This article focuses on issues pertaining to risk management in the context of financial

assets which give rise to variability or deviation in the expected return.

Financial assets represent claims to ownership/cash/income as in the case of share

certificates, or debt instruments like bonds, term finance certificates (TFCs) and
government securities. The evidence of ownership or creditorship is now increasingly
available only as an electronic entry to an account on a computer system.

People are generally said to be risk averse. But is it possible to find an investment which
is completely free from risk? The answer is a firm no! Why? Because a completely risk
free investment would be one which would repay at a future date, an amount equivalent
in purchasing power to that represented by the amount originally invested. For this to
happen, two necessary conditions should be complied:

(i) The promised amount is actually paid i.e. there is no chance of default; (ii).an
additional amount is also paid, if required, to compensate for decline in purchasing
power, measured in terms of the price index of the consumption basket of the investor.

When the issuer of security is a sovereign government empowered to print currency,

condition No (i) can usually be met but no issuer of a security would perhaps ever be able
to offer anything close to what condition No. (ii) represents.

Investment options and risks: Individual investors have the following investment options
available: short to medium-term and long-term government securities; various short to
long-term deposit schemes, COIs etc offered by commercial banks and non-banking
financial institutions (NBFI’s); stock market shares; long and short-term finance
certificates; real estate; gold, silver and precious stones and foreign currencies.

How can an investor minimise the investment risk? The main option currently appears to
be diversification of investments because hedging devices like derivatives are not
available in our markets. Moreover, derivatives like options and futures are considered to
be un-Islamic.

Diversification however, is not very effective in the case of small investors with limited
funds. Thus the need to be satisfied with a relatively low return by investing a certain
percentage (depending on their appetite for risk) of their funds in low risk government
securities. Institutional investors can do the same and generally their average return on
investment should be higher than that of the individual investors, given their greater
ability to take risk.

In the short run, diversification appears to be the main risk minimisation tool, with an
important income smoothening role being played by the government securities. How
ever, in the long run, effective regulatory intervention to minimise the manipulation
component of the risk would be the key, followed by development of debt instruments
conforming to the Shariah.
Secondary market for debt instruments: Presently about 685 companies are listed on the
Karachi Stock Exchange. However, the secondary market for shares is far more
developed than the market for debt instruments, with less than five per cent of listed
companies currently having debt securities listed on the Karachi Stock Exchange. The
listed debt securities are term finance certificates (TFCs) and Sukuks (Islamic bonds),
which are equivalent to bonds traded worldwide on security exchanges.

It is pertinent to examine the inhibiting factors for issuance of debt securities by

companies. After all, there can be no secondary debt market development without the
primary market first being firmly in saddle. The matter can be examined both from the
prospective holders (buyers) of TFCs and from the issuers viewpoint. The two main
categories of buyers of TFCs are individual investors and institutional investors.
Individual investors belonging to the segment of retired salaried employees generally do
not have a significant capacity to face the risk of default. Thus, they have traditionally
favoured the National Savings Schemes. The monthly income scheme and special saving
certificates (offering six monthly returns with a three-year maturity) are popular for
providing regular near risk free income.

The Defence Savings Certificates, with maturities up to ten years give an option for long-
term capital appreciation for people who can afford to set aside some amount for the long
term but are not willing to take the risk of default. The rate of return on these schemes
has not been able to keep pace with the rate of inflation. The government would like to
restrict the cost of borrowing.

Realising that the risk taking ability of a majority of individual investor is low, the
government perhaps does not foresee a significant fall in deposits into its saving schemes,
despite the lowering of returns. This has really hit the individual investor hard,
particularly the retired salaried class.

This category of people would be keen to invest at least a portion of their funds in TFCs,
if the promised yield is even 2-3 percentage points more than government schemes. This
class is the least likely to subject, even a part of their life time savings, to the volatility of
our stock exchanges.

Private limited and public limited companies would also be interested to varying degrees
in picking up TFCs. This is the type of investment, which can serve to smoothen the
fluctuations in a company’s earnings. The extent of interest of any company in such
investments would of course depend upon its cash flow pattern, liquidity and reserves
position, its stage of development i.e. whether it has vertical or horizontal growth
opportunities still available or its products or services are at the maturity stage, the tax
implications of its earnings on TFCs etc.

Apparently, the companies generally would be interested in investing some portion of

their earnings in debt instruments like TFCs and with a higher capacity to take risks as
compared to individual investors. However, they have to be reasonably sure that the
secondary market is sufficiently developed to give them comfort on the liquidity aspect
of the investments. This is important because while the individual investor would also be
interested in assured return and liquidity, the corporate investor would place a much
higher premium on liquidity.

For instance, no company having a seasonal requirement of funds, say for purchase of
raw material, would like to be in a situation where it has investments in hand which it
cannot quickly convert into cash at the time of need.

From the TFC issuing company’s viewpoint, the following matters need to be considered:

* Will it be easier to get a loan from the banking system or to issue a TFC?

* Would the effective cost of funds be lower if TFC financing is resorted to rather than
going for a loan from a bank or a consortium of banks?

* Should the company go for rating of their TFC issue? What if it gets a poor rating?

* If the TFC issue is under-subscribed, what implications will it hold for continuance of
the company as a going concern?

* Is the government supportive in promoting the growth of TFCs or is it applying brakes

to restrict their issuance?

During the first six months of 1998, a number TFC issues were under active processing
and the chances of development of secondary markets appeared bright, with the major
brokerage houses gearing themselves to play the role of market makers and reputed
foreign banks as well local DFIs teaming up to underwrite their public issues.

However, the feverish activity going on at that time suddenly came to a grinding halt
when the government decided to withdraw the tax exemption facility on income from
TFCs, previously applicable to corporate TFC investors. Another limiting factor was that
for companies with good standing, who had the opportunity to raise funds through the
banking system, the TFC option did not entail a significant advantage in terms of the
effective borrowing cost after accounting for the public floatation costs, rating cost,
private placement and underwriting commissions etc. The same would more or less hold
true today.

What prompted government’s action which virtually killed the TFCs market? Perhaps the
government apprehended that if the TFCs market developed too fast, the individual
investor might tilt towards it and thereby the government may lose a substantial part of its
major source of public debt i.e. investment in its national savings schemes.

It also appears that the underwriting institutions were unable to generate sufficient public
interest in the TFCs. Perhaps the public also perceived the default risk to be high, given
the history of bank loan defaults. Foreign investment in the TFCs has been virtually
absent. Apparently due to a high degree of perceived sovereign risk of Pakistan, high
default risk, as well as foreign exchange risk of rupee denominated TFCs.

Presently, it seems that the debt securities market would not pick up much until the
Sukuk market picks up momentum. However, an enabling regulatory framework, though
necessary, will not be sufficient to provide a fillip to the debt market. It is also essential
that the economy should pick up and generate requirement for long term debt funds.

Risk management practices: In order to have an idea about how the brokerage houses
play their risk management role, relative to their own risk and that of their clients, a
questionnaire was circulated amongst 26 registered corporate members of the Karachi
Stock Exchange. Only nine responses were received but still they have been helpful in
understanding, how the brokerage houses view risk, the risks they handle and what
technologies they employ.

The main operating income of brokerage houses is through commission they earn on
buying/selling on behalf of their clients. Usually they do not buy/sell on their own
account but whenever they do, the earnings or losses would be classified as ‘other income
/ (loss)’. In other words, exposing their own funds to stock market risk is not the usual
operating activity of the brokerage houses

Risk management by brokerage houses can be divided into the following main parts:

* Default risk i.e. the risk that a client fails to settle payment against a transaction
undertaken by the brokerage house on its behalf, on the backing of a margin account

* Investment risk of clients

Discussions with brokerage house executives reveal that brokerage houses do not
generally ask for margin deposits from institutional clients, as chances of default are not
considered significant. However, in the case of small clients or individuals, brokerage
houses do operate on margins.

Based on the judgment of risk involved, such clients are required to maintain a minimum
margin, with the brokerage house. This normally ranges between 25—30 per cent of the
amount of total exposure taken by the brokerage house, on behalf of a client. In effect the
margin percentage reflects the brokerage houses’ assessment of the maximum price
erosion during the normal settlement period of one week. Should default occur, the
brokerage house has the option to sell the shares at the reduced market price and use the
margin to cover its loss.

In the case of investment risk of its client, the risk has to be borne entirely by the clients
because it is their funds which have been invested. However, as investment advisors, it is
the moral and professional obligation of brokerage houses to give the best possible advice
and help manage the clients’ risk. Thus, although the brokerage house is not directly
exposed to investment risk, it faces the risk of losing reputation and clients, should its
advice turn out to be wrong too often. From the responses received to the questionnaire
circulated amongst brokerage houses, it is gathered that a majority of them are using
sophisticated customised computer software. Only one out of nine respondents has
indicated that they do not use any computer software for risk management purposes.
Computer software is used both for monitoring the margin maintenance of clients and for
undertaking technical/fundamental analyses of specific companies and sectors.

As for risk minimisation options used by the brokerage houses, it was not at all surprising
that all the respondents believe in diversification and advise their clients to diversify their
investments across companies, as well as across industrial sectors. However, it was
surprising that only one of the respondents has indicated hedging as a tool being used for
minimising investment risk.

Apparently most of the brokerage houses believe that there are no hedging instruments
currently available in the financial system. Six out of nine respondents say that no
hedging instruments exist. However, three of the respondents regard TFCs as a hedging
instrument from the point of view of capital preservation and providing a minimum stable
income component to a balanced portfolio. These respondents have mentioned one or
more out of following as hedging instruments, besides TFCs: (the use of these
instruments remains very limited, however).

National Saving Certificates, high return deposit accounts, Certificates of Investments

(COIs), foreign currency accounts, treasury bills and Pakistan Investment Bonds (PIBs).