Prospective Investor

Pakistan Mercantile Exchange Limited

December 2006
NCEL

Contents
Welcome Risks in Trading Futures Introduction to Futures

PMEX Highlights
PMEX Business Model How to Trade at PMEX Investor Safeguards Demo
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Risks in Trading Futures

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Should You Trade Commodity Futures?

Trading commodity futures is not for everyone. It can be a volatile and risky business. Before you invest any money in futures contracts, you should:
Consider your financial experience, goals, and financial resources Understand commodity futures contracts and your obligations before entering the market Be aware that you can lose more than your initial investment Only take risk for the amount that you can afford to lose Understand your exposure to risk and other aspects of trading by thoroughly reviewing the risk disclosure documents your broker is required to provide you
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Can I lose Money Trading Futures?

Yes, if you are reckless
Lax controls, poor corporate governance, over confidence, hoping to recover through taking an even bigger position, etc.

But it is not Rocket Science

Proper Understanding and Respect of Risk can ensure losses are contained and gains are preserved

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Introduction to Derivatives

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Who Participates in Futures Markets?

Meets the needs of three groups:
Those who wish to discover information about future prices of commodities (suppliers such as farmers) Natural Longs
Users & intermediaries Natural Shorts

Those who wish to invest (investors) and have a view extremely important as they provide liquidity and depth to the market
Investors are essential for the market

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Futures Perspectives
Gains (Losses) for longs are offset by equal losses (gains) for shorts Counterparties in Futures are involved in a zero sum game - for every winner there is an offsetting loser

Futures exchanges counter excessive speculation and concentration through position limits
Clearinghouse runs a perfectly matched book and does not take positions in the market A common fallacy - high margin mitigates risk

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What are Derivatives?

A derivative can be defined as a contract that derives most of its value from some basic underlying asset: Examples: Futures a right and an obligation - Commodity, precious metals, single stock, interest rates,
stock index, energy, etc.

Options a right but NOT an obligation??? Swaps Etc

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What are Futures Contracts?

FUTURES Definition: a contract between a buyer and a seller under which the seller agrees to deliver a specific commodity on a specific future date to the buyer for a predetermined price to be paid on the delivery date It conveys an Obligation Price is negotiated at the time of execution of a trade on an exchange

Every futures contract has predetermined:

- Quantity of commodity - Quality of commodity - Delivery location - Delivery date
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Why are Futures different to Equities?

It is a Promise/ Obligation and not an Asset By buying/selling an Asset by paying the price in full there is no further liability transaction over a short time period

Buying/selling an Obligation only requires a margin hence you continue to be exposed to risk of paying additional margins till expiration A futures investor can sell a future without having first bought it if he is expecting prices of the commodity to go down in the future. This option is not available in stocks.

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Why are Futures different to Equities?

Frequent checks on the Price of Futures given Convergence arising out of regular cycle of expiries It is important to emphasize that sellers of Futures have the same margin obligations as buyers Whereas, buyers may be called on to deposit additional margin when prices decline Sellers may be called on to deposit additional margin when prices increase Losses can be many times your investment (initial margin) and unlimited!
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Types of Futures
Commodity Futures (Agricultural, Precious Metals, Base
Metals, etc)

Financial Futures (Bonds, Interest Rates, Currency, Stock

indices, single stocks, etc)

New Generation (Weather, Economic Indicators, Inflation,

etc..)

Implicit Futures

(Property, Farms, etc)

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Futures v. Forwards
Futures
Exchange Traded Standardised Guaranteed Settlement

Forwards
Over-the-Counter (OTC) Non-Standard No Guarantee

Margined
All participants treated same Liquidity
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No Margining
Prices can vary according to credit risks Can be illiquid

History
Implied Futures have been traded historically
Japanese Rice Futures 17th Century Chicago first example of modern futures exchange Mid 19th Century Commodity Futures - first products Commodity Exchanges trade contracts on commodities and not commodities themselves

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Global Commodity Exchanges

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PMEX

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Highlights
Demutualised, all-electronic commodity futures exchange Provide secure Client Level online access via the Internet with a unique id for each and every Client Broker/Client & Client/Client segregation of funds NCEL Clearing House will provide complete Novation act as the Central Counterparty Settlement Guarantee Fund to provide complete protection for all open positions Investor Protection Fund to cover losses in case of closed positions and idle balances with Brokers Daily Marking-to-market of Open positions and collection of variation NCEL margin on T+0 basis, electronically

Regulatory Framework
Primary Legislation
Securities and Exchange Ordinance 1969

Rules

Commodity Exchange & Futures Contract Rules 2005

Regulations

NCEL Regulations

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PMEX Regulations
Exchange does not have any powers to make or grant exceptions Complete Segregation of funds: Broker level (Broker/Client & Client/Client) Clearing bank (Broker/Client) Exchange (Broker/Client & Client/Client) Clearly defined events leading to financial and nonfinancial defaults Financial default leads to automatic cancellation of Membership
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Core Components of PMEX

IT & SYSTEMS
Trading Systems Connectivity and networks Database & Disaster Recovery Application development

ANALYTICS
Risk Management Research Real-time Analysis Software Specifications

OPERATIONS
Clearing and Settlement Margining and Accounting On-line Banking Delivery

COMPLIANCE
Member Services Surveillance and Monitoring Discipline and Enforcement Process Management

PRODUCT RESEARCH & DEVELOPMENT

Contract Development Specifications and Testing Logistics and Spot Market Practices
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What are Key Differentiators?

Intellectual Capital is our greatest asset Use of state-of-the-art technology to offer transparent platform for easy and equal access to all market participants Unambiguous Trading Regulations to provide complete confidence and protection to investors and users Risk Management and Market Monitoring based on international Best Practices Thoroughly researched contract specifications to mirror market practices

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Is there a Social Value?

Yes!
Managing and transferring risk Generates publicly observable prices containing markets expectations of current and future economic value of certain assets Reduces price volatility and brings in stability Brings in standardization quality Warehousing, Commodity Financing

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Benefits of a Derivatives Exchange

Transparency in price discovery of both cash and futures Transferring risk from someone averse to risk to someone with an appetite

Transitioning investors into a more controlled environment

Creating savings and investments in the long run Developing intellectual capital and awareness Enhances markets image and standing, and leads to an increase in FDI
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Novation- Central Counterparty

Negotiate Price to go Short

Trader A

Negotiate Price to go Long

Trader B

Short

Long Short Clearing Deposit Deposit Margin

Clearing Deposit

Deposit Margin

Long

Clearing House

Individualized Initial Margins & Margin Calls

Financial Safeguards

Clearing Deposits (Default Funds)

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Default Protection: Segregation of

Participant Risk

Market Participants

Clearing Participants

SGF

Clearing Participants

Market Participants

Prop Prop Prop

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Default Protection: Segregation of

Participant Risk

Market Participants

Clearing Participants

SGF

Clearing Participants

Market Participants

X
Prop Prop
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Prop X

Completely Isolated if a default takes place

PMEX Trading System

PMEX Trading Platform
Assigned Deal
Trade Capture Pre-Trade Risk Management

NCEL Broker

Mark to Market Trader A Market Monitoring

Position Update

Risk Mgmt

Systems Update Trader B

Banking & Settlement

A & B Clients of NCEL Broker

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Contract Choice and Design

Four out of Five new futures contracts fail and are de-listed within the first three years of trading Two possible reasons: Lack of demand for the contract itself Poor contract design Of course these two reasons are related to one another

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How do you Design a Contract?

Research is critical to the success of a contract

Interaction with market participants

Simplicity Designed for industry to mirror industry practice

Minimal entry/exit costs

Ensure Price Convergence through credible threat of delivery

Tracking of Basis - Responsibility of Market Oversight Dept.

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How do Prices Move over Time?

Prices Futures Basis Cash

Present
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Time Maturity

What are Contract Specifications?

The Asset Quality & Certification requirements The Contract Size Quantity Duration

Delivery Arrangements Location and Warehouses Documentation required

Delivery Months

Price Quotes
Price Limits Position Limits Margins
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PMEX Gold Futures Contract

Contract Size: 100 gms of 995 Fineness Price Quotation: Rs/10 gms Monthly Expiries, starting with April 2007 3 Calendar Months available for trading

Current Gold Price around Rs. 12,500/ 10 gms

Contract Value around Rs. 125,000 Tick Size: Re. 1

Tick Value: Rs. 10

Initial Margin 4.25% Clearing Margin 2.50% (Leverage 40 times)

Physically Deliverable Contract NCEL

Risk Management

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What is Risk?
Risk is multidimensional
Market Risk Credit Risk

Financial Risks

Operational Risk Reputational Risk

Business and strategic risks

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What is Risk?
One can slice and dice these multiple dimensions of risk
Equity Risk Market Risk Interest Rate Risk Currency Risk Credit Risk

Commodity Risk
Operational Risk Reputational Risk Business and strategic risks

Financial Risks

Settlement Risk

Replacement Cost Risk

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What is Risk?
Identification
Market Risk

Risk Mitigation Strategy

Equity Risk Interest Rate Risk Currency Risk

Margined Risk

Credit Risk Commodity Risk Operational Risk Reputational Risk Business and strategic risks

Financial Risks

Settlement Risk

Replacement Cost Risk

Unmargined Risk

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Best Practice Risk Management

Framework for Risk Management can be benchmarked in terms of:

Policies Methodologies Infrastructure

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Best Practice Risk Management

Framework for Risk Management can be benchmarked in terms of:

Policies Methodologies Infrastructure

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Risk Management @ PMEX

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Market Risk Mitigants

Complete segregation cornerstone Initial Margins determined using VaR No netting-off between clients Pre-Trade Check Spot Month Delivery Margin Credits
Intra commodity spreads Inter commodity spreads

Daily Mark-to-Market of Positions Variation Margin in Cash only Daily Settlement Price Process
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Pre-Trade Check for Members & Clients

Member/Client J-Trader
Buy/Sell Order

Electronic Broker
MCB

SARA
No
If P or C (SODNLV) > Order Margin Required

SODNLV Updates

System Back Office

Yes

Matching Engine
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Risk Management Example

(illustration only)
60 50 40 30 20 10 0
Lower Price Limit Upper Price Limit Settlement Price

Variable Margin

Spot Month Margin Initial Margin

B eg in

th

Tr ad

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D el

iv er y

in g

Sp

ot

M on

on

th

Credit Risk - Brokers

Minimum Networth ability to meet obligations with some
balance sheet restructuring

Segregated Net Capital Balance Solvency & Liquidity

Minimum Clearing Deposit

Clearing Limit multiple of Clearing Deposit
E.g. minimum deposit Rs 0.5 million Multiple 40 times (2.5% clearing deposit) Clearing Limit = Rs20 million Gross/Gross across all commodities and across all clients

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Other Tools & Measures

Market Monitoring up to Client Level in real-time
To counter front running, wash trading, trading opposites, etc

Unambiguous default provisions

Misconduct, un-business like conduct and unprofessional conduct clearly defined

Each and every participant has to follow the Regulations, Circulars, Notices and Guidelines Granting Exemptions or making exceptions not in PMEXs vocabulary
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Position Limits
Position Limits Members & Clients To counter excessive speculation and manipulation Limits the number of contracts that can be entered into:
Gross across all clients Gross across all contracts Grossed up to the Member level

Open contracts held by one individual investor with different brokers are combined using Client IDs

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NCEL Trading System

One of the costs for brokers is investment in client management and back office system However, NCEL being an equal opportunity provider offers this to its brokers for free

PMEX will provide a complete end-to-end online trading & Client Management system to brokers: Risk Management (pre-trade check), Electronic Fund Transfer, Margin Call generation, online 24/7 access to daily ledgers and accounting, secure access (USB key and personal digital certificates), access to historical data, etc. Margin calls with online bank transfers facility Pre-trade check and daily mark-to-market protects brokers from client defaults

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PMEX Technology
Focus on availability , strong security, and ease of use State-of-the-art data center with biometric access control and fire protection system Redundant network both internal and external, multiple ISP links 100% Internet driven exchange Strong two factor authentication of traders using USB Keys (smart cards) Authentication based on Digital Certificate credentials Disaster recovery based on Veritas clustering, remote replication and tape library backup solutions Separate Disaster Recovery site for business NCEL continuity

USB Key

Trading on PMEX

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Trading on PMEX
Investors have two methods of trading on PMEX:
1. Direct access to the market 2. Traditional route of placing orders through brokers

In both cases, Broker is the Obligor to the Exchange Broker responsible for ensuring all Client Margins are paid Broker responsible for ensuring Clients comply with PMEX Regulations Broker responsible for Exposure/Margin/Position monitoring of all clients Broker earns commissions from both types of Clients Less Overheads if Clients allowed direct access

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Clients give cheques /cash to Broker

Client Margin Payments

Client Monitors Daily Ledgers

Clearing Bank

Client A Rs.5,000

Client B Rs.5,000

Brokerage House

PMEX

Rs. 5,000

Rs. 5,000

Segregated Margin Accounts

NCEL Back Office

Broker Broker proprietary account Client A 5,000 Client B 5,000
Client A Ledger Client B Ledger 5,000 5,000

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How to Start Trading?

Step 1 Step 2 Step 3 Step 4
Contact an PMEX Registered Broker Read and Sign Risk Disclosure Documents If required, ask for Direct Trading Terminal Broker Opens Trading Account Payment of Initial Margin to Broker Insist on Account Statements from Broker

Step 5
Step 6 Step 7 Step 8 Step 9

Verify that Margins have been paid to PMEX

Ask for training, if using Direct Terminal Enter Orders, Monitor Position, Pay Margins
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www.pmex.com.pk

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