Derivatives Market in GCC Cutting a (very) long market short

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1 R E S E A R C H Research Highlights: Examining the need for the introduction & growth of derivatives market in GCC. Derivatives Market in GCC Cutting a (very) long market short In spite of having an advanced trading infrastructure, most of the GCC capital markets (except Kuwait) haven t yet started the process of introducing derivatives products. Our previous research (Managing GCC Volatility) has established the fact that GCC stock markets are the most volatile in the world. Given the growing size and volatility of GCC capital markets, the road ahead is clearly to have a complete market structure that will enable stakeholders cost-effectively raise capital and manage risk. A key missing link in this process is the derivatives segment. GCC stocks markets have remained a long-only market for a very long time. Across the globe derivatives, especially Options and Futures, has played a very crucial role in capital market development. Equity Derivatives market has now reached a size of $114.1 trillion (Appendix 1). The presence of strong equity culture along with limitations of GCC capital markets provides a compelling platform for introduction of derivatives market in the GCC region. Strategic investors can unlock their potential without diluting their stake. Institutional investors would welcome this as they are familiar with using such instruments for fixed income and other instruments. From a regulators point of view, there are questions such as: To what extent derivatives destabilize the financial system, and how should these risks be addressed? What is the impact of derivatives upon market efficiency and liquidity of the cash market? Can we borrow the experience of developed markets to developing markets? M.R. Raghu CFA, FRM Head of Research rmandagolathur@markaz.com Hussein A. Zeineddine Manager- Equity Derivatives hazeineddine@markaz.com We propose to address some of these concerns in this paper through a discussion of the following: A. Limitations of GCC capital markets B. Application Areas C. Current Status in GCC & D. Suggested Road Map Kuwait Financial Centre S.A.K. Markaz P. O. Box 23444, Safat 13095, Kuwait Tel: Fax:

2 GCC market structure is still incomplete with inadequate growth of debt market and absence of derivatives market. A. Limitations of GCC Capital Markets The case for derivatives basically stems from the various limitations that beset the GCC capital markets. Hence, it is worth recounting some of them. a. Incomplete Market Structure Complete market structure is brought about by the presence of equity market, debt market and derivatives market. While GCC markets have scored on equity markets, they are yet to score on the other two important segments. Islamic bond markets are gaining ground through the issuance of sukuks and other instruments. Lack of secondary market is hampering its pricing and growth. Due to under supply of such instruments, institutions tend to hold them to maturity thus providing no liquidity. Except for Kuwait, derivatives market is absent in other GCC countries. Equity Market Debt Market GCC Capital Markets Derivatives Market GCC markets lack both breadth and depth of the market. b. Lack of Depth and Breadth Breadth is indicated by the number of companies listed in the stock market while depth is indicated by the active contribution of these companies. GCC stock markets do not score well on both counts. Table 1: Market Breadth No of companies Saudi Arabia UAE Kuwait Bahrain Oman Qatar Total Market Cap (USD b) Market cap per company (USD b) Source: Markaz Analysis 2

3 Given the size of the GCC markets, the number of companies listed is very small. In terms of number of companies, GCC region hosts about 550 companies as at the end of year When measured against the size of the market (market capitalization), it can be seen that the growth in the number of companies is muted relative to the growth in market size. While in 2002, the average market cap per company was USD 0.44 billion, the ratio shot up to 1.55 by 2006 as during this period markets grew by 5 times, while number of companies grew only by 1.5 times. (Table 1) Table 2: Market Depth 2006 Market Cap (USD b) No of Companies Av Market cap (USD b) Saudi Arabia UAE Kuwait Bahrain Oman Qatar Egypt Malaysia 236 1, Australia , India 819 4, Korea 834 1, China Source: World Federation of exchanges & Markaz Analysis GCC markets are long-only markets limiting the possible trading strategies and hence growth. In terms of market depth, it can be seen that relative to the size of some of the GCC markets (Saudi Arabia and UAE, especially), the number of companies are relatively small. The average market cap ratio for Saudi Arabia 4.03 is significantly higher than say India s 0.17 or Malaysia s c. Skewed Liquidity & High Speculation The GCC markets are classified as long only markets where trading strategies are limited to buying when market is expected to go up and liquidating when it is expected to fall down. In fact, the absence of the short-sale activities in such markets does not allow investors to enhance their returns during the down trend. Thus investors are left with no choice but to liquidate their positions which on one hand will exacerbate the effect of the downfall while on the other hand will adversely affect the liquidity of the market. The size of the decrease in the liquidity levels is driven to a great extent by the size of the corresponding downfall. Thus if the downfall is very sharp the liquidity could be completely drained- out. Kuwaiti market during the period 2005 to 2006 can be offered as a good example. Although the Kuwaiti market is characterized by the presence of a wide diversity of sectors with a major presence for the blue chip companies such as NBK, MTC, and PWC etc, the market was not able to sustain liquidity during the correction movement in February 06. Investors as well as fund managers, in the lack of the hedging tools such as the put options, were desperately trying to liquidate their positions while the market was heading down and draining out the liquidity with it. This results in a Domino effect. (Figure 4) 3

4 Figure 4: Kuwaiti General Market Index 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4, ,000, ,000, ,000, ,000, ,000, ,000, ,000,000 50,000,000 0 Feb-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Sep-06 Value Traded (KD) Price Index Most of the GCC stock markets are speculative as well, though in varying degrees. While volumes are concentrated in few stocks, even these are among penny stocks. To present an example (Table 3), we can see in Saudi Arabia the most active shares constitute nearly 30% of total volume while they account only for 6% of market capitalization. The second highest traded stock in Saudi Arabia (Al Mawashi Al Mukarish) is a penny stock with 0.19% share in the market cap. Table 3: Saudi Most Active Shares Share in volume traded Saudi Electricity 15% 11% 10% Al Mawashi Al Mukarish 13% 8% 8% National Shipping 7% 4% 2% Arriyadh Dev 4% 4% 3% Saudi Industrial Development 4% 3% 2% Gassim Agriculture 3% 5% 2% Saudi Public Transport co 3% 5% 3% Saudi Automotive Services 2% 1% 3% 52% 41% 32% Share in Market Cap Saudi Electricity 9.70% 4.98% 4.42% Al Mawashi Al Mukarish 0.18% 0.11% 0.19% National Shipping 0.73% 0.80% 0.58% Arriyadh Dev 0.22% 0.35% 0.16% Saudi Industrial Development 0.11% 0.14% 0.08% Gassim Agriculture 0.08% 0.16% 0.09% Saudi Public Transport co 0.22% 0.27% 0.18% Saudi Automotive Services 0.07% 0.15% 0.10% 11% 7% 6% Source: Markaz Analysis 4

5 Fall in liquidity is accompanied by growth in volumes. The downturn of GCC stock markets during 2006 was accompanied by drying up of market liquidity (Figure 1). Fall in liquidity (value traded) is curiously accompanied by growth in volumes (Figure 2) signifying that mid and small cap stocks are being increasingly pursued for speculative reasons at the cost of large cap blue chips. 40% Figure 1: Liquidity Squeeze* 20% 0% -20% -40% -60% -80% Saudi Arabia Kuwait Dubai Qatar Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 *% change in value traded to the corresponding period one year before 500% Figure 2: Liquidity Squeeze* 400% 300% 200% 100% 0% -100% Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Saudi Arabia Kuwait Dubai Qatar *% change in volume traded to the corresponding period one year before Liquidity is the heart of a market. While GCC markets have grown during the past few years in size, it has failed to mature in terms of market breadth. Narrow market structure leads to price spikes resulting in increased volatility. GCC markets experienced very high volatility in the past. d. High Volatility GCC countries experienced relatively very high risk compared to other international indices. Among GCC, Saudi Arabia, Dubai, Abu Dhabi and Qatar exhibited high levels of risk while Kuwait, Oman and Bahrain has been at levels comparable to other international markets. The increase in risk for Saudi Arabia has been remarkable from 24% to 49% literally doubling. (Figure 3) 5

6 Figure 3: Volatility (Standard Deviation) 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 49.46% 24.12% 38.40% 35.24% 24.40% 28.68% 26.99% 30.89% 16.88% 12.49% 12.17% 15.09% % 11.48% 10.02% 10.28% 14.16% 12.51% 15.42% 15.42% 18.07% 11.96% 19.73% 13.38% 25.68% 17.10% 0.00% Saudi Arabia Dubai ADSM Qatar Kuwait Oman Bahrain S&P 500 Nasdaq BRIC Emerging Mkt Nikkei 225 Sensex (India) The representation of institutions in the GCC market is sparse. e. Lack of Institutional Investment Participation of institutions in the capital market lends stability and credibility as institutional investors are considered to be more rational and long-term oriented than individual investors. Though a difficult thing to measure, a broad proxy would be the mutual fund segment. It is understood that other categories of institutions in the GCC like pension funds, central banks, etc prefer to invest through mutual funds. Table 4 provides statistics pertaining to mutual funds. Except Saudi Arabia and Kuwait, all other markets have very meager institutional participation. Curiously enough, in spite of a respectable figure, Saudi Arabia continues to be the most volatile and speculative market in the GCC. Table 4:Institutional Participation Mutual Fund Assets Market Cap Saudi Arabia % UAE % Kuwait % Oman % Bahrain % Qatar % Source: Markaz Analysis, Data as of Dec 2006 in USD Million 6

7 B. Application Areas In this section, we highlight some application areas for derivatives within the context of GCC capital markets. Short Selling Options strategies Trading Volatility & Structured Products Short-selling refers to selling a stock that is not owned. Shorting (selling high and buying low) is not allowed in GCC. a. Short Selling It is interesting to note that historical stock market speculative excesses have been committed not only on the bull side but on the bear side as well. While speculation per se is good for the market, excesses are not. Both over-valuation and under-valuation of stocks reflect market inefficiencies. A short sale is a sale of securities which the seller does not own at the time of effecting a sale. The theoretical pinning to this is very simple. In a scenario where a particular stock is under valued, market participants will identify this and buy up the stock with the result that the stock price tends to rise eliminating under-valuation. In this case, the market participant makes a profit and the market s pricing efficiency will also improve. The same logic can be applied to over-valued stocks. Similar to earlier logic, market participants will now sell over-valued stocks which will reduce the market price and improve pricing efficiency. Hence, there is nothing immoral about this. However, short-selling strategy is not as straight forward as the strategy of buying under-valued stocks. In the case of shortselling, the short seller has to borrow the stocks sold short during the entire process till he returns the borrowed stock. While there is nothing undesirable about short-selling, history is replete with abuses on short-selling making the need to regulate this more than what is necessary. This is because short-selling could result in a loss that can be indefinite. In a long-only strategy, the maximum loss could be at best 100%. In a short-sale, the potential loss can be much higher because there is no limit to price rise. Short-selling in a context where floating stock is small (as is the case with many stocks in GCC) may lead to manipulative practices viz., short squeeze. A short squeeze arises when bulls are able to corner the supply of stock and bid up the price artificially. Existence of short-selling is not a precondition for improved market efficiently, provided the market is blessed with active and well-informed investors. However, in the absence of active and well-informed investors, encouraging short-selling with appropriate regulatory checks and balances will certainly improve market pricing efficiency. This, in turn, will lead to efficient resource allocation. Also, short-selling is much more beneficial if applied in a portfolio context than in individual stock context. If there is a rise in market prices, the investors will incur loss on their portfolios of short-sales but would be compensated by the gains on their actual investment holdings. In short, short selling promotes more active search for over-valued stocks and more speedy adjustment of market prices to company performance. 7

8 b. Option Strategies Covered call strategy involves writing call option on a stock that the investor owns. Covered Call Strategy A covered call is an option strategy that involves writing (selling) a call option on a stock that the investor owns. This strategy is one of the most basic and widely used where investors can generate increased income from the underlying stock which can be either purchased simultaneously with writing the call option or is already held. In both cases the underlying shares will fully "cover" the obligation created as a result of writing the call option contract. However, the strategy gives investor a limited profit potential of the premium received while the downside risk in limited to the stock price minus the premium. (Refer Appendix: 2 for Illustration) Protective Put Strategy A protective put is an option strategy that involves buying a put option on a stock that the investor owns. The protective put is the most famous strategy that is used to hedge against the decrease in the value of the shares owned. It is called a protective put because the gain on the put option purchased will "protect" the investor from any loss arising from decrease in the value of the owned share. (Refer Appendix: 2 for Illustration) Both covered call and protective put can find extensive application in the GCC region. The high level of strategic holding by families in leading blue chip companies provides excellent ground for generating income through writing call options. Similarly, large exposure to GCC stock market can be effectively protected through buying put options. c. Trading volatility Traditional equity trading is mainly based on speculating the market movement of the underlying equity and can be done through two strategies. The first one is to buy low and sell high which is a long strategy while the second is to sell high and buy low which is called shorting (not allowed in GCC markets). On the other hand, volatility trading entails strategies designed to speculate on changes in the volatility of the market rather than on its direction. Volatility is traded through many products or tools of which the simplest and most famous is options. Option is a product which can provide investors with plenty of opportunities and trading alternatives to generate returns under almost all market conditions. Volatility can be either historical or implied. Defining Volatility Volatility is the term that is used to measure how actively the price of an underlying instrument (stock, future, or index) changes within a period of time. It is also one of the most important variables to pricing options. Volatility traders have two volatility parameters that are involved in the decision-making process. These parameters are: 8

9 1) Historical Volatility: It is statistical measure to quantify historical volatility. It is generally measured with the use of standard deviation (dispersion around the mean) expressed in percentages for different time periods. For example you can compute a 20 day, 40 day or 120 days of volatility. 2) Implied Volatility: As described by its name, it shows what the market predicts as the volatility of the underlying instrument to be over its life. For instance, the implied volatility of an option contract can be derived by plugging in its market price in an option pricing model such as the Black-Scholes. Trading Options Recall that investors need to have a tool in order to trade volatility. In this report we will use the options as an illustrative tool to show how volatility can be traded. There are essentially two types of trading strategies that are used by the option traders 1) Strategies that are based on taking a speculation on the direction of the price movement of the underlying equity or "directional trading". 2) Strategies that are based on taking a bet on the market volatility of the option contract or "volatility trading". Directional Trading Traders who rely on directional trading to make profits have first to take a guess on the movement of the underlying equity price and then establish the corresponding position in the option market. It is advantageous to implement this strategy using options than direct equity exposure as options provide many benefits. (Appendix 3). Volatility Trading Similar to the fundamental equity trading approach where traders seek to identify overvalued and undervalued stocks based on a comparison between the equity market price and its intrinsic value, the volatility traders will compare the implied volatility of an option contract with the historical volatility. Trading actions can be summarized as follows: Scenario Implied Volatility > Historical Volatility Implied Volatility < Historical Volatility Trading Action Sell Volatility Buy Volatility One sells volatility when the historical volatility is lower than the implied volatility. Thus if the implied volatility is higher than the historical volatility, then this would be an indication that the option contract is overpriced, and consequently, "selling volatility" is recommended and vice-versa. This is illustrated by using the implied volatility vs. historical volatility chart of the Intel Corporation stock. (Figure 4) 9

10 Historically Volatility, like stock prices, is meanreverting. Intel Corporation Sell Sell Figure 4 IV HV Sell Buy Buy Buy Source: IVolatility.com The chart demonstrates the fact that implied volatility exhibit a mean reverting characteristics i.e., if the implied volatility of the stock shoots up or down in response to a major event that is expected by the market, it will eventually move back "revert" towards its mean. Historical Volatility Cones Volatility Cones initially proposed by Burghart and Lane (1990) are often used by option traders to figure out whether the implied volatilities traded in the market are cheap or expensive. The volatility cone chart is a very useful tool to predict the future volatility of the stock as it presents important characteristics of the volatility of a particular stock. It is also useful in comparing the predicted future volatility of a stock with its actual realized volatility. To illustrate we'll use the volatility cone chart of the Intel Corporation Stock. Structured products are designed to meet specific investor needs. 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Historical Volatility Cone Intel Co. Mar 05 to Feb Min Mean Max Last Days to Expiry Source: Markaz The mean reverting behavior of volatility is evident in the above cone chart which shows the distribution of the Intel stock volatility over different periods for a 2-year range of data. Starting from the extreme left on the X- axis, we can see that over 30 days period, the volatility has ranged approximately from 13% to 39%. Over 120 days period during the last 2 years the volatility has ranged from approximately 19% to 28%. The mean volatility has ranged from 23% to 25%. As one moves further out in time the lines converge towards the mean, and the mean becomes stable. Thus the volatility is indeed "mean reverting". Another implication that can be 10

11 Derivatives find extensive application in capital guaranteed notes. observed from the volatility cone chart is that the range (max min) of the shorter periods (30 days) volatilities is wider than that of the longer periods (120 days) which indicates that the shorter the period the more the variation of the volatility around its mean. Kindly refer Appendix 4 for volatility cone charts for the GCC region. It is worth noting that in order to make the volatility trading process effective, traders should maintain a delta neutral position which can be achieved through dynamic hedging techniques where the underlying market price risk can be eliminated. c. Structured Products A structured product is a financial instrument that mostly combines a conventional asset class such as equity or a fixed income security with a derivative instrument. Structured products are usually designed to meet the investors' specific needs taking into consideration the existing market conditions. Single Stock Basket of Stocks Equity Index Bonds Mutual Funds Hedge Funds Commodities ETFs, etc Structured Products Call Options Put Options Exotic Options Swaps Futures, etc There are many advantages for investing in the structured products which includes: Capital Protection Enhanced Returns Controlling risk (volatility) Portfolio Diversification Utilize Current Market Trend Each structured product is unique by itself. Among the many types of structured products the most popular is the capital protected equity products or "the capital guaranteed notes". It provides to some extent a risk free ownership of the underlying asset (stock, index, a basket of stocks). Capital Guaranteed Notes A capital guaranteed note is a note which guarantees the investor a certain percentage of capital while giving a chance to participate in the upside movement of the value of an underlying stock or basket or index. The percentage of the capital guaranteed (C %) and the upside participation rate (R %) can be structured based on investor preference. The higher the percentage of capital guaranteed (C %), the lower the participation rate (R %) as illustrated below: 11

12 Capital Normal Upside Participation Rate Range Guarantee 90% 85% 100% 100% 40% 55% 105% 5% 15% If the performance of the underlying asset that the note is linked to is denoted by (P %), then the Payoff of the note at maturity would be: Payoff = Initial Investment * C% + Initial Investment *R%*P% (Refer Appendix: 2 for Illustration) Dynamic Strategies (CPPI) Constant Proportion Portfolio Insurance (CPPI) is an investment strategy whereby funds are allocated dynamically between two types of assets, a risky growth asset such as equities and non-risky asset like bonds, cash etc. The allocation is determined by a prescribed formula and designed to preserve capital at a future date. CPPI has played a crucial role in the structured equity markets. CPPI provides capital protection by reducing equity exposure in declining markets and increasing it in rising markets. At maturity the investor gets the capital guaranteed plus appreciation in the dynamic basket invested both in risky and risk free asset. (Refer Appendix: 2 for Illustration) Markaz initiated a proposal to provide the options services in Kuwait. C. Current Status (GCC) In this section, we trace the growth and development of derivatives market in the GCC region. As noted earlier, only Kuwait has some form of derivatives in the form of options and futures/forward market. The genesis and workings of this is presented below. a. Options Market With rapid growth worldwide, trading options did not exist in the Middle East Stock Exchanges or in the Arab Stock Exchanges until Kuwait Financial Centre S.A.K. Markaz initiated a proposal to provide the options service in Kuwait Stock Exchange in year Markaz suggested establishing a system for trading in options through a Fund viz., Forsa Fund to work as a market maker for options trading in the first stage. After analyzing the characteristics of the Kuwait Stock Exchange (KSE), its nature of risks and determining the needs of investors, Markaz suggested a complete mechanism for option trading at KSE after taking into account the current mechanism in international markets. Many trials and simulations were carried out using historical data for system compatibility with the KSE and measuring the risks resulting from option trading in markets. Testing and measurements were made continuously till March 2005 when KSE allowed Call options to be traded by Forsa Fund. Trading on the first day (March 28, 2005) was on 13 stocks and 75 contracts with a total strike value of KD 2,378, Options value and volume traded fell during year 2006 compared to year 2005 mainly on the back of weak market sentiment. (Figure 5). This reduced the total net premium (Net Premium=Premium received-amount paid back to investor in case he sells the option back before expiry) generated from this activity. (Figure 6) 12

13 Figure 5: Options Value & Volume Traded Value Traded 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000, ,000, ,000,000 80,000,000 60,000,000 40,000,000 20,000,000 0 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Volume Traded Nov-06 Volume Traded Value Traded Figure 6: Net Premium Received 2,000,000 1,500,000 1,000,000 KD 500,000 0 Forsa fund provides daily liquidity through quoting bid and ask prices for all option contracts. (500,000) (1,000,000) Mar-05 May-05 Jul-05 Sep-05 Nov-05 How it works Forsa option contracts are currently traded in the secondary market on 45 listed stocks in the Kuwait Stock Exchange. The contracts are between the Market Maker (Forsa Fund) and the Option Buyer (trader). By this contract, Forsa Fund confers the option buyer the right but not the obligation to buy (in the case of call options) or sell (in the case of put options) a specific number of stocks at a specific price called the strike price before or at a specific date called the expiration date. In return, the option buyer will pay Forsa Fund the price of the option contract or the option premium. Therefore, the option buyer during the term of the contract, may exercise his right to buy (in the case of call options) the underlying stocks from Forsa Fund at the strike price, or exercise his right to sell (in the case of put options) the underlying stocks to Forsa Fund at the strike price. If the investor does not exercise the option during the term of the contract, the validity of the contract will expire at the expiration date. It should be noted that KSE presently permits only call options. Any statement above on the put option is purely for explanatory purposes only and does not imply its existence. Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 In order to provide the necessary liquidity to the market, the Forsa Fund will daily quote bid and ask prices to all the option contracts it writes with a purpose of creating a trading environment that confers the trader the opportunity to sell or exercise the contract. (Refer Appendix: 2 for Illustration) 13

14 Forward contract represents an agreement between the buyer and seller in which the buyer agrees to buy a certain number of shares from the seller for a fixed price during a future period of time. Mechanism of option Trading Forsa Options are traded at the trading floor of the Kuwait Stock Exchange (KSE) after the close of the spot market from 12:45 PM till 1:15 PM. The Fund as a market maker will provide the investors with the bid and ask prices for all the existing option contracts. Investor who wishes to trade in Forsa options should be a registered trader at KSE. He has to route his orders through the brokers in KSE. After the execution of the deal, the broker provides the investor with a contract showing the details of the option trade. The investor has three ways in which he can settle the Option Contract. He can sell the contract back to the buyer i.e. Forsa Fund. Forsa Fund is obliged to provide bid price for all the Option it sold and be ready to buyback the Option from the buyer of the Option. He can exercise his right to buy, in case of Call Option and right to sell, in case of put option. Forsa Fund is obliged to perform the contract. If the investor wishes to sell or exercise his contract back, it should be done through the same broker who executed the original trade. & Take no action and let the Option expire where if the Option is in the money, the contract will be automatically cash settled. The settlement cycle of the option contracts is the same as that of the spot and the forward markets. The brokerage and commission charges will be applied as per the KSE Rules. Major Players At the moment, only Kuwait Financial Center S.A.K Markaz through the Forsa Fund can make market in call options. Nearly 75% to 80% of investors offset their contracts in spot market. Brokerage and Commission Charges The brokerage, clearing and settlement fees charged for option trading in Kuwait Stock Exchange are charged to both the option buyer and the market maker. The total fees for each of the option buyer and the market maker is 5.5% of the contract value and this is actually reflected in the large Ask-Bid spread (around 10.5%). Brokerage Fees: 1.25% (one leg) Clearing and settlement Fees: 1.5% (one leg) To illustrate, in the NBK call option example presented previously the option buyer and the market maker has each to pay KD 70 (2,550 * 2.75%) at the time the contract is initiated and KD 79.2 (2,880 * 2.75%) at the time the contract is settled. Statistics regarding Kuwait options market is presented in Appendix-5 b. Forwards & Futures Forwards Market According to the rules and regulations for trading forward contracts at the Kuwait Stock Exchange, a forward contract represents an agreement between the forward buyer (trader) and the forward seller (market maker) in which the buyer agrees to buy a certain number of shares from the seller for a fixed price (equity spot price) during a future period of time. 14

15 Futures market operates very similar to forward market. At the inception of the forward contact, the forward buyer will pay an upfront premium (price of the forward contract) to the market maker plus 40% of the equity spot price as an initial margin. In return, the seller will deposit the shares with the Kuwait Clearing Company (KCC) that will preserve them to the buyer who should settle the remaining 60% of the value of the equity specified in the forward contract to the market maker before the maturity of the forward contract. If the buyer decides not to pay the remaining 60% (incase the price of the underlying stock decreased), then at maturity the ownership of the shares will return back to the market maker leaving the buyer with a loss of the premium paid as well as the 40% initial margin. Any corporate actions related to the shares under the forward contract are preserved with KCC to be submitted to the buyer once he settles the remaining 60% balance. In case the forward contract expires without settling the remaining 60% balance the dividends are returned to the seller along with the underlying shares. In order to reduce the market makers credit risk in case the spot price of the underlying declines significantly a 40% decline would wipe out the buyers down payment margin the buyer has to pay a 10% margin call minimum to keep the contract active or can voluntarily close the contract. Failing to do either of the above results in the contract being terminated and the stock and dividends etc. returned to the seller, who retains the original margins. If the stock cannot be liquidated promptly, in this case, the seller could lose money on the liquidation. There are 17 players in the futures/forward market as against 1 in options. Currently the forward market offers contracts for 3, 6, 9 and 12 month periods and operates after the spot trading session (12:45PM to 01:15PM). This market is very suitable to the KSE trading environment where the majority of the speculators buy forward contracts to gain financial leverage, and if they make money they sell the shares out in the spot market thereby settling the balance payment before maturity of the contract. Based on historical figures and KSE trading atmosphere, 75% - 85% investors offsets/early settle their contracts in spot market. The Portfolio will receive the final payment balance before maturity of contracts. This enables the portfolio to reinvest the capital before its maturity date. There is a gain in time value of period where final payment is received in advance. During periods of decline, 60% of the investors whose contracts have fallen below the coverage level prefer to pay the margin calls. The reason being that the investor s psyche does not allow him to let go of a contract in which he has invested the upfront payment of 40%. The buyer receives the Margin Calls and thereby minimizes his risk further by 10% (minimum). A graphical presentation on the workings of the forward market is presented in Appendix: 6 Futures Market The futures market operates in a completely similar manner as the forward market except that the future market operates during the spot trading session (9:30AM to 12:15PM). Because forwards are traded after the close of the spot market, the manager has to maintain a minimum inventory holding and be able to find the liquidity to cover it, whereas in the case of the futures market, traders would first request for the shares, whereby the market maker would make the direct purchase of shares from the spot 15

16 market and pass them on to the trader through the future contract after adding the premium and commissions. Thus there will be no need to accumulate stocks unlike the forward market. Market Players Unlike options market where there is only one market maker, the futures and forward market enjoys many players. An indicative list of players is provided in Appendix: 7. Statistics regarding Kuwait futures market is presented in Appendix-6 D. Road Map A major motivation for introduction and growth of derivatives in the GCC region is that it can enable transfer of risk between individuals and firms in the economy. More simply, it is like buying and selling insurance. While the risk-averse investor buys insurance, a risk-seeking investor sells the insurance. Past researches have produced very encouraging findings, some of which are summarized below. Introduction of derivatives do not destabilize the underlying market. On the contrary, it improves liquidity and reduces informational imbalances in the market. Derivatives play a very important role in terms of price discovery and in completing the market. They provide a solid basis for institutional investors and mutual fund managers for risk management. This role as a risk management tool clearly assumes that derivatives trading do not increase market volatility and risk. For e.g., put options will reduce the volatility in the market as irrational exuberance would be corrected much before it becomes a bubble and affects the socio economic set up/ordinary investors. Put options will help the market reach its true level faster and help prevent manipulative practices. Availability of derivatives (especially equity derivatives) has enabled traders to transact large volumes at much lower transaction costs relative to the cash market. This, in turn, will increase market depth and volatility, two major limitations of GCC markets. Studies also point to the fact that introduction of options seemed to have helped stabilize trading in the underlying stocks. It is observed that volumes in the underlying stocks increase after the introduction of stock options. Studies have also found that after the introduction of options, prices tend to reflect new information more quickly leading to narrowing of bid-ask spreads. The Road Map In terms of an action plan for GCC regulators, we suggest the following: 1. Set up a Derivatives Exchange: Exchange-Traded Derivatives can be a solid basis to start the process than OTC. Derivatives which trade on an exchange are called Exchange-Traded Derivatives, while a derivative contract which is privately negotiated is called an OTC derivative. Trades on an exchange generally take place with anonymity and go through a clearing corporation while that of OTC do not. Hence, forming a derivatives exchange will be the most important first step to be taken. 16

17 2. Draft Regulatory Framework: GCC capital markets are neither emerging markets (from an economic strength point of view) nor a developed market from a market microstructure point of view. Hence, it is pertinent to form a committee of highly experienced and qualified people drawn from various financial institutions to come up with a customized regulatory framework for the orderly governance of derivatives. A lot can be learned from the experience of some of the Asian capital markets that have successfully set-up such frameworks. 3. Introduce Index Equity Derivatives: Equity derivatives are the most common worldwide, especially index futures followed by index options and security-specific options. Internationally, options on individual stocks are common; futures on individual stocks are not that common. Index based equity derivatives (options and futures) are quite popular among investors as they are excellent hedging tools and also present few regulatory headaches when compared to leveraged trading on individual stocks. This has led to regulatory encouragement of index futures and discouragement against futures on individuals stocks. 4. Introduce Short-Selling: As we explained earlier, market efficiency can be significantly enhanced through introduction of short-selling. Just as we have margin requirements on the long-side, we can have similar regulatory checks to prevent misuse of this important tool. If dealt with properly, short-sales can check bear-side excesses in a falling market. 5. Introduce Stock Equity Derivatives: With a well stabilized index based equity derivatives, the risks of stock-based equity derivatives is well contained. As we can see from the above, except for Kuwait none of the other GCC markets have taken any of the steps suggested above. Even in the case of Kuwait, introduction of derivatives in the form of call options did not adhere to a structured process as explained above. There are still gaps to be addressed (Appendix: 8). 17

18 Appendix 1: Growth of Derivatives Market in Asia Global exchange-based trading in equity derivatives has almost doubled over the last three years from $54 trillion in 2002 to $114.1 trillion of notional value (on 6.3 billion contracts by end-2005). The volume of global trading in 2006 had already reached $96.1 trillion as of August On Asia s exchanges, equity derivatives have witnessed the most rapid growth of all traded derivative products (foreign exchange, interest rate, equity, commodities, and credit derivatives). Equity derivative trading in emerging Asia has mushroomed from $16.5 trillion in 2002 to $40.3 trillion in 2005 (and $37.1 trillion by the end of August 2006), and now represents 38.6 percent and 43.9 percent of worldwide equity derivatives turnover by notional value and number of trades respectively. This mainly represents very rapid growth in Korea, which hosts the world s most active derivatives market the Korean Futures Exchange. Equity derivatives are mainly traded on organized exchanges rather than OTC. Annual OTC equity derivatives trading in Asia (excluding Japan) is only around $100 billion (BIS, 2005). Most equity derivatives are exchange-traded (ETD), as opposed to foreign exchange and interest rate derivatives, which are mostly traded OTC. Formalized and regulated exchanges are leading the growth in Asian derivative markets, which can be divided into three categories: (i) fully demutualized exchanges (Hong Kong SAR and Singapore), which offer a wide range of derivative products; (ii) partially demutualized exchanges (Korea, India, and Malaysia), which have specialized in equity futures and index products; and (iii) derivative markets with no or marginal exchange-based trading and limited OTC derivative trading (China, Indonesia, the Philippines, and Thailand). Equity derivatives markets are much less well-developed in other emerging Asian countries. In general, high levels of ETD tend to be associated with high equity trading in deep and sufficiently wide cash markets, mainly because the development of derivatives necessitates sufficient liquidity of cash markets (including pricing benchmarks) to ensure efficient price discovery. Since 2000, growth in overall derivative trading only in Korea, Hong Kong SAR, and Taiwan POC has outstripped growth of both domestic market capitalization and cash trading in equity markets. These countries currently exhibit high turnover ratios of almost 1½ to more than 36 times of outstanding stock, while average global turnover ratios of equity derivatives tend to converge to one (BIS, 2004; and WFE, 2005). Since most of equity derivative contracts are traded in these countries, their high turnover ratio has kept aggregate equity derivative trading in emerging market Asia at more than 10 times GDP, stock market capitalization, and stock trading. Although stock exchanges in countries such as China, Indonesia, Malaysia, Thailand, and the Philippines also have strong trading activity in cash markets, similar to that in emerging market and mature market countries with established derivative markets, trading in equity derivatives remains very limited. Contract sizes in emerging Asian countries have more than doubled, from $8,200 in 2003 to $19,000 by August 2006, but they still lag behind global averages. Contract sizes of equity derivatives in countries like India and Malaysia are still less than half of the notional amount per trade in Asia and less than a third of the notional amount per trade in the United States. Besides Hong Kong SAR, only the equity derivative market in Korea offers contract sizes in emerging Asia similar to mature market economies. The strong development of equity derivatives in Korea and India reflects a robust operational and legal infrastructure (Fratzscher, 2006). For example, both countries have well-designed trading platforms, which provide access to both domestic and foreign institutional investors. Indonesia has just established the Jakarta Futures Exchange and introduced equity index futures at the Surabaya Stock Exchange. The Thailand Futures Exchange (TFEX), in operation since 2004, started trading its first stock index future only in April In the Philippines, equity derivatives have not been traded since the Manila Futures Exchange closed in By comparison, countries that are lagging have (for example) weak trading infrastructures, shortcomings in relevant laws that create uncertainty about whether derivatives contracts can be enforced (or even whether trading derivatives is permitted), tax provisions that are unfriendly to derivatives, bans on short selling, and restrictions on investment by foreigners. Reaping the full benefits of equity derivatives markets by fostering their wider development also requires careful management of risks to financial stability. In Asian countries without formal derivative exchanges, the rising popularity of OTC derivatives entails greater emphasis on disclosure and transparency, good governance and risk management. Systemic risk is 18

19 potentially reduced when trading occurs in well-structured and formally regulated exchanges that impose appropriate margin requirements and position limits, administer centralized clearing and settlement, engage in market surveillance, undertake adequate disclosure, and mutualize risks through loss-sharing arrangements, capital deposits of members, and international excess-of-loss insurance. It is also reduced when supervisors and regulators can ascertain the exposure of systemically important financial institutions to derivatives markets. Sizable retail trading of derivatives may pose its own challenges and could (in principle) entail significant knock-on effects on real sectors; for example, a market downturn that inflicted widespread losses on households could affect confidence and spending. A good understanding of all these issues is incumbent on country officials charged with safeguarding financial stability. Source: Asian Equity Markets: Growth, Opportunities & Challenges by Catriona Purfield, Hiroko Oura, Charles Kramer, and Andreas Jobst. IMF Working Paper WP/06/266. Appendix 2: Illustrations 1. Covered Call An investor owns 1000 shares of NBK at KD He also sells a 1 month call option contract on NBK for 1000 shares at a strike price of KD for a premium of 50 Fills, which he receives per share from the buyer of the Option. This position initiated is called a Covered Call because the investor is covered with the stock in case the buyer exercises his right to buy the shares at the strike price. The strategy is favored when the investor expects the share price to exhibit a small movement over the lifetime of the option contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock owned, and/or provide a limited amount of protection against a decline in underlying stock value. Profit and loss of the trade Trade Details Stock Value 1000 shares at KD 2 each = KD 2000 Number of call options sold 1000 Strike Price KD Option premium per share 50 Fills Total option premium received KD 50 Scenario Payoff Rationale If Share price moves to KD 3 KD 50 The option premium which is KD 50, since the option holder will exercise the option and the underlying shares will have to be delivered. If Share price stays flat at KD 2 KD 50 The option will expire worthless and hence the option writer keeps the premium which is KD 50 If Share price falls to KD 1 (KD 950) Loss of underlying stock value which is KD 1 per share i.e., KD Profit on premium received which is KD 50. Net loss: KD

20 100 Profit / Loss 50 Profit/ Loss Stock Price Covered Call Writer 2. Protective Put For example if an investor is holding 1000 shares of NBK at a price of KD and the investor buys a 1 month put option contract of 1000 shares at strike KD then it is called as a protective put strategy. Stock View The strategy is implemented with a positive view on the stock; however the investor wants to hedge his downside risk. Buying a put option is like buying insurance for the stock and hence if the stock does not go down in price, he loses only the premium paid. Profit and Loss of the trade Trade Details Stock Value 1000 shares at KD 2 each = KD 2000 No of put options bought 1000 Strike Price KD Option premium per share 50 Fills Total option premium paid KD 50 Scenario Payoff Rationale KD 950 If Share price moves to KD 3 The underlying position value improves due to stock price appreciation. However, the put option expires worthless and hence the premium paid is wasted. If Share price stays flat at KD 2 -KD 50 The put option will expire worthless and hence the loss will be the premium paid. If Share price falls to KD 1 -KD 50 Sine the option is in the money, the option holder will exercise his option. Profit on exercising the option will be KD However the underlying equity position also loses its value to the extent of KD 1000 and hence they are neutralized. Hence, the net loss will be equal to the premium paid which is KD 50 20

21 200 Stock price Profit / Loss Profit/ Loss Protective Put Writer Stock Price 3. Capital Guaranteed Note A 3-year 100% capital guaranteed note with a participation rate of 45% Linked to a Kuwait Basket of Shares. The note provides 100% capital guarantee at maturity which is 3 years thereby eliminating the downside risk. On the upside, it gives 45% of the appreciation in the Kuwait Basket of shares over the 3 year period. This note will be suitable for an investor who has a bullish view on the Kuwait market and seeks to have exposure to it, but on the other hand wants to fully protect his capital. Structure The issuer of the guaranteed note will receive a capital of KD 1000 from the investor who purchased the note. The issuer will invest the proceeds in buying: 1) A zero coupon bond that matures in 3 years. The price of the bond will be the present value of the capital received PV (KD 1000) 5.55% or KD 850. The bond will guarantee that the issuer will be able at maturity to pay the capital that was initially received from the investor. 2) A call option on the Kuwait Basket with 3 years to expiry that will cost approximately 33.3% of the total value of the Kuwait Basket. Hence by paying the remaining KD 150 for the call Option, the issuer will get a 100% exposure (participation) to a basket of total value of KD 450 (150/33.33%) which is equal to 45% of the amount of capital invested by investor (KD1,000) thereby 45% of capital invested is exposed to market returns. In other words, the participation rate is calculated by dividing the relative amount left for the options (15%) by the relative option premium (33.33%) or 45%. Hence such a structured product is a combination of a zero coupon bond (asset class) and a call option (derivative instrument). 21