Development of derivatives market in PakistanEntry of derivatives began in early in 1990 with currency swaps called dirty “swaps”. Few banks are allowed by SBP to deal in derivatives securities.

SBP regulate the OTC market for

1. Foreign currency option 2. Forward rate agreements 3. Interest rate swaps

All derivatives agreements require formal approval of the central banks. In 2011 the Securities and Exchange Commission in Pakistan allowed mutual funds to use derivatives for Hedging purpose

Derivatives users in Pakistan Following are the users of derivatives instruments in Pakistan 1. Hedgers, speculators, Arbitrageurs2. Individuals 3. Institutional investors 4. Banks, others financial intermediaries

Derivatives is derived from the following products:1. Shares

2. Debentures

3. Mutual funds

4. Gold

5. Steel

6. Interest rate

7. Currencies.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers

in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

 

 Benefits of derivatives Following would be the benefits of derivatives market

1. Price discovery 2. Risk management 3. Improve market efficiency for underlying assets 4. Reduce market transaction costs

Understanding the types of derivatives market1. Forward This is a form of contract wherein two parties agree on buying or selling an asset at an agreed price. The actual exchange then happens on a future date, thus the term forwards. The contract happens among the parties themselves without an outside party interfering. The contract in a forward type of financial derivative is non-standardized. It is subject to the choices of the parties engaged in a forward contract.2. Futures A futures contract is similar in some manner to the forward type. It also involves an agreement on sales of an asset on a future time. However, financial derivatives contracts of this category have a standardized contract form. The terms and conditions of the contract are arranged by a third party called a clearing house.3. Options This type of contract allow the person involved to have the option of exercising his right on the assets. Transactions start at a specified price called a strike price. A maturity date is then set for the owner to exercise his option of buying or selling the asset. The owner has the option of using his right on the exact date of maturity and not before in a European option. The American option allows the owner to exercise his right on or before the maturity date.4. Swaps Contracts involving swaps allow transactions to occur before a future date. Like all financial derivative types, swaps derive their financial value based on the underlying asset.The above examples are the most common forms of contracts on financial derivatives. There are many other types that could be made out of a combination of the above examples. When these forms are combined, the contract takes on new features or characteristics that are unique and different from the other forms.Knowing the types of financial derivatives makes it easier to understand how it works. Now that you know the different contracts involved in financial derivatives, it will be easier to

choose an option that suits your need. The concept of financial derivatives may operate on an abstract level but its applications and impact are definitely felt in the real world.