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Issues financial risk management.

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 creditor ship 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 minimize the investment risk? The main option currently appears to be diversification of investments because hedging devices like derivatives are not available in our markets 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 minimization tool, with an important income smoothening role being played by the government securities. How ever, in the long run, effective regulatory intervention to minimize the die manipulation component of the risk would be the key, followed by development of debt instruments conforming to the Shanah.

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 favored 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,

Realizing 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. weather 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 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 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, through necessary, will not be sufficient to provide a fillip to the debt market. Its 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 employe.

The main operating income of brokerage houses is through commission they earn on buying/selling an 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 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 formally 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.

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).
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Author:Zuberi, H. Jamal
Publication:Economic Review
Geographic Code:9PAKI
Date:Nov 1, 2010
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