Mark to Market Procedures

o Services and Products

o Originations of Products

o Netting and etc

Step.02 In the second step, market performance will be compared with and without

risk management factors to check the effectiveness of the guidelines of the Risk

management.

4. Software employed: The Software that will be used is Spreadsheet.

5. Research Schedule: The time frame of this research is approximately one year.

39

6. Population: The Population of the study is the Equity Market of Pakistan. The study is intended to

find out that whether or not risk management practices in Pakistan stock markets are

align with that of stock markets of emerging countries like Australian, Indian and

Russian stock Markets.

7. Sample: Karachi Stock Exchange is the sample of this study. Equity market of Pakistan is

consisting of Karachi Stock Exchange, Lahore Stock Exchange and Islamabad Stock

Exchange. Since the KSE is one of the best performing stock market of Asia and

characterize with the high level of volatility and its market capitalization is higher

than that of other stock exchanges in Pakistan that is the reason KSE is taken as

sample of this study. This sample that is taken is “Convenience sampling” based on

convenience to cover KSE.

8. Measurement Selection: Data collection method will be secondary i.e. all the data from risk management

guidelines and market performance will be taken of the selected stock markets.

40

Chapter.04

Data Analysis and Findings

4.1 Best Risk management practices of emerging Stock market

Following are the best practices of risk management in emerging stock markets (Australia, Malaysia, Bombay, New York and London Stock exchange)

4.1.1 Listing Eligibility:

Bombay Stock Exchange, the companies need to have minimum market capitalization

requirements of Rs.250 millions and minimum public float of 100 million because

India is a growing market and its stock exchange consists of huge number of big

companies i.e. 4900 therefore their capital requirements are higher than KSE. In

London Stock Exchange, the company must have requirement of minimum market

capitalization of 700000 pounds with a minimum public float of 25%. To be listed on

NASDAQ, a company must have issued at least 1.25 million shares of stock worth

$70 million, and to get listed on NYSE, a company must have issued shares worth

$100 million and must have earned $10 million over 3 years. All the bigger stock

exchanges have different requirements to get listed which solely depend on their

market capitalization.

4.1.2 Products portfolio

41

Diversification is the most important component to help you reach your long-range

financial goals by investing into variety of product portfolio while minimizing your

risk. No matter how much diversification the investors opt for, it can never reduce

risk down to zero.

The diversification could be achieved through various means and they are:

Diversifying the portfolio by investing it among different investment avenues

like stocks, bonds and mutual funds can reduce risk.

The securities that the investors invest into vary in the risk factor and they are

not restricted to pick only blue chip companies but picking different

investments with different rates of return ensures that the large gains offset

losses in a particular area.

The securities that the investors invest into should vary by industry and

minimize the unsystematic risk to small group of companies. The theory of

portfolio suggests that after investing into 10-12 diversified stocks, the

investors achieve diversification and hence, they need to buy stocks of

different sizes from various industries.

Diversification substantially reduces risk with little impact on potential returns. The

key involves investing into categories or securities that are dissimilar because their

returns are affected by different factors and they face different kinds of risks.

Diversification among the major asset categories such as stocks, fixed-income and

money market investment can help reduce market risk, inflation risk and liquidity

risk, since these categories are affected by different market and economic factors.

There are various products being offered by KSE so that investors invest into the

portfolio of securities and diversify their risk. It is basically one of the most efficient

techniques to decrease risk by diversifying it. Apart from that, the customized

services and infrastructure being provided by KSE also saves investors from high

risk. Fully automated system for clearing, trading and settlement minimizes the

chances of fraud and hence, give crystal clear picture for trading of stocks. KSE is

continuously adopting changes in order to have safe and secure transaction therefore;

42

they have installed internet routed trading facility and gateway trading i.e. Order

Management System. To avoid risk and provide secure transaction, investors and

fund managers also have an access to information through Display Only Terminal. To

ensure security of data and to maintain it, brokers are connected to KSE through VPN

which a unique identity is provided to each broker to have protected transaction.

KSE tickers are displayed on all business TV channels through live feeds from KSE

system so that investors have an idea of the prices of various stocks and take decision

to invest into the stocks of certain company. Customized data is provided to investors

for the purpose of trading and assessment of their portfolio. Moreover, KSE website

provide market data on real time basis which includes company’s profiles, their

financial position and summary of marketing activities that are going on in that

company which provides a clear picture of companies to the investors where they

intend to invest and hence, minimizes the risk of loss.

4.1.3 Netting

While identifying the best practices for Netting, the question arises that from whose

perspective the best practices should be identified either from a single ISO’s

perspective or from ISO market participants’ perspective. For netting, the financial

impacts on market participants should be considered and the Subcommittee has

decided that the “best’ should be defined from ISO market participants’ perspective

along with the systematic impacts. Because these ISOs exist to serve the markets and

their market participants are responsible for bearing the default risks, the market

participants’ perspective seems appropriate. As there is a variety of market

participants, the best practice for netting varies by the type of these participants. For

example, a small municipality may find the main source of its netting benefits from

Intra-ISO netting rather than Inter-ISO netting. Therefore, the municipality’s

preferred “best practice” for netting may be the solution with the lowest direct impact

on ISO administrative fees. Alternatively, a power generator using natural gas located

43

in multiple markets may find that it receives more netting benefits from

Inter-ISO/Cross-Market (including OTC natural gas) netting. Therefore, the generator

might find the “best practice” for netting as a solution that maximizes the netting

across multiple ISO and physical OTC power and natural gas markets.

Some of the best practices for Intra-ISO netting and Inter-ISO netting are as under:

Best Practice for Intra-ISO Netting: This approach obtains a security interest in the

market participant’s positions and receivables to be a low cost way to protect ISOs

and other market participants and allow them netting off against other obligations to

the ISOs. The market participants who materially benefit from Intra-ISO netting will

need to bear the incremental cost and complexity of re-arranging their security

interest agreements with financial or other entities.

Best Practice for Inter-ISO/Cross-Market Netting: The global best practice for

Inter-ISO/Cross-Market Netting is reflected in the European experience with

European Commodities Clearing and NASDAQ OMX in which there is netting

across ISO, OTC and exchange markets using a third party clearinghouse. Since ISOs

parallel other Central Counterparty type marketplaces, it seems logical that ISOs

interfacing with clearinghouses or other Central Counterparty entities would bring

greater capital and credit risk management efficiencies.

4.1.4. Mark to Market:

Market risk is significant in public investment portfolios. Due to price volatility,

valuing investments at their current price is necessary to provide a realistic measure

of a portfolio’s true liquidation value. Over time, reporting standards for state and

local government investment portfolios have been enhanced so that investors,

governing bodies, and the public remain informed of the current market value of the

portfolio. Regular disclosure of the value of a governmental entity’s investments is an

44

important step to furthering taxpayer and market confidence in state and local

government investment practices. The Government Finance Officers Association

(GFOA) recommends that state and local government officials responsible for

investment portfolio reporting determine the market value of all securities in the

portfolio on at least a quarterly basis. These values should be obtained from a

reputable and independent source and disclosed to the governing body or other

oversight body at least quarterly in a written report.

It is recommended that the written report include the market value, book value, and

unrealized gain or loss of the securities in the portfolio. If there is a significant event

in the local or national economy that might affect the value of the portfolio, then a

mid-term valuation of the portfolio should be conducted. Governments that employ a

more active portfolio management style should consider more frequent marking to

market and reporting.

4.1.5 Clearing and settlements:

In the context of securities clearing and settlement systems, the nature of governance

planning acquires a dimension that goes beyond their traditional function in corporate

law. They comprise a tool for regulators and central banks to achieve their respective

policy goals relating to market operation, market integrity, and systemic stability.

Whatever the model of corporate governance used in a jurisdiction, securities clearing

and settlement systems should adopt and ensure effective implementation of the

highest corporate governance standards or best practices adopted or recommended for

companies in the authority in which it operates as such standards or practices evolve

over time. Generally, this would imply that securities clearing and settlement systems

at minimum should adopt and implement the best practices recommended for listed

companies. Additionally, a securities clearing or settlement system should adopt

corporate governance mechanisms adequate to address the interests of users and the

public in the operation of the system. Board members should also take into account

the interests of users and the public in board decisions, in particular, those relating to

qualifications for system access, fair pricing, and the integrity of the risk management

45

system, innovation and efficiency, and the achievement of the policy objectives of

competent authorities. Securities clearing and settlement systems should make

adequate disclosures regarding their corporate governance arrangements so that users

and the public can ascertain the manner in which conflicts of interest among owners,

the board, users and the public interest are prevented or mitigated. Corporate

governance arrangements of securities clearing and settlement systems should be the

subject of adequate regulation and oversight to ensure that services are provided at

fair prices to users under fair and equitable conditions of access; that the risk

management programs of system operators are effective; that risk management

decisions are not affected by considerations extraneous to the risk management

function; and that, to the maximum extent possible, functional service providers

compete in equivalent conditions of competition. Looking forward the adoption of a

harmonized regulatory regime for securities, clearing and settlement systems should

be considered to complete the internal market within the Community and to better

achieve the policy goals relating to the governance of those systems.

4.2 Benchmarking of Risk Management Practices

Based on above best practices of risk management of emerging stock market we can set a benchmark.

Factor Best practice

Eligibility of Listing

Minimum Market Capitalization Range $50 million above.

Netting

Intra-ISO Netting: best practice of netting Small Investors who are usually risk averse is to transact within the market with different investors of same risk and return characteristics to net off their obligations.

Inter-ISO/cross Market Netting: Best practice defines that the large investors

46

should net off their obligations cross markets.

Mark to Market

Valuing Investments at their current price to provide a realistic measure of portfolio’s true liquidation value.

Over time, Reporting, standards for state and local governments investment portfolio have been enhanced so that investors, governing bodies, and the public remain informed of the current market value of the portfolio.

Standards reports should include market value, book value and unrealized gain or loss of the securities in the portfolio.

Product Portfolio

Diversifying the portfolio by investing it among different investment avenues like stocks, bonds and mutual funds etc.

Securities that the investors invest into vary in the risk factor.

The securities that the investors invest into should vary by industry and minimize the unsystematic risk

Clearing and settlements

Securities clearing and settlement systems should adopt and ensure effective implementation of the highest corporate governance standards.

Corporate governance mechanisms to address the interests of users and the public in the operation of the system.

Corporate governance arrangements so that users and the public can ascertain the manner in which conflicts of interest among owners, the board, users and the

47

public interest are prevented or mitigated.

Clearing and settlement systems should be the subject of adequate regulation and oversight to ensure that services are provided at fair prices to users under fair and equitable conditions of access.

4.3 Analysis of Risk Management Practices at KSE

Karachi Stock Exchange was established for the purpose of assisting, regulating and

controlling business of buying, selling and dealing in securities. It provides a market

for trading of securities to individuals and organizations who want to invest their

saving through purchase of shares in Stock Exchange and it provides a physical

location for buying and selling of securities. Risk in stock market is an ordinary

phenomenon. If half of the investment is lost, you must double your returns in order

to reach break-even. Managing risk in stock markets first need to require identifying

the type of risk and take actions to minimize the impact of risk on your investments

portfolio. In order to minimize risk, investors firstly need to invest with the trend of

the market which can reduce the likelihood that your stock will fall when market

trend is rising. Secondly, investors need to diversify their investment portfolio across

different companies and sectors. By following these guidelines, a company or

investor could make fine and sound investment without any fear of risk or loss.

Following are some of the factors on the basis of which risk management analysis

will be done on comparative basis of effectiveness and efficiency of these factors in

Pakistan stock Market and the emerging stock market (Australia, India and Russia).

4.3.1 Eligibility of Listing:

Listing requirements are the set of conditions imposed by a given Stock Exchange

upon companies that want to be listed. These conditions include minimum number of

48

shares outstanding, minimum market capitalization and minimum annual income.

Investors or companies who are interested in investing into the stocks of any country,

they need to be eligible for investing and must meet all the criteria which allow them

to invest into the stocks of certain company. For any investment company to be listed

on KSE, several regulations need to be followed in order to reduce risk and help

investors to maintain their rights.

No company will be listed on KSE unless it is registered under the Ordinance

as a public Limited company and its minimum paid-up capital is Rs.200

million.

To succeed public offer of equity, it has to be subscribed by at least 500

companies.

The offering document has to be cleared by KSE before it is submitted to

SECP for approval.

The company who is seeking to list is required to fulfill the relevant

requirements of exchange under the listing regulations and the disclosures as

required under the second schedule of company’s ordinance 1984 and

company’s rules 1996 (KSE Website).

All these regulations for listing need to be followed in order to maintain safe

investment and avoid deregulations. All the investors and companies are required to

register under Ordinance as a public limited company with Rs.200 million paid-up

capitals in order to insure that companies are capable enough to pay for its losses if

any occur while investing into securities. Moreover, the companies need to invest into

a portfolio of shares in order to diversify risk and more capital is required to invest in

those securities. Therefore, these companies need to subscribe themselves by 500

companies and kept clearing by KSE.

4.3.2 Products and services:

49

KSE offers several products and services to its investors to invest in the portfolio of

investments and diversify their risk. Their products include ready market; cash settled

future market, deliverable future market and stock index future market. Ready

market is also known as regular market where sellers and buyers gather for the

intention of trade and the settlement of trade occurs after 2 days after trade. All the

short term investments are done into Ready Market whose settlement period is less.

Cash settled futures are standard contracts to buy or sell certain instruments at a

certain date in future at specified price and settlement period is 30, 60 and 90 days

after purchase of contract. All settlement occurs purely on cash basis. Stock index

futures are traded in the number of contracts where settlement occurs after 90 days of

purchase of contract. Deliverable futures are forward contracts to buy and sell

certain instruments and settlement period are 30 days after purchase.

Services provided by Karachi Stock Exchange are:

They provide customized services and state-of-the-art technology

infrastructure which give it an edge over other exchanges in the country.

It provides fully automated trading, clearing and settlement system.

Internet routed trading facility and gateway trading (Order Management

System)

Investors and fund managers can also access information through Display

Only Terminal

Internet trading facilities are available and order driven system

Brokers are connected to KSE through VPN (to ensure security of data)

Moreover it provides data services which are:

KSE tickers are displayed on TV channels through live feeds from KSE

system

Investors provided customized data packages for trading and assessment of

their portfolio on a real time basis.

50

Data feed provided to major international redistributors (Reuters, Bloomberg)

on real time basis.

KSE website offers data of market on real time basis, including listed

company profiles, snap shot of financials, press releases and summary of

market activities on real

time basis.

4.3.3 Netting:

In the local context, netting means offsetting sales and purchases by a broker in each

security to reduce his cumulative unsettled trades called “exposure.”

Netting refers to allowing positive value and a negative value to set-off and cancel

each other out to terminate their effect. Netting decreases credit exposure, increases

business with existing counterparties, and reduces both operational and settlement

risk and operational costs.

Netting is used in energy and other markets to reduce cash requirements and credit

exposure. Such exposure can be reduced by “netting” such transactions together, as

long as the proper legal documents and appropriate risk processes are in place.

According to the netting rules, exposure of each member will be calculated by

security wise, client-wise and market-wise by Exchange trading system at any point

in time. No netting of open positions will be allowed across markets.

Two types of netting are there:

Intra-ISO netting

Inter-ISO and cross-market netting

Intra-ISO Netting means an ISO would net the buys and sells of “comparable”

transactions with any one member.

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Inter-ISO/Cross-Market Netting has a couple dimensions. First, it could include

netting of transactions across multiple ISOs. A second dimension of the

Inter-ISO/Cross-Market Netting is the netting across ISO and OTC markets.

The Netting Subcommittee searched for “best practices” and several guidelines were

provided. First, for a practice to be a “best practice” it had to be an existing practice at

one of the power markets. Preferably, this “best practice” would exist at a US ISO,

but the Subcommittee did look to other ISOs around the world.

4.3.3.1 Netting rules at KSE:

Netting within Ready Markets: Netting shall be allowed between buy and

sell positions in the same security on the same day for the same client.

Likewise buy and sell positions of a Member’s proprietary trades in same

security on the same day can be netted against each other (KSE).

Netting within Deliverable Futures Market: Netting shall be allowed

between buy and sell positions in the same security for the same client in the

same contract period. Likewise buy and sell positions in same security in the

same contract period for the proprietary trades of a member can be netted

against each other.

Netting shall only be allowed between buy and sell positions in the same

security for the same client in the same contract period and not for the

different client. Likewise netting is not allowed between buy and sell position

in different scrip for the same client and it is not allowed across different

contracts (30, 60 & 90) for the same client in the same scrip (KSE).

Netting within CSF (Cash-Settled Futures) Market: CSF Market shall be

considered a separate market for the purposes of calculating exposure of a

Member and netting shall not be allowed with Ready or Deliverable Futures

Contract Market (KSE).

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Netting within Stock Index Futures Contract Market: Regulations

Governing Stock Index Futures Contract Market shall govern the netting of

open positions of a member for determining such members Exposure for the

purposes of these Regulations.

No netting shall be allowed across clients, across markets, across contract

period, across settlement period and across different securities (KSE).

4.3.4 Mark to market procedures:

Mark to market procedure involves recording the price or the value of a security,

portfolio or account on daily basis to calculate profits and losses or to confirm

that margin requirements are being met. It is the act of assigning market value to an

asset and a mode of analysis for portfolio credit risk.

Determination of MtM Losses: MtM Loss (or profit) shall be calculated on trade to

trade basis for each scrip separately, for each client and for proprietary open positions

of a member on the basis of the last executed prices during trading hours on a trading

day. The final determination and collection of MtM Losses at the end of trading day

shall be at the Closing Prices as determined by the Exchange. Provided that the basic

exemption permissible to a member under the regulations applicable to a particular

Market will be deductible, while calculating such MtM Losses of the member (KSE).

Netting: While determining the MtM Losses (or profit) payable by a member, netting

shall be permissible across trades in different securities for the same client or across

trades in different securities for proprietary trades of a member, in the same

settlement date or contract period. No other netting such as across clients, across

markets, across contract periods, across settlement dates shall be allowed (KSE).

MtM Losses deposit:

53

(a) Each member will pay its MtM Losses to the Exchange at any point in time (as

demanded by the Exchange) or at the end of each trading day but not later than prior

to opening of trading on the next day.

(b) MtM losses of members (client as well as proprietary positions) having total

Exposures in the Deliverable Futures Contract Market of more than Rs. 200 million

will be collected twice a day, including at the end of each trading day (KSE).

4.3.5 Clearing and Settlements:

Clearing denotes all activities from the time a commitment is made for

a transaction until it is settled. Clearing is necessary because the speed of trades is

much faster than the cycle time for completing the underlying transaction. In its

widest sense clearing involves the management of post-trading, pre-settlement credit

exposures, to ensure that trades are settled in accordance with market rules, even if a

buyer or seller should become insolvent prior to settlement.

Processes included in clearing are reporting/monitoring, risk margining, netting of

trades to single positions, tax handling, and failure handling.

A clearing house is a financial institution that

provides clearing and settlement services for financial and commodities derivatives

and securities transactions. These transactions may be executed on a futures

exchange or securities exchange, as well as off-exchange in the over-the-

counter (OTC) markets. Its purpose is to reduce the risk of one or more clearing firm

failing to honor its trade settlement obligations. Once a trade has been executed by

two counterparties either on an exchange or in the OTC markets, the trade can be

handed over to a clearing house which then steps between the two original traders'

clearing firms and assumes the legal counterparty risk for the trade. 

The settlement in the Karachi Stock Exchange takes place through the centralized

clearing house. The shares that are traded from the Karachi Stock Exchange on

Monday and Tuesday of any week are settled the following Monday. The payments

that are made to the members or the investors are channelized through the Clearing

House (KSE).

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4.3.5.1 Settlement and clearing for Deliverable Future Contracts:

The Clearing House shall receive payments from Members on settlement days within

the time specified as per the Regulations of the Clearing Company. In case any

Member fails to make any payment to the Clearing House within the specified time,

default proceedings shall be initiated against that member under relevant Regulations

of the Clearing Company. In the event of declaration of dividend, bonus, right and

privileges pertaining to securities being traded in the Deliverable Futures Market for

which the Share Transfer Books of the Company are to be closed during the pendency

of the settlement, the Exchange shall predate the last day of business and the

settlement date of that particular security.

Daily Clearing: It shall be at the Daily Settlement Price of the day and MtM amounts, after

adjustments of MtM Losses received during the day in cash, in respect of a Client

account in a particular scrip, shall be collected from Members in cash on T+0

settlement basis i.e. by day-end on trade day through Clearing House. The Exchange

shall hold back MtM profits of a Member on his Client account in particular scrip

until its Final Settlement. However, MTM profit of a Member on his Client account

in particular scrip will be adjusted against the MtM Loss in the same scrip of such

Client Account on UIN basis (KSE).

Final Clearing It shall be on last day of Contract Period at Final Settlement Price of that day on T+2

settlement basis through the Clearing House. However, Mark to Market Losses shall

continue to be collected on a daily basis, based on closing price of the security for the

55

purpose of Risk Management in the Ready Market. MtM Profits withheld by the

Exchange will be paid to the respective members on the T+2 settlement day through

Clearing Company (KSE).

Special Clearing It is where the exchange determines that circumstances warrants in the best interest of

the Market and Market Participants that suspension of the scrip is necessary, the

Exchange may announce a special clearing in the particular Contract. In case special

clearing is announced, trading in particular scrip shall be suspended until such time

the MtM Losses are settled in cash and the market shall open after all MtM Losses

have been settled in the suspended scrip (KSE).

4.3.5.2 Settlement and clearing for Cash Settled Future Contracts:

Daily Clearing It shall be held at the Daily Settlement Price of the day and MtM Losses/Profits shall

be settled on in the following manner:

Net MtM Losses shall be collected from Members in cash on T+0 settlement

basis (by day-end on trade day) through Clearing House.

Net MtM Profits shall be disbursed to Members in cash on T+1 settlement

basis through Clearing House.

Scrip-wise outstanding position of Brokers will be revalued at relevant Daily

Settlement Price. The system will consider such revalued amounts as traded

values for collection of mark-to-market losses and for making payment of

mark to market profits (KSE).

Final Clearing & Settlement It is done upon closing of contract, final settlement shall take place on T+1 basis and

the resulting profits or losses, calculated on the basis of “Final Settlement Price” shall

be settled in cash. The payment and collection of profits or losses on final settlement

56

to/from Brokers shall be carried out by the Clearing Company within the stipulated

time and in the prescribed manner (KSE).

4.3.5.3 Special Clearing It is when the exchange may announce a special clearing in a Contract or in particular

scrip in a Contract subject to the prior approval of the Commission, in an emergency

situation which may include riot or strike, fire, accident at the Exchange, change of

government or act of God or for any other catastrophic event. In case a special

clearing is announced, trading shall be suspended and all Open Interest will be

required to be settled within one day of the suspension or prior to the opening of the

market. The market would remain suspended till further notice from the Exchange

(KSE).

There are three types of clearing for the safety of investors. One of them is done on a

daily basis where settlement and clearing is done at the end of the day. Final clearing

is done on the last day of contract period while special clearing is made on special

circumstances like emergency situation of riots or strikes, change of the government

or natural calamity. All these types of clearing were initiated in order to provide safe

environment to the investors to invest into certain securities and provide them with

greater confidence to invest in KSE.

4.4 Other initiatives by KSE:

Apart from that, there are many initiatives being taken by KSE regulatory bodies to

increase investor’s confidence into the market.

Customer Services Department is developed to resolve disputes between

investors and brokers with the help of arbitrators.

Investor Protection Fund (IPF) has been created to protect investors in case of

broker default.

57

Clearing House Protection Fund (CHPF) is created to protect brokers in the

event of another member/broker default.

Moreover, investor’s guide is available and education seminars are also held

on regular basis and investor’s help desk is created to help answer queries of

investors (KSE).

In year 2006, KSE with the help of SECP revised Risk Management measures with a

view to safe and orderly transition of market to a new risk management. Several

changes in the previous risk management measures were made in order to give safe

and sound environment to the investors for making such transactions. In the new risk

management practices presented by SECP, CFS financed scrip were increased to 40

where CFS and Ready market were separated and new market margins were

introduced for CFS in order to have secure investment. New netting regime for CFS,

Ready and Future markets were developed and new VAR based margin was

introduced.

VAR is a measure use to estimate how much the value of shares or portfolio of shares

could decrease over a period of time under daily movement of share prices. It is used

by Stock Exchanges to measure the market risk of the transacted but unsettled shares.

This VAR regime is used by banks and other financial institutions in order to measure

risk on their investments. VAR calculates the maximum loss expected on an

investment, over a given time period and given a specified degree of confidence.

While making revision in the Risk Management Practices, it was explained that VAR

based system will take time to get fully implemented as it requires to install new

computer software to calculate risk at the end of each day for all scrip on client basis.

4.5 Comparing KSE Risk Management Practices against Benchmark

KSE is a platform which provides physical market to the investors to invest their

savings into the portfolio of securities. There are a lot of fluctuations in the Stock

58

Exchange market of any country because economic and political conditions have high

influence on its index points. To date, Pakistan is going through unstable conditions

which has influenced its functions; especially the credit crunch of fiscal year 2007-

2008 when KSE went down to around 4000 points and investors faced huge losses. In

order to save investors from the loss of investment, several risk management practices

are adopted by KSE so that investors do not lose their confidence and continue to

invest in its products.

Listing criteria of KSE is such that until and unless the company is not registered

under ordinance as Public Limited Company and does not contain minimum paid-up

capital of Rs. 200 million; it can not list itself with KSE. The capital requirement is

provided in order to ensure that company is capable enough to meet all the

requirements and is able enough to pay if any losses occur. Apart from that, more

capital is required by KSE so that company could invest in portfolio of securities to

avoid risk by diversification. It offers various products like ready and future markets

which gives investors a chance to invest into the portfolio of securities.

It has customized services for its investors and state-of-the-art technology

infrastructure which makes it competitive exchange compared to others. It consists of

fully automated trading, clearing and settlement system which minimizes the chances

of error and eliminate risk. Brokers are connected with KSE through VPN to ensure

that the data is secure. It has internet routed trading facility and gateway trading

which is also called Order Management System.

As for as Netting is concerned, it is only allowed between buy and sell positions in

the same security for the same client in the same contract period and not for a

different client. Likewise netting is not allowed between buy and sell position in

different scrip for the same client and it is not allowed across different contracts (30,

60 & 90) for the same client in the same scrip. In KSE, netting is not allowed across

clients, across markets, across contract period, across settlement period and across

different securities. The reason it is not allowed is because it can increase the chances

of risk if investors do it across clients, markets or different securities.

59

In order to keep track of settlement in KSE, Clearing House was found where

settlement takes place through a centralized system. The payments that are made to

the members or the investors are channelized through the Clearing House which

makes this process clear and transparent. The clearing house is required to collect

payments from the investors on the settlement days and if any investor fails to make

payment, default proceedings are initiated against him according to the regulations

which ensure other investors that their payments are in safe hands. Three types of

clearing are done at KSE i.e. daily, final and special. Daily clearing is done at the end

of each day and final trading is made upon closing of contract which is settled in cash

within stipulated time and manner.

Moreover, KSE has taken many initiatives to maintain their investor’s confidence so

that they keep on investing in the exchange like Customer Service Department is

developed to resolve disputes among investors and brokers. IPF is created to protect

investors if brokers default on any transaction and CHPF is created to protect brokers

from default. Apart from this, investor’s guide and educational seminars take place to

help answer investor’s queries.

KSE keeps on making changes in their Risk Management Practices so that they can

provide their investors and brokers with a secure environment to invest in and earn

profits using their services

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Chapter.05

Conclusion and Recommendations

5.1 Conclusion:KSE, a physical place where buyers and sellers gather for the purpose of investing

into securities of the particular companies, is continuously making improvements in

its risk management practices in order to provide investors with a harmless

environment and sound transactions where there are fewer chances of loss and more

for profit. In 2006, KSE with the help of SECP revised risk management regulations

with a view to have orderly transition of market with these risk management

practices. Ready market and CFS were separated and new netting regime for CFS,

ready and future markets were developed. Another new regime was introduced i.e.

VAR (Value at Risk) to give investors an idea regarding their investments. VAR is

basically a measure use to estimate how much value of shares or portfolio of shares

could decrease over a period of time under daily movement of share prices. It is used

to measure the market risk of the transacted but unsettled shares and it calculates

maximum loss expected on an investment over a given period of time. Apart from it,

various technologies are being used by KSE like KATS (Karachi Automated Trading

System), disaster recovery management and business continuity programs database

back ups in order to ensure security for the investors. Customer service support is

developed to cater to member’s complaints regarding computer network and trading

system. Moreover, it has partnerships with Microsoft, Oracle, and Unisys for its IT

infrastructure. FIX (Financial Information Exchange) has been adopted for both

trading and market data. With the help of FIX, KSE is able to attract local, regional

and global liquidity by providing its members with automated trading platform and

market access to international partners. In approach to maintain security, KSE’s

listing criteria is such that the company need to have minimum paid-up capital of 200

million and has to subscribe itself with at least 500 companies so that there are less

chances of default. Various products are available for investors to invest in the

61

portfolio of stocks and diversify risk. To save investors from chances of fraud, fully

automated system for clearing, trading and settlement are being adopted by KSE.

Several netting rules have been applied in all the products being offered like Ready

market, Deliverable Future market, Cash settled future and Stock Index future market

because netting decreases credit exposure and also reduces both operational and

settlement risks. In addition to that, mark-to-market procedures are being followed to

record the price of security or portfolio of securities on a daily basis and to calculate

profits and losses. Its clearing house is activated so that the speed of trade is fast

enough to pass all transactions within time. Slowly and gradually, changes are taking

place in KSE to make it more secure environment for both the investors and brokers

and less chances for default risk.

5.2 Future Outlook:The future of KSE appears to be electronic as competition is continuously growing

between the remaining traditional specialist systems against new system i.e. ECN

(Electronic Communication Network). ECN is the term used in financial circles for a

type of computer system that facilitates trading of financial products outside of stock

exchanges. The primary products that are traded on ECNs are stocks and currencies.

ECNs increase competition among trading firms by lowering transaction costs, giving

clients full access to their order books and offering order matching outside of

traditional exchange hours. ECNs have changed ordinary stock transaction processing

into a commodity type business.

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5.3 Recommendations:

They should adopt ECN system in order to make exchange fully electronic

which can reduce transaction costs and give their clients full access after

exchange hours.

KSE should promote derivative products into the market as they can prove to

be successful products in future and various big stock exchanges offer

derivatives.

They should come up with the investor’s education programs and seminars

where they should guide their investors to make safe and healthy investment

where there are fewer chances of default.

They should introduce online training sessions for investors who are unable to

visit KSE like foreign investors and hence, can get information through their

online training system.

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