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RISK AND RETURN MANAGEMENT: AN ANALYSIS OF FINANCIAL ENVIRONMENT IN PAKISTAN
DOCTORAL DISSERTATION BY
SYED SHABm UL HASAN
DEPARTMENT OF PUBLIC ADMINISTRATION UNIVERSITY OF KARACHI
KARACHI - PAKISTAN 2008
RISK AND RETURN MANAGEMENT:AN ANALYSIS OF FINANCIALENVIRONMENT IN PAKISTAN
A DISSERTATION SUBMITTED TO THETNIVERSITYOF KARACHI IN FIJLFILLMENT OF
THE REQUIREMENTS FOR THE DEGREE OFDOCTOR OF PHILOSOPHY
PIJtsLIC ADMINISTRATION
BY
SYED SHABIB UL HASAN
IN
UNDER THE SUPERVTSION OFPROF. DR. MOHAMMAD ABUZAR WAJIDI
DEPARTMENT OF PUBLIC ADMINISTRATIONTJNIVERSITY OF KARACHI
KARACHI - PAKISTAN2008
CEryIEIUTE
C.rri6€d thd Mr. Syld sb$ib d Hrle S0 Sl,€d ltluoe Hsoa h|5
wrio.d |ib 6.si! dlL4 "Risk tnd R alm frbn g.ma : AD Andyli' of
Finsnci.l Bnvironmdt in Pakblrn" fron D.Partmcot of Public
AdDintuodim, Urivcfrit of Ktacht rownds ihe ffrffillm€nt of the
rrquiEm.ot of ItD. D.gtEa
The diss.rtstion i! b65ed on original rc!€grh.
(PROr. DR. MO
Univ€r'nty of KI&hi'
AALE Of COIt'IEt\ttTS
List of llluarrtiou:Lirt of Abbr.virtiors:
0. Introducaior...........
0.1 lntodudion to$e R€scarch................................. . . 2
0.2R€s€$chHypo1h6is..........................-. ......-- .. ..40.3 R6€rrch lssu.--............................--.............. ....... ....... 4o.4Res€lrlhQudlion-...........-.-...-.-...........-............... ...... .40.5R6cehoqiectives...............-.....-. ..... .......-........5
0.6R6.ehMethodology........................................ .. 6
0.6.1. S.lelionof R€s€archTopic..........................-... ........ 7
0.6.2. Submisid ofth.lnitigl Pmposd fd R.se.rch................. ?
0.6.3.Rese.rchSuwcy..........................-........... ..E0.6.4.Research|nterviews............................... ... .80.6.5. Publiqtions lnd Acdemic Rearch..................... . 9
0.6.6. Compila onddcon laliotr of Res.eh.d Dau ... ..... l00.6.?. Qualitdile and Quldit liE Aralysis........... ... .... l0
0.? S.Icctioo ofRd.rtcl Sslnp|e................................-... ........ llo.Echa eisoverview........ .......... 12
o.9lir.ntue Revi€e ......... .............. 20
Cb.pt r# r Rtulrd R.luru Frtmcrvork.....'.'....,...... 29
f.l. Th. Risk Conept........ .................. 12
t.2. ffskcl&lsific5tids.-.... ... .. 33
f.2. f. Non Dive6ifirblc Risk ... 34
f.2.2. DivetsifilbL Risk....... ..... ... . 35
1.2.3. Dive6ificalioD .. ....- ..- - 3E
1.2.1.1. Exlending Dive6incation lnl@arimallv . - 40
L2.3.2. Int€mational Dive6ificadon and Conelaliot .... ..... 42
1.2.3.3. hlemalional Dile6ificdtion and the Home Bias l'octo' 44
l -2.3.4. Diversilt€tion Using Emdging Martets ... ... . 45
l.l. RiskMsGmentAppbaches.......--.- . .....--,....----...--- 4E
l.l.l. Risk Quanificatiotr-Tte CAPM ^pprcach...
.............. 50
1.3.2. Risk Qumlificalion ' Allmadles ro CAPM .... ' 52
1.3.2.1. Arbitrage Pricing Model . 52
l.l.2.2. Mutri FactorModel-..... .....- .. .. 53
1.4 Conepts of Relum-...... - " 54
1.4 t Relum Dcllned.......... . .
L4.2. ChdaclcrFr,r\ oftmcrgng MaAd Retums
1.4.2.1 Liberaliarion Flled.
I 4.2.2. Non-Nomal Disribution! ....
1.4.2.J. PRdic.abliq............
I a 2 5. Coftlauon ed Mrler lnregarion
1.5. tusl md Rerum Tradeoll
1.5. I lem struLtw of tusl-Relum lr3d@tl
55
58
58
g)
63
65
6E
10
13
Chapter#2 ComponentsofFiDlrcislf,ntiror'nent"""'E3
2.1. FitrdcialMekets........ . ,' 87
2.l.l.Typ.sofFinucialMdte$.. ..... ..... . EE
2.1 .2. Finscial Mukers in Energing Eonomi6 90
2.2. Findcial InstitulioN.... ...-- -- . 9l
2.2.r.signilicanceofFinociallnstilutions.-- .... . . 95
2.2,2. FinanciallDstitution in open Economv Regine,.. .1002,3. Fdeignsector........... .... " 104
2.3.l. Foreign Sector sd Martet Developoe in Emerging Economies 106
2.3.2- Spillove6: Do They Really Mattcr?.. . ...-.. 109
2.3.3. Spilfovm and Domesric Produclili9 ---- ll22.3-4. C6t-Bercfit Anallsis of forciSn ltlestmenl lmp&r'' l l 5
2-4EmciotMdketll)?oth$h................. ....... .....120
2-4.r.TheRmdomwalkModel............ . ... .-- -122
2.4.2.TheConc€ptofMarkelltlicicncy................ ...-.. 124
2.4.3. Srock Ma.ker Anomali - --.. 121
2.4.4. Tesls of Fudam.ntal valu!|ion... ........ ............ 129
2.4.5. EMH Imlli€tions in EmerSing Countdes ... .. lll
Cbspter # 3
lut47
1.2. Risk Con.oms for Investo6 in Em.rging MmkeB .. . l5l
1.2.1. Country Risk............ .. . l5l
3.2.2. Exchege Rate Risk-... --- .. . 158
3.2.3. Intsest Rate Risk....... 162
1.2.3.1.EffecrsofIntercslRateRisk................- . ....... 164
1.2.4. Economic Risk.......... .... . 165
3.2.5. Fimncidl Ris1........... . l6E
Conponents lnd Sourcd of Risk
Conc€rns io EtnerShg 8conomi6............
3.1. A Brc.d PeBpstive on Forcig' Inv.sm€nl.....
I2.7 L Mtuker Liberah/arion
I2 8 sedorspec,fic Ri\l ...
l?0
t73
t75
t79
t82
tu Pakist!n....,........................,,,......... l9l4-f. Anra.rinS lnveshent md Ma*cr Lib€rlianion---... .................. 194
4.2. Inve$ne SeninsinPalisran........................................ ...-. 199
4.1. IdpedtiveFeaNresofPalisrar\Economy............................... 206
4.3.1. Markel Framework..... ,,,,,,,,,.... 2o7
4.3.1.1. The Privoliation Dri ,,,,,,,,,., 209
4.3.l.2.lnflowofForei8nlnvesIment..................-................2ll
4.3.l.3.lnvqioFParticipalioni.Privdtiaiion----..........,,,,,.......214
4.l.r.4.M.rlcrPerfomance.-..........-..................................- zlE
4.1.2. Tl€ Politico- Socio Edvi.odment..................................... 224
4.3.2.l.Poliri@lcultur€...................-................................225
4.12.2 Socro-F.onomrc serup............ ... ............. . 2.2'
4.1,2,1.InfrstructureSra1u.............................-.......,,..,,..-..236
4.3.3.RegulatoryAmgement.....,,..............-..........-..............236
4.3.3.1-ReSulations,LiensesedPemils.......--.........-...........240
4.3.1.2.PolicyImplemenratio..............................................242
4.3.3.3.laxationlssu€s............................--.-......................243
4.3.3.4. Prolit Repat.ialion... ............... . 245
Chspter # 4 Itrvestmerrrnd Financirlf,trvironm€tt
Cb.pter#5 Rilk Mrnag.merl i! P.kistrn....,.,.,.,...-.1.L Seuity PricinS in Pakis
5.1.1. The Kdachr Slock L\chage... .... ..
5.l.2. Seuriti€s & Exchdge Comnissior of Pakis1an......... ...........
5 1.2.1. Vhion and Musion otSLCP
5.1.3. Price Mdipulation inPokisiln\ Capital Marker...................
r. 1.4. Inept Reaularor) Serup
5.1.5. Brolemae Sysrem......
249
251
251
253
254
257
2to
261
5.1.6. Mmitulalion Mechanis ....... 263
5.2.RhkPreniumEstimalioninPakhtah......................-.. 265
5.2.1.HisloricalP.emiumApproach...........................--...... 266
5.2.2. tnplied Equily Prcmium Apprcach -.............. ----.... 26E
5.3.QuanlitativePo.ifolioManaSem€nl........-......... ... 269
5.1-f . Q.P.M] a Ce for Pa&ista!.....................---- - - - ---..... 21 |
5-4. Vafue ar Risk Appdch ro Risk A$6$nem.....--.--....-...... .. 274
5.4.r.Altmativev@RModels......-.-................--.......----........277
5.4.1.1. Pdmer.,c Methods ...-..................................... .. 277
5.4.1.2.NonpalmelricMelbods..........................................279
5.4.1.3. Seni Pdamer.ic Models ... .... . ........ ........ ........ .... . 281
5.4.14. CompdisonofModels............................................. 2E4
5.4-2.lmplemenlationofv@RinPakhtan--................................2E5
5.4-2.1.vrlue@RiskMod€lforPalistat.--.........-.--................28?
5.5. Hed8in86RiskMi1i941ionToo1........................................... 249
5.5.1. Roleof Derivativ6Exchan8cs.................-.......---............ 291
5.5.2. Derivativ6 Meket in Palistd.............................. -. -... - - -.. 293
Ch.prer#6 DataPrescntatio.rndAnalysis,................-. 302
6. 1 Resedch FindinCs . . . . . . . . . . . . . . . . . . . . . . . . . 303
6.l.l.lnveslnenrEnvironmenlCoDduciveness..............................303
6.1.2. I evel ol Risk ( oncerns inCompaiDon ro Lmnging
EcononigoftheRegion-.........................-.................... 309
6.1.3. Roleof Govmment i!Prcvidinglnli" StflcluE--...............-.. 312
6.1.4. EtrcientHmd ResourccrcD.velopMuket.. .....--............. 315
6,1.5. Incertives forFoEign Investo6.-................... ..............--- 319
6.1.6. Regulatory Fdewo.k .............. 322
6.r.7.ApplicationofModelstoForecdtvoldiliry......-..................325
6.1.8. Hedgine lnslruments in Pakistan ...........-........................... l2E
Illustmtion l.llllustration 2.1
lllustrariof, 3.1
lllustmtion 3.2
Illustration 3-3
Illustmtion 4.1
Illustmrion 4.2
Illustraiion 4.3
Illustration 4.4
lllustEtion 4-5
I llustralion 4.6
Illullmtion4.7
lllustration4.8
L r 5'T O F r L L0 SrlMtI OgtS
Systemaric and Non Systematic Risk .............. 36
Lack ofEmnomic Opemess Cycle -....-.-........ l0lComponents of Risk and Actions
R€quir€EliminatingtheRisk....................... 148
Hosl Counlry DeErminmts of FDI ................ I 50
Comtly tusk Ass€ssment ........................... I 55
lnvestment Climate lndicators in Fou Counlries I 9E
5 Year Moving Av€rage GDP Grorth Rate . . . . . . 202
Top l0 Consraints to Finn
Investment in Pakist$ (2002)...................... 2uNet Inflow ofForeign Private Investment........ 212
Pakistan croqlh and Development lndicatoB... 217
KSEadClobaf Mdkets.........-......-.-.-...... 2t9
lndicatoB of Karachi Stock Exchase -....... -... 221
Capitalizadon !o CDP Ratio of Selected
counlries 2002-03.. ........ . . ....... -. ..... -.... .. .. . 223
lnflation dd Real GDP Growth Rates
1973 -2000........................-....-.-........... 228
5 Ytr Moving Avemge Inflafi on .-....-.......... 230
Pakistan: lDflarion dd Monetary
Gro{th l999ll - 20056........................... 232
Pakistan: lnllalion and wlea. Suppon
Price 1999:l - 2005:6............................... 234
Illustnlion 4.10
lllustation4.ll
Illushtion4.9
llluslration 4.12
ADB
ADD
APM
CAPM
CBR
ccG
cFs
CLT
corCPI
cRc
DFI
DSR
EMH
EVT
FDBR
FDI
FRA
FX
GARCH
GDP
GEV
LIS(Of $8rc'llA'fiOt'f
Asirn D€velopnent Blnk
Authonzd D€rivalives D€ller
tubitrage Pricing Mod€l
Capital Ass€t Pricing Model
C€ntial Bo8.rd of Revenue
Cod€ of Corpornt€ Govemsnc-€
Continuous Financing Sysl€m
C€ntial Limir Theory
C,Iry-over Tr!ffrction!
CnsMer Pdce lndcx
Cr€dit R nng Conprni€s
Depository Financial Inslitution
Debt Service Ratio
Efi icient M.rk€i Hypoth€sis
Extreme Value Theory
Financial Dcrivativcs BusinessR€gulations
Foreign Dir€cl lnvcstn€ni
Forwad R G Agr€€mmts
Forcigd ExchanSc
Generalized AutoRcSr€ssive Conditional Hetemskedasticit
Gross Domesiic Productivity
Genemliz€d Extlnc Value
cNP Gross National Productivity
HS Historical Simulation
IERP lmplied Equity Risk Pr€mium
IMF Intemarional Monetary Fund
In.R Inv€stment R roIR lmpon Ratio
lRs Iner€slRal€ Swaps
KEsc Karachi Electric supply Corporsdon
KSE lGrachi Slock Exchang€
LSE Laho.e Stock Exchange
MDS Mixed Data Sanpling
MFM Multi Factor Model
MG Domestic Mon€y Supply Growth
MNC Multi National Companies
MNE Mulri-National E enrises
MSCI Morgan Stanley Capital Intemarional
NCE Nalional Commodity Exchange
NMI Non Markei Mat€r Institution
OECD Organizalion for Economic C@peration and Developm€nt
OLI Ownership,Localion,lntemalizalion
OTC Over the Counter
PtE Price Eaming Ratio
PTCL Pakistan Telecommunicalions Compuy Ltd.
QML GARCH Quai-Mdimum Likelihoodc€neralized AutoRegressive
Condilional Heteroskedaslicii
QPM Quanritativ€PonfolioManagement
QSS Qudtit tivr Stocl S.le.lion
R&D R..dc,h&Dcv.l@dRM Ri&lr.ticrSBP S@B.otofP*ituSBCP S€criti.. & Exch|'g. Crmi.io ofPatitto
Slz spocbl !!rl|ci.l zG6V.R VatF dRilkvC VarirE CovlrireWB WoddBr*Vr'TO WorU ftld€ ora.dz.don
ACWo'WLEOqE tE9,tT
Firsl and foremost, greatest and mosl honesl Sratitude io the
AII-Mishly Allah forenabling the complelion of the task ofthis
resedch paper. Ii gives author immense gmlification to €xpress
humble and heanfelt thanks to sup€rvisor Dr- Abu Zar Wajidi.
De3n, Faculty of Mdagement snd Adrninistraive Sci€nces and
Director Evening program, University of Kafachi. for his
esreemed suidance. supenision &d in-valuable suppon in
facilihting and prepmtion of this research paper. His suppon
and guidanc€ h6 made this pap€r meningtul dd his comments
and advice have facilitat€d in moving along the right direction.
Gratilude towads aU the people who help€d in preparation of
ihis e*uch by the; teedback on suryeys and inleruiews is
expressed. The author would also lik€ to convey sincerc
appreciation for compassionate help with palience, extended
explanations and claificalions during ihe meetings and
discussions from Mr. Ali Husnain, Meinb€r Kdachi Stock
Exchange, Mr Zafd lqbal, Treasury Division Bank Al-Falah
Ltd. Mr. Shahzad Abdullah. Senior FX dealer Bank Al-Falah
Ltd, Mr Sobail Siddiqli, Branch Manager Bank Al-Falah Ltd,
Mr Ahmer Nizzm, Mdager Citi Bank, Mr. Nihal Cassirn,
Member Karachi Stock Exchange for they have to take time our
of their busy schedule and 1o endow with all the suppori md
data required for the study.
The author likes to express heanfelt acknowledgem€nt to Dr.
Allter Baloch, Dr. Klalid lraqi, Afsheef, Nizm for all they
have done in nak;ng this rcsearch possible wift their
suggestions and encouragement.
Author would also like 0o especially nention here the sinc€rest
cooperation and efons ofhis falher Syed Murntaz Hasan whos€
encoumg€ment and direction help, not only in Seting md
gathering all the data needcd for the resedch bu1 also to move
forward in life. ConcE€dly, the effons ad encouragements of
b.otheE Shahbaz, Shdawaz Shabab, Shahzd, Shahw odShajee can never b€ ienor€d but n€eds to b€ encouraged ddacknowledged. The author also likes to extend appfeciations to
his colleagues Ms. Saina, Mr. Shahid md Ms. Ch@l for the;r
It would b€ no justice if the author fails to me.tion the prayeE
and suppon of his nother Shaukar Ara, wife taryal, sister
Roohi, brother-inlaw Imtiuuddin, ud ister-inlaw JahMb.It would b€ unfair if th€ author fsils to menlion th€ support dd
PEy€B of lh€ in Iaws who have almys encouraSed the author
for high€r goals. Last, bui definitely not the least, the autho.
likes 1o acknowledae the contibution of his daughter Asna.
niees ed nephews as Ihe author w6 not able to give them
tiine when they needed it most.
Furthemore, honesl appreciation is expresscd towards
Ahmed Ali Siddiqui, M. Mushlaq, Mr. Adnd, Mr. Munsif,
to allolhers who 4sisted in (he completion oflh;s Ph.D.
Mr.
AES'-rq,AC'r
The basic nmction of econonic policy in dy coufltry is to channel the
savings of invesbrs to the productive hands in order to p.omote the
economic grosth. It is th.ough rhe investment inflows that rh€ opportunity
for groMh is created by providins tunds 1o individuals and goups who
invest in new projecrs. This, in tum, enables the eflicimt and effective
circulation of money ;n the economy, creates more job opponunities and
elevates the standard of living. Th€ capital inflow performance is considered
as the barcmeter for qwtirying economic grosth in r€al lerms and leads ro
higher liquidity ed invesbr confidence. Wh€n an economy sends our a
investment, resuhing in funherstrong signal, it eventually attEcts foreign
This reseh paper will mainly focus on resting the €cenr market
perfoma.ce here in lighl of key indicators for a true economic boom in
Therc bas been €xtensive claim, in recent rimes, about the imp.ovement ;n
Pakistan's economic perfomdce, reflectins highly conducive environment
for investors. However dEre are different perceptions abour it which
r€qu;rcs for d invesligation to dig out that whelher the confidedce exhibit€d
by the investor can be considered as being logical and based on reasons rhat
de sound and dependable in the long rerm or the boom ;s just a bubble about
to bursl. In addition, Siven the uncenainry ad volar;liry in the economy. rhe
recent economic trend of arcwth has yet to jusri! itslf for a prudenr
investorlo be inter€sred in the Pakistan's economy
€merging eco'onies like Pakisian. B€ins a lhird world e@nomy. Pakistan is
on lh€ couse ofbeins.esdded as a mp;dly d€veloping meket in the slobal
dena. Th€r€ rc numerous developmem projects undetray such as dams
dd highway constructiom. However, by the in@mational standards, lhe
pace ofthe developm€ntal p.ocess is slow which adds up to the .isk factors
considered by a prudent domestic or foreign inveslor. ln recenr times, there
have b€en s€veral policy adjustnents introduced in a gradual and sysiemaric
nanner Fom the regulatory authorities. Their objective is to sueamline the
regulalory limework in ord€r to cout€r the efTects of unfriendly addiscouraging events and procedures especially for foreign investments.
These measures span a horian that includ€s the broad policy of op€ning-up
fte €conomy for intematioml investos. However, in o.de. to ava;l the
benefits of inv€stment opportunities, there is a need for the establishment
dd development of an €fficient risk nitiAation structure within th€ finrncial
market th.ough an analysis. This ealysis idendfies key a@s .equired to be
evaluated to fomulate strategies so as to carry out rhe st€ps to follow the
strategic ftamework. SECP and SBP have formulated a comprehensive
strate$/ !o look inlo the matrer and work out a road map for the development
of financial mark€t in line with th€ best inlemationat pEcrices, which,
hoqe!er. should be maintained on a lone rem basis
-!,'!Lr'!,)pt -.,/ J ! -1 ttwQt/ L..trd!"o,..'.t'v&.ltiva./- 1 ri /=,,\,ti4re7sr, ) E'.2-L4,et/*,1,,b{ A t-Z cjt' ld rivttV e vL, 0
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0.1 lrtroductior ao lbe Rgcarch
This r€s€arch study €ntitled 'the Risk and Retum Managcftent An Analysis
of Financial Environme in Pakistan' is a detailed testing of rclcvanl issues,
conducted in a critical rEview of r€s€arch papcrs and anicles prescnted bv
profeisionals and academicians.
Risk and retum r€lalionship is one of thc impona.t delcrminants for lhe
inv€stor, esp€cially for th€ inflow of forci8, investmcnt, which rcsls on
c€nain other detcminans as well and define the level and 8rowlh
crpabilities in thc economy. ln the ev.luation of invcshent proce$
*herher, for€ign direct invesrm€nt or ponfolio investn€nt, economic
detenninanB aE not thc only influcncing facto6. R.athcr, polnical, social'
cultuml and legal issues ar€ some of the oth€r key factoB thal have a direct
impact on the level ot invesrment inflows bolh from local and lior€ign
However, in order to €valuale the pros and cons of polential investment
op€ning, investors keep searching the ways and means 10 mitigate
investrn€nt risk by adopiing sophisticared and up to datc tc{hniqucs prior to
makinA the investment. This m.y pmve comParatieely more cxPensiv€ but
lhe payback is far more wonhwhile, especially when dealing wilh a volatile
and uncertain ma*et environmenl. Uncedainly and volatility arc inh€r€nt
featuras ofd emerging ma*et likc Patistff, which leavcs fte window wide
open for a re.sonable investo. to capitalizc this atuibute of thc ftarkd by
following such Gchniques.
During the last decade notable major political, social, infra struclural and
economic chsges have come to see. In Pakistan thes€ changes have
nanaged to tEnsform the image of the 4onony to podray a more open and
attractive outlook for investment. The prcsence of sound a.nd emcient
financial markeis beinS complemenEd by the recent economic performance
hs become increasingly importml lbr Pakistm, especially as part of the
financial seto. r€foms initiatcd dur;na $e rccenl yean while the
impressive economic perfornanoe has helped financial markers 8rcw bolh in
tems of size and depth, equally signilicmt is the necessity ofcontinuity of
the golltb mom€ntum in tuture because sone quaners oflhe socieiy have
expres*d fteir doubts. It is wonh noting though, thal opponuities provided
by improv€d linlages amorg markers ar the domestic level and a dsing
degree of integralion w;lh the intemational financial systeins, are not
av.ilable free of cosl, as the r;sk associaled with financi.l mdk€t aciivities
arc incr€aing with a mpidly growing economy. ln orde. to optimize the
benefits, ir has become equally si8niiicant for both the regulators a! w€ll as
the market players 1o inprove efficiency measurcs and adopt bett€r risk
managernent procedures. (sBP 2005)'
It is obsered ihat changes in economic approach lo liberalization and
der€gulation by governments and regulalory institutions usually have led 10
significanr improvement in the financjal €nvironment ud mErket structure.
However. the pdncipal reason for the hck of attraction, perceived by
inte.national inveslors, to invesi in Pakistan. is the politico-economic
iBtability resulted in fraSile envimnmenl causd by inconsistent policies.
0.2 Essrs!-IJ!9!Ei9
OJ R6earcb Islue
This research focuses on highlighting ihe existence of f&rors of worii 1o
investoE and the pcrfbmance of Pakhtd s economy under the recdt
6onomic refoms impl€menled by the govemment and rcaulato.y
authorities. The study also discusses the sonomic perfomance and the risks
for the invesl,ors in the Pakistan's financial environmenl nd how these nsk
factors aff*t the level of capital inflows, boih from local and foreign
0.4 Bc!sls!-O!s!!!9s
The central issue in this study is to identiry lhe investment environmeni in
Pakisten, in tenns of ils conduciveness for a foreien investor. baled on risk
ed retum tundamentals. The rcason for rhis issue is the fad rhat the
Pakiskn's economy is undergoing ma.jor reforms rowdds achieving this
goal. me aim oflhis research is summaris€d in the following question:
Whctire the prircip.l opportunilies ad threlts io.r invstor€itber io
tcms of foreigD di.ect itrvestnedl or portfolio investme.l itr Prki.ta! ts
conpired to thrt of other enorging economies, and whether recenl
politico-economic signals fron the Noromy rre strong enough to brirg
and bold itrvesiors on.loDgtcrn basis?
o.s &!sE!-9u.cqir9!
This sludy is aimed at idenrirying thc key reasons for the cunent l€v€l of
capital inflows in Pakistan md evaluales the economic perfomance in e&h
. To idmiry the key areas thar an investor has rc look for when making
inveshent decision and ro relate it with lhe resmctur;na that took place
prior to the rec€nreconomic uplift in l,akistd.
. To id€ndry $e major steps t len by rhe curenl regime ro brinS changes
in investments md regulatory framework.
. To scrutinize the recent cconomic performance in ord€r to test the
stability and connnuiry ofthe nnproved perfonnance.
. To evaluate 'he
role ofsovemmenr's economic policis in the conlext ofglobalization dd grcaler mdket jntegraliod between the dev€loped and th€
€merging ecooomy narkets.
. To compre ed contrast the perfbmcc parallels in otler economi€s
and idend! key diffcrcnces.
0.6 Esssrs!-!4e$.sCsl9q
This r.search has been conducted by lbllowing the stddard suv€y method
thmugh questionnaires structured to draw close-ended respons€s. Th€
s€cond part of primary dala collecti(ll comprises of inlediews involving
structured queslions from idividuals with dislincl finmcial and policy-
naking brckgrounds. -fwenty
individuals w€re seleded on b4is of standad
proc€durcs to rcprcsent diveBe markct and economic secro6 in ordet to
eoable thc rcsearcher to deduce results based on a maximum parallel horian
on the econom) . I he n Jmber oi rc"pordents ro rhe 'ur e) quenionnarre * a5
fony five. These indiv;duals w€re randomly selected from a population of
ninery individuals from diferent walks oflife.
ln this pan, a detailed method ofconducting this rcsdch will be discussed.
Therc werc. in tota', *ven $ages thnl con$irure $e whole process. Th6e
stages arc presenied in a brief tbmat hcre with funher details to follow:
Sel€ction ofresearch topic with duc supervision fiom assigned supervisof
. Prcparadon dd submission olan initial proposal, summadsing the major
processes to be cdied oul Lhrcugh 'hc
@uAe of lhe rcsearch.
. Conducring the rsdch rrve) rhrouC.h rhe standad pro<edure ot
quBlionnai.es with empl€s ftom r€leldt sectos ofthe economy.
. One-to-one interiews were conducted with a p.udenlly selected goup of
individuals from specific sedors ol'rhc economy i. order ro broaden lhe
rcsedch horizon to cover maximum dimensions oflhc.esearch.
. Resedch was canied oul also through relevant published mal€rials
oblain€d Fom difT€rcnt sources such as financial journals, rcscarch papers,
web-b6ed joumals and books.
. Comtilalion of the suNey and inieruiew dala was conducrcd and
incorporated with the acadenic rcsearch dd corclaled lo the overall
. A fml dalysis ofthe dala and research was conducled and prcsenlcd ita sysFnatic qualhative ud quantjlative method with reSdd to rcscarch
findings.
0.6.1. Se!9s$9!-el-B$eerc!-Ispis
Ir was considerably rricky to selecr thc research problcm. but by virruc ofconsrdt hard-work, ftc researchcr succestully sclecred fie rcsearch
problem. Th€ selection involved exploration ofva.ious topics rclating 10 the
area of interest as proposed by lhe rcscarch-supervisor. Consequently, three
top'cs were selected and funher feading dd data collcction wd cadied-our
to dalys the scopc of @ch srudy. Ba$d on availabilily of sources ofinformation and aptitude, thc ropic 'Risk and Retum MaMgedent: an
Akalysh ofFinancial Envnonhent in Pakitah \\as in lly selected.
0.6.2. Subnh.iotr of the Iniri.l Pros.l tor RMrch
An:er the selection ofa topic ofresearch. the inilial propo$l was dcsigned
for the study. l-his includes a summary of the ovcrall rcsemh that will be
caried-out in several steps. The topic was turth€r sludi€d and explored
before a bnef fianework of lhe research issue Ms presented. Furdtemorc, a
structure ofprocesses was al$ conductcd during lhe course ofsubm;ssionof
research prcposalforthe a.lmission in higher research studies.
0.63. BseersLsu!9!
Thb r€search work has been conducred on the bais of primary da13 and
divided in0o two s€gments. In the first pan, a suNey has been conducted
which consists ofa method;cally desiSned questiomaile and is based on lhe
view to drawing relevant infomation with convenience for fie respondenrs
and researcher. The survey comptises of close'ended questions wilh
provision of any additional comments lrcm lhe respond€nB. A sample of
forty five respondents was s€leded frum a populadon of ninety, basd upon
iheir field ofwork, experience andjob designation.
0.6.4. Re.errch lrlerviews
In the second pad, primary dala collectlon was cmied-out thrcugh research
interviews. The sample selected lbr tb;s objecdve comprised of five
individuals from r€levanl sedors ol the economy- Most of the rcspondentj
wer€ fiom the relevanl backSround, having served in the meket for al lersl
five years. hailing from differen! sreas ofthe corporate sector ranging froln
capital IMkel to banking secror and to invesrment advisory seNices sector.
0.6.5. Pobliqaions and Acldemic Rcscirch
The secondary dara was also adhercd to where the resemh *as done Ei.g a
thorough analysis md evalutioo of rclevanl material via
'Ilpse souces include scholarly joumals, research anicl€s, nes briefs,
counry rcviews by Blobal financnn insituions, rcgulatory autho.ities,
books, official publications from thc wo.ld Bank. ].he Asie Development
Bank, The Slate Bmk of Pakiskn, 'lhc Karachi Stock Exchange and The
Secuities and Exchange Commission of Pakistan. Stddard referencing
procedms were followcd with due care, in order to attribule du€ credit for
original resedch 1o thc authors ol lhe publicalions made use of in this
res€arch, however if ther€ is ny rcllrence lcn to be mentioned that would
be mtirely unint€ntional and the rcsearch apologises for dy such incidenl.
0.6.6. Comoilation apd Correlotion of Relca rched Data
The data gathered through primary and secondaw sou.ces was coEelat€d
and mmpiled d per standards and duly rcfe.enced. Th€ information
ohrined lhrough primary research Nas incorpomted ;nto the analysis ofthe
th€or€ti.rl dimension of th€ rcscarch and presented in a syslematic and
orderly fashion so as to facilitale thc .€ader to comprehend th€ overall
0.6,7. Q!!!i!e.$]33!d!u.4!!c!vs4!!lxg!
Th€ $rnritative dala adopred in the work is dram mainly fton ihe research
surv€y conducted using quesdoMaircs. Th€ questionnaire wa desigred such
thai the respondenls could sysiemalically provide infomation in a clos€-
ended fomat, as well a they were able to exprcss any turther commenls and
recommendations that may be wonhwhile to the research. The qualilative
data was also considercd dd its source in thc research findings s€ction of
this paper was mainly deduced tior thc inrerliews that were conducted
ftom primary data couection. Delailcd and iniordative sessions with all the
int€rviewees were held wilh a vieN to crealing better comprehension of
conpl€xities of the ;nveshcnt landscape in Pakistan's financial
0.7. S!b!ierd!es!4l!!s!E&
The sel€.tion criterion for lhe sample was Bainly relied on the r€lev$cy of
@h individual lo the resarch topic. Th€ questiomire wes d€sign€d so as
to deduce information on most of lhe €vents md activiti€s afTecting lhe
population. The sample from lhe populslion was selected on the pinciple
that the mosr relevsnt hdividuals were able to respond with most reliable
hformrtion. B€sids, the sanpl€ selection Eas also baled on thr€e main
ar€as of s€lection cnterion. First - ile clos€ness to the issues rchting to the
r8earch and rhe r€spondent's reputadon in rhe rclevanl sccror. Sccond - the
level of s€niority and compet€nce in the relevdt sector of the ccoromy.
Third - the respondent's cunent prcfession and activiries being linked
directly to th€ area ofresearch.
0.8 g!.e.p!sE-9v9qE!
In this section, a brief oveoi€w of each chapler of dissertation is preseirt€d
with a view ro providing rhe .ead€r an idea about what these chapte6 arE
aimed at and how thes chaple6 ar€ structured. Following is a bnef
sumary of the arcas covered:
ebpsr!
It discusses rh€ retum and nsk concepr tundane als which are considered
as lhe focal poinl of the study of inv$tment. and rhe two factors jointly
constitute lhe foundation of investmcnt decision. Stated in simple tenns,
investors wish to em a rewdd on rcir money tbr taking up the challenges.
These r€wards arc rhe motivaling forcc in lhe investment process as it is the
rehttt for und€rlakng the invesment. dd investoE always have the desire
to maximize the expecEd retums subjcct to consrainu. Going a srep tunher,
the stxdy explores the idiosyncralic lcalures ofthc cmerging markel retums
a4 therefore, suggests lha! these rcturns for invesloF are characterired by
uique lbatures and cannot be trealcd as if rhel were equal 1o develop€d
Da*el Eums based on their dislincl;ve chaEcter;sri(s
The other half of the investmenl dechion fundamentals is the uncerlainty
about the expected retums. An investo. musl always search and csess the
ditrer€nt kind ofvariables ttal could affect rhe expecred outcome about rhe
rctm. Some of the variabiliry of the rerums can be eliminated by th€
investor over lhe coure by having multiple investmcnts refened ro as a
divereified ponfolio. llowever, therc are facron that raise the uncenainty
ll
about the Seneral economic and $cial condilions and that cannot t€
€li'ni'ated by way of holdins a divcrsified ponlblio rcfered to as non-
diveBifiable or systematic risk. 'the issue ol diveBificalion beomes even
more impo.tanl in case of emerging marker rclurns and, d th€ sludy ha!
dhcussed in detlil. the inveslor has ro always look lbr ways and means to
rcduce the impact of volatility in the isues associaled with inv€stm€ni!
though inaemational diversification.
Apan from the above, lhe chapter 0lso evaluales the economic ero*rhwitnessed id emerging economies in the reccnt dnes leading to heightened
forcign interest. The study focuses thc fad rhar cuncnr siuation requics for
nodification of risk and reum model to include additional risk facton
specific to emerging economies in ord€r to prolide justification to the
for€ign ;nvestor's rationale for theh inves.menr in emerSing sonomies. The
study al$ bnefly discusses lhe 'nosr
wid€ly convers€d models of pricjnS
alsels b6ed on their risk and retum liamework. [inally, rhis chapter tries 10
focus the vital issue of dsk-rcturn lradcoff reSarded ds the "fundamental law
of findce" or the "sound sl€ep at niaht" lest as evcry inlestorwould like b€xf'ect minimum va.iations in expected rctums.
Chrpter 2
In this chapler, the resercher has examined various componenrs of financial
envircmenr that bear d impact on thc decision lor investment, especially in
e emerging economy. It is also invcstigated 6 to how different inv€stos
resf'ond to the levcls ofvariations involved.
HavinS revi€w€d the r;sk and rctum essentials, iI becomes imperative ro
dis.uss $e environment accommodating $ese aclivities. The chapler
focuses on the definition of financial mdket dd its classification, th€
chaJacterislics of the inslilulion involled and lhc component of foreiSn
sector ;n inveslmenr dynmics. liinancial narkcl is considered as a
ncchdism that allows peoplc to e\cbnage moncy for securities or for
cohmodides such as sold orsimilaf precious merals. llowever, in a boad€r
perspective any commodity mdket might be conside.ed a finmcial mark€t,
provided fiar the usual purpose oftrade is not the immediate consumption of
the comodity, but Ether as a means of delaying or acceleratinS
consumpdon over time. Due to the lilality of financial markets, the chapter
canies oul a ihorough discussion on different kinds of markets such as fte
prinEry & secondary markets and thc capital & moncy markets. It has aho
been delibeEted upon as bow finarcial markel pl ys a viral role in the
nodemJay socicties, $y, by ha\ing been madc available incr€ased
investment opponunities md impmving fte standad of living rhereof.
Furthermore they have also provided belter diveBificarion openings for easy
shifts in investmenl risk levels b invcstom.
Th€ significrnce offinancial instirutions should aho be rccosnizd as it hag
been increasingly acknowledged rhal lhes€ ;nstitutions play a key role in lhe
process of economic dev€lopmenl. |jnmcial iostitulions aenerally enhance
lbe etrciency levcl of findcial markcl. The chapter focnses on rhe validity
ofthe p€rception that lhe dir€ct impact of financial ins(irurions on rhe rcal
€conomy is relatively low but rhe indirecl impacr ol financial markers and
institutions on economic activities be^r muing imporlance.
t1
The chapt€r also tnes ro shed lighl on the exisling literature on hunEn,
financial & social capital fomdion ar lhe role thc foreign sector cm play
in nunudng lhe financial markets ir emerging economies provid€d they
adopt an open stance on economic fronls. Last bul definitely not the least:
the chapEr spotlights one of the most crucial altribues of mark€l mshdism
rh.t is to rransfom infomation into price. In order b atkact the foreiSn
investbent the host counrry must lakc action to reflect thal the mark€t posses
ev€ry chdacterisrics to safeguard th€ inleslor againsr lhc ha?2rds eising out
of price mechanism. The tem clllciency is used lo dcscribe a nark€t
wherEin rel€va infomation ;s impolnded inlo the price of findcial ds€cs.
The ellicient market hpothesis is concemed with the behavioui of prices h
ellPell
This chapler takes the discussion forwa.d from what has been thrashed out
in previous chapters about the dsk and retum lmdanenrals and the financial
envircment. This discussion aims 11 examining rhe various nalures and
sources of risk concems that affect rhe decision of an investor esp€cially
foreign invesror because of the pcrceiv€d importance of foreisn investment
in economies like Pakistd. The maSnnude and impact of each ;sk hcto.
veies with the tme horizon for the inveslm.nl and every type of risk can
influence an investor's decision to inlcst in a mtrket, depending on the risk
dsssmenl of the target markct. 'lhc common typcs of risks involved in
making an investmenl deision and the; magnitude ol- influence or the
investmenr are elabo.ated in rhe following di$ussioni however the debare
on va.ious risk concems has inlentionally been kepr focused to highlight the
t5
vi€w-poinr of the foreign inve$ors.
It must also be kepr in view that rll variables discussed in the chapler
idenlify opponunilies for bolh rewdfds and challcnges to lhe investors.
Rewards crop up in thc form ol findirg ways to profi1 from th€ incfease i.the value ofth€ invcnJbenl arising oul ofposiiive movenenl of concemed
variable or variables. Cooversely, challeryes entail from balancing rh€
pot€ntial for such gaim aaain$ thc possibility of loss€s arising oul of
advers€ movement in veiable/s associated with inveshent.
Som€ of the dsk concems, whjch thc study has tried to shed lighl upon
include country risk which is considered as tbe starling poinl for the
invcsto.'s analysis. Exchange rare risk is the second risk concem that the
study has tried lo discuss, and fundamcntally this kind ofrisk €manates fro|n
chang€s in exchange mte which may be a rcsuh of political inst biliry
besides olher related factors. Nexl ro the cxchdge rate risk, the study
focuses the interest rale risk which is the sensnivily of a debfs price to
changes in inlerest rate and rhis rcaponse of the debi's value, in m,
depends on lhe securiry's time b maturily and its conpon rate.
Funhermorc, th€ study also dhcuscs th€ .isk conccms lik€ fluctuations in
economic perfomance. market va.ilrions. inflado. faclor, financial and
political chcumstances in addidon lo sector specific scenarios. The puQose
is lo assess lhe condilions on which the invesbr would b3 able to decide
about investing in the economy. The level ofvolalility and the magnitude of
each faci,or may be differcnt for each investor. but the study has tried lo painl
thc piclure on a broader spectrum.
Chapt€r4
This chaDter deals with the so€cific investmcn! and financial envi.oment in
Pakistan and in thar contexl, aims ar exploring in detail the issues, which
affe.t the investor's behavior. ll h{s been emphaired, tltroughout the
hisrory of Pakjstan. thaL economic er\ironnrcn! should be rmstbmed in a
way so as to enhance private seclor involve'ncnt ar all fronls. Fo. the past
two decades in parlicirlar, Pakistan is aclilcl) calght up at all fronts lo
transfom the environment as mosl conducive for the inveslor. Economists in
Patistan have alwals maintained that for the sake of havinS optimum
utiliation ofabmdar! resources herc. pfivsle paniciparion is a must. Also,
those who espouse liberalizarion have argucd that privatized markels
allocat€ rcsurces most efficiently. ljichengreen (2003I in panicular, holds
up that financial liberalization allo*s a country to expand and diveBiry
investmenls, thicken financial markets and encoumae eonomic gro\th.
However, this philosophy has not bccn able to aloid objeclion 6 there is
another school ofthought wbo disrSrccs. Mosl prominently, Sligl;lz (2002)4
argues thal iffindcial actor's deals with perfect information and transparent
economies, then intemationally conrpetitive markets arc, indeed, Pareto
optimal. Neverlheless. if investors happen 10 face infornation asymmetries
and inetlicienl markrls, as they olien do in developing economies,
liberalization may.esuh in debilitating fi nancial volariliry.
The chaprer also makes an attcmfl ro cvaluatc l']akislan's strife lo transform
il! imoge of m unartraclivc antl comtlcd .conomy inro d open,
progressive and h"nsparent one, for lhc sole purposc of €ncouFging capital
l1
inflows in the economy- Eflorts l() tacilitate thc econom'c openn€ss,
predominantly lo thc intemational investor, havc becn onSoing a88r€ssively
since the beginning of the lat dsade.
With the kind of severily in the competition to atmct lhe foreign investoN
among emerging economi€s of the rcgion, performance of the €conomy in
the lrea of degre€ of openness could only be cvaluated by having a
comparative dalysis. In reged lo overcoming the inhibitions of lh€
investors. the prcsent govemnenl ol l'akislan, like nrost govemments ofthe
r€cent pdl, has made adjustments and caried oul policy'making so as to
encourage growlh in foreign investmcnts. The stud!' has rargeled areas, to
evaluate the work donc to nuke the cconomy more inveshem-friendly and
wh€ther overcoming these obstacles would reduce Lhe overall counry risk
quorienl fo. the economy or not.
Ch.orers
This chapter highlight th€ peBisencc of political inslability coupled with
sonomic instabillly, which crops nunrcrous isk- rclaled issues for invesiofs
in Pakisran- The risk associated with investment in such an economy tends to
bc on the highe. side. This r€quires a rarioMl approach to risk management
to atlain desimble results out of the inlesfiem decision. Pakistan, how€ver,
h actively seehng to improvc its market struclure by intoducing larious
reforms- Most oftheso refoms de aimed at reSulatory fiamework so as lo
enhance its image i,1 lhe incmadonal sccnario, thercby attEcting more
forcig investmenl !o improve its cconomic grotrIn. This approach is
llr
essntial d th€re is dearth of indigenous rcsource genersdon and th@ is
much ned ro boosl the ove.dll efticiency of the market Furthemor€, in
Paki$an, after the 9/1 I incident, bclicf has grown that markets here need
improvements in their legal and instilulional setup to attracl th€ inveslors
lokins ro sain from the alobal adjusrments. Gla€se. et al. (2001)'and Lg
Pona el al., (2003f have found thul the eovemancc of equttv ma*et
inGmediari€s, has received increased emphasis ftrough the appropriate
design and enforccmcnt of law and regulation paniculally in emersing
narkets. The govemment is commiucd lo p.oviding full nadonal lreatnent
md ftll legal protedion to fo.eign iovesmenr- The 1976 Forci8n Pnvate
Investment Promolion and Protectior Ac! spccitically provides lhat foreiSn
investment will not be subjecl to higher income 1ax levels than lhose
ass€ssed on sjm;lar investments madc by Pakislani cnizcns This Acr and the
1992 Economic Relbms Act arc lhc primary slalutory safeSudds for the
nghts of foreign direcr inve$oF. While Pakista's lcgal lramework and
economic atrate$/ do not discriminatc againsl fbreign investnent, conrmct
€nforcemenl can be problemalic in vi€w ol the domestic cour. system's
inefficiency and lack of transparency. The sludy b€lieves that self
regulations, by brokcrs to handle risk concems in e'neraing economies like
Pakistan. wilh expensive law enforccnrcn( arc unlilely ro be successfril. The
study also considcrs that despite such conccms. liulc is known about the
costs of risk measurcmeni ed forccasline issues, and feels the need to
discuss th€ issue of risk managemcrL md forecastinS with reference to
Pfista in this chaptcr.
0.9
Tte issue oirisk dd retum managemeni has rccen y atlaincd popularity in
Patisran. but a lol is still to be srudied and analyzed in this arca. since the
early 1990s, €merging economies have worked exlensively to inegmle local
narket with rhe Slobal market 10 acquiE ecess 1,o foreiSn capital.
Consequenlly, not only did capital flows to energing markets incrcase
dmmatically. but subsBnr;al changes in lheir conposition wcfe.lso seen.
Mdkets de consideEd inregEled when assets of ;deol;cal risk commd the
same expected rctum in€sp€ctive of lheir domjcile. Iheoretically,
liberalization should bring aboul emerging mdkct intcgralion with thc
global capilal markc!, md its effects on emerging equily mekets ee then
cler as for€ign invesroB will bid up the prices of local slotks witr
divenification potential. Al the same time, all investoB will shun inefficient
seclo6. However, in view of the fact that stock marker libemlizarion is
deemed as one ofthe foremosl reasons for cmftins ancw milieu for financial
inveshents in emerging sonomies, many sudies havc cmpirically scmned
the changcs that occuned in emerging capital mdkets after the libecliation
(Bekaen and Harvey, 2003)'. The be$ p6n of these stud;es testifies thal the
libemlizalion ofcapiul narkets was of assisrdce 10 emcrging economies in
thar il allows for inremalional risk sharing belwe€n domestic and foreign
investors through capital mdket integration Gee. e.g., Bekaert and Harvey,
19953r Srulz, l999et canieri et. a/. 200210; md lwaia and wu, 2o(Xrrt'?. In
addition, there is als empi.ical substantiation to propos€ that the concrcte
libenliation may lower the cos( of capiLl leading 10 cconomic welfares
(see, e.g., Rekaen and Hawey, 2000 r: and Bekaen cl. al ,2oo)"\. Apan
20
from this, more than a few studi€s confirm rhe facl fiat $e liberaliralion of
capital mdkets enhances narker efticiency, as foreign investors often have
need of hish t.ansparcncy and suilable reaulatory framework (see, Kim dd
Singal, 2000''; and Knambaq 2000').
'Ihc obvious resuhs ofliberaliration drive;ndicate gfoslh in opponunities 1o
.aise capital througl the capibl markels in emerging economies with
enhanced ability to diveNiry risk (Bonser-Neal and Dewenter. 1999").
Emefging markets also show increded stock prices, which could be
attribu@d to increased demsd (Kim md Sinsal, 2000'"). They made a
Beneml observation lhal high volatility of stck p.ices in emerAing markels
makc inlesro6 morc ave6e to hold slocks and guidc lhem to dcmand a
higher risk premium, thus incrcaling lhe cosl of capilal and reducing the
invcstmenr tevelr'. Some ofrh€ studi€s have tried ro €laborate that alftougl
the main obj€clive of financial deregulalion should bc to increase fte supply
of funds for inveshent. but the consequence of financial libcralization on
thc supply of funds lbr investmenl is theoretically ambiguous. McKinnon
(19?3):0 ud Shaw (1973)" d8ue that low inleresl rates on deposits dispirit
household savings and, as a rcsuh favo. if,r€rEst mte liberalization.
Furlhermore, the cxistence of interest rale ceilings alteN fte alloca(ion of
cledit and may escort to undeFinvestment in the projccls that havc a high
expected Ete of.etum, but de risky. I lowever, on the other hand lhe nostrucruralis. (vd Wijnbersen (1982:r, 1983a, 1983b, t985)) contends lhat
th€ existence of infomal credil markets can ovcnum the effecl of an
addition in interest rabs on the loblquantity ofsavinSs:r.
A general impression is that eflici€ncy of ca?ital markels is Nually on the
2l
doMdde in emerging economies ahhough they seem ro ;njecr oew relbrms
so as 1() keep them undercheck. Bonser-N€al dd Dewenler ( 1999)rr observc
rhal costs oft€diDa play a major rolc in defining $e invBtment slFt€gies.
However, limiled literatw is available on fie size dd trends in cosls of
rmding fiom the emerging markets. Besides. wh;le K])mbala (2000fr and
Kumar and rsebekos (1999f6 emphasire the need 10 creatc an cfllciml
markel in order lo enhmce thc role of slock mdkets in the delelopmenl
pr@ess, there is little evidence on the disl]iburion chdacteristic of slock
rctums. lhe prevailing valuation rcchnique in emerging markets lacks
certa;n aspects, which leads to an ove." or undeFvaluation of inveshent
prcjects. Ritell (1992)'?r and Khambala (2000)" note that risht disclosure
requircments and conprehensiv€ regulabry framework adds to confidencc
amonS investoF to entrust their resources to lhe emerging slek markets.
Demirgi4-Kum md Levine (1996P also €xamined that economies with
tough dd efiicient information disclosurc laws, inlemalionally accePled
accounting stadards dd regulatory enviroment- Nol reslricting
;ntemational capital nows have a propensity to h.ve la.8er dd more liquid
However, foreign investment can also have adverse effects, as the 1994
Mexican and 1997 Southeast Asian crises illustmte. As foreisn capital flows
may worsen lhings with rc8ard to seriing monelary policy, drive up real
exchange raGs md raise the volatilily of local equily mdkets. lt musl also
be undestood that libeEliztion could be hamful to capital mdkets in new
liberalized emersine economies. Nu'nerous empiri€l studies try to idendry
the causes ofeononic dd financid crkes i! energinA comlries: KnSmd
(199)ro, Obstfeld (1994tr, Camor and Packcr (1996)rr. Eichengrcen et al.
22
(1996tr, Frankel and Ros€ (1996)1, Coldstein (1996IJ, Golds@in a.d
Tumer (1996t6, Kaminsky and Reinhart ( 1999f', Komulainen and
Lukkarila (2003)fl rs well as to develop leadinS indicators: Diebold and
Rudebus.h (1989fr, Stock and watlon (1989f, Kaninsky et al. (1997)''.
Some authoG have tri€d !o make it loud and clear that fo.eign tmding and
free capital mobility ensuing ftom lib€nlizltion policies may raise stock
market volarility and instabilily leading ro market crarhcs (scc, Calvo and
R€inhart, | 996'2; Krugman, | 99dr; Froot et ?1, 2001'; and Bor€nzstein and
Gelos,2001)". Th€ proponents ofrhis view often submit to lhe advent of
finsncial turmoil during the 1990s as a good exarnple of adveBe €fiecls
induc€d by liberalization on energing economies.
Focusing on stock matkets inslitutional serup, Kunar and Ts€tsekos ( 1999)""
rcfl€cted the implied difTe.ences lhrt exist berween the emerging markeE
and d€velop€d stock mark€ls institutional set up. Howevcr, Pardy (l992Il
argues that the d€velopmenr of srock markeb depends not only on lhe
institutional scl uo. but also on ftc macro-economic dd fiscal environment-
Sung ( 192)'r poinrs rhe rema*able Frfomancc of some e'nerging 'natl€ts
to the po€ilive reaction of for€ign and local invesloG to economic rcfonns.
Similarly, BoNer-Nesl and Dewe er (1999)" obs€fle thar inv€stoE tend to
show growing inlerest in some em€r8in8 markets, and this dep€nds on lhe
prospccls for rapid cconomic growl}, financial rcforms and the benefi(s from
int€mational divmifiqiion. Funhermorc, Kawakatsu and Morcy (1999)e
attribuG gro*lh of the emcrging markeB lo institutional changes, in
panicular, the changes in hws allowinA forci8n6 to invesl legally in the
ma*els. Moreover, in dive6irying lheir ponfolios 0oward €mergin8
narkets. rarional intemational invcstoE do consider that the integration
2l
proc€ss might lower exp€ct€d r€tums and incr€ase conelation! between
em€rging ma*€t and world mark€t retums.
This study aims at contdbuting to this lit€rature wilh two issu€s lo dis.u3s.
The staning point of th€ study is to clabomte generalized financial
fmme$ork applicable to most ofihe em€rging €conomies wh€re investor has
to face varying kin4s ofdifficultid or shock! wh€n striving for cetuin l€vel
of retum especially involvinS int€mational opc6tions. The second saarting
poinr is rhe inpact ofthe deregulation and privatization driv€ introduc€d in
lhe Pakinani invesb€nt environment to €nhance the €conom;c quality in
rcsponse !o risk in difer€nl arcas, and lo absoA upcominS shocks that could
be larye enouSh to derail indiscriminately th€ local or foreign investnent
Notes atrd References
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w** sb p sov. pk/pu b licdriontF_S A 2004/Ch{prc._9. pd fEichengreen, Bdrry \200i),'Cqi1u| Fbw and (i.r. Ch. l0: CapiEl Contols:Capital ldea or Capi$l Folly?" and Ch, llr 'laming Capital Flows ' M.$&husBlniiruc olTechnologJ: MITPF$, pp 273-306
SiSlir, JoFph E. (2002),'C!pi6lMiA.r Lib.Elialionand Eich.ng. Rat RegmeslRisk shholt Resnd.' ,,r,,/rr d/ th? An.ti.d '4.adery al Polilicat md skialS.ie,.p t?9.0 Tne An.idn ac!d.6t ol Politic.land SooialSciencc, USA. pp.219'
Gl@r, E.. Johnbn. S , Shl.if.r. A.. (2001). Cqs ve6us rhe Cahns Or4.4Jomul ol E ononi! 116. M6siu*ns Innhut ol Tcchnolo&/: MIT P6, pp
k Pon4 R.. tip€z{.-Sihn.s, r.. Shl.i|.i A.. (2001), Whli Wods in S..orni6bssT Unpoblished Wo*ing P!p4 9a81. National hrea oI Eemnn Res?oth.cmbridgq MA 02 ll3. USA.
B.*'.n. O., llney. C. R., (2003), 'R.$4h i. EmergiDS MlAd Finan.e: ldtangb $. FnbE . fftryrra lrr*.6 Lvrd. Elsvicr Scide B.V NY l0ol7: NY, pp 2
Bek..n G od Hdcy C.R. (19951 _'tireV.rting World M.rr.t hkgdion"Jom'al oJ Fi@e 5O, Anal$ t in!tr Asiltidn: USA pp. 401-4,14.
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l0 Crdidi F Emna V. sd Hog!. K (20011 Ch@crizing Wdld Markd InrcBF.iantnough rim._. Mccill Univ.Fily Wo*iig P4.t: Ce.d! pD l-lID.ra s. ud wu. s. (20u). s@k Mad.r Lib.€lizrion od lnEodaoMl RjskShains . WorkinB P.D.r. Drpd.rft,r o/rdorori.s, The lniv.Nity of Kms6, pp l -2
Duc Khuong Ngny.n. (200t), Libeolianion ol Em.BinB f:quity M?rkeb AndVolarilny , CERAG-UMR 5320CNRS. Utrive6itr CEnoblc: Fhn*, pp.: 6.
I]
l3 Beken G. rnd Hcney C.R. (2000), Forei!tr Sp€cul{o* dd Em.rdng EquityM^rkes . Ja,mal of Findce. 55. Ameri.!tr Fitrncc Aseiatiotr: USA pp567-573.
Bekftn C., Hfley, C R , dM Lundbhd, C. (2001 ). tamergre tiqu'ty Msrkds and
Elononrc Cmw$' , ,/doral {y'ravlapturt ENomhns 66. Els.ri.r Scicn.e B.V: NY10017,NewYo ! pp 46?-470
Kim, E. H. md SingiL, V. (2000). "Srek Mark l Opcnings Experi€nce olEnergingFrarcnies". Jomol d Susina$, Vnivcro4 ofchlcato Pte$: Chicago. 7l( | ). 25.66.
t5
25
K,l.mbob, D. (2000). Inpact of FoEign Inv*hent d voldili! 'nd
Gbwth olEmcreing Stol Me*el", M,r,erdrl dr?ss feltea 3. Cmk S.hool of BusiE$.Sri louis Univc*iry: USA,pp.5059.
BonserN{|, C rnd Dewenrer, K.L. (1999), Dec Finmcial Mtrkt Dlvelopmctrr
Srinularc Srviner? Eliden.e lrcm ENBing Stocl Mrkebi. ('"rrsrrrfr4&Monic P.licr, t7l7). Nestern Eanomic A$ocialion Inrem{ionrl: USA ppl70'380.
ll
l3 Kim, E. H. .nd Singil. V. (2000), Op Cit p9.\4 35.
19 Ch roph.. J. Oen, vicbr Murindc. Roe W. Nguei, (2000), _K.y MkotoctuEAnd Policy hs@s For En.rain3 Stdl Mrls: Whor H,rc we rff.d? finaMand l>*lopmdr Res@h PFgBmn. Wetang P.p€r S€.i6 No 16. Indnuk fsDev.lamen! policy md MMa.ndr. Univcuily of Mmhster MANCHESI ER.
pp.2 {. hnpt/llN.n ac.uMdpm/
20 McKinnon. RI lt9lt),'Mo,ey ontl Qtitul k E@nni Derebpn nt Bn\kn\AslNnuiotrs WishinCror DC. p62.
l2
Shav. E.s. (1971), 'Fikancjal IhepNnihg ih Ecd.njc DevelaPndf, Oxlatdtjniv.any Pa$: New Ytr*, pp. 2l-26
V.n Wijnbergcn S.r.G. (1932). "Skgflatiomrt Eltes oa Mondary sbbiliarionPolici.s A Qumribrive Anallsis ol Sath K.t n , Jomdl oI DevelopMt Ecfuni$t0, Elsvid s.ine B.v NY l00l7r N.! Yod, pp.lll-69.
i. V.i Wijnb€qpn, SJ.G. (1933.). _CEdn Policy. Infldio {d Oo*1h in tIinrnciauy ReFs€d Econdy . ./o tnal of DzrclopM, E on"'ns l!. El*vicrScicE B.v NY 10017: Nd Yolk pp.4555.
ii. v.n wijnb€.sen, s, G (l93lb), Inlcmr Rft Moeserenr in LDL a. totrn/iol Mon4ao E o"onica 12. El*ri.r Scicne B,V NY 10017: NY. pp. 433.52.
iii Var Wijnbereen, SJ.C (1935), Mrcrc-Mnomic Eal€s ol Chontcs r lrlnkhrtrci Rares: Simulation Resuhs fot Sorrl KoEa. Jomal aI Daelar,nlrtZaon,,i.a 13, Elsvie. Science A.V NY | 001 7r New York, pp 5,11 54
Luc L*ven, (2001). Fina.ciil Libenlianion ed Fi'ancins Connainc Eridcnc.lno PanelDahon Eme€i.g Economica", FinrncialS..ror vice Prtsidency, Wondga.k: W.shin8ron. pp. I 4.
t,r BosrNdl, C. ffd D€v€nr.i K.L. ( 1999). 02.
Khrmboh. D. 1201D). il Ct . pp. 50'59.
Kun.r. P.c. dd Tselc, c.P.11999). "Th. DifeEfridion of Em.'dns EqunyMuk ta , awlied Fimtul EcoN'is.9. Roun.dgr. Nes Yql. NY 10016: US]t
27 Rdcll.A.(1992), compdng lhe PfifDm.ne ofsr&k Exchange Tftdii8 stscfrl.li ftu lktemdti'olkdi.n ol Cutitul Motrt^ ad he Requldkt, R!t,o^!,l,i',glelon,l rnd D. schoenmrk r(edg, Omh!'n & Trohan: L.ndon, pp &4 35.
23 Khambara, D (2000), oP' ci(, tp.51J5.
,:]
26
29 D.mieiig-Kunt, A. 'id Lcvine.R.(1996)."SlockMarkel ftvelopmenr And Finaiulllnremed iflies Sr,lis.d f_!crs", are traru Au.k E otud|. pzvi*. l0(2), 3 4 |-69
l0 Kru!@, Paul R (19991 I}e R4m oJ D.Presin Lznni$ ,
ll Ob.rf.fd. M. (1994) "Risl-T.t,n3. Globll Divsili€rim, GoMh ,Ifu lnE/io,cor,rn Xsvt a 34(5). ADerics E oN'nic A$@idion: Ndhvillc, USA. tp. l3l0't329.
l2 Canror. R., Pock.r, 1.. 1996, l\e O.r.mi@b md lmp.ct ol soveEtn Cr.di!Ratings. Jonal oI Fired lrcm, In$itniioMl Inv.$oi Inc lounals Grcup: Nc*
ll Eich.ng's, 8.. Ros, A. K., W4losa C.. (1996).'tonbgious Cuftncv c $C.Wo&ing Pap€r 563 | . l'ari@a/ ,@ au a.J E ohonic Reseorch, Canbride., MA 02lt&
l4 Fhikcllefirey A. Ro*, Andres K , ( 1996). curency ctrh.s in Eme€ine Ms[.6Umpnical rndicaroG . Tehnaof R.Fd lt4g, C.E.P.k Distalin Pqers,l ?
It Ooldstcin. M.. (1996). -TlE Seve. D€idly Sins: Prcsunprive IndicaM ofVuln.Ebiliq b FinucillCris in Em.Aing E@Domies", 7?.rrtdl ielDz. lnditd.for lntcnatio'll Economics: Us,A. p.4
16 Ooldslein. M. Tunr.r, P. (19%). "Brnkiq Cises in Emergine Economns: OriSrs
'nd Policy Opriona . Ecorort Pa?vr 46. BlS.: USA. p. ?.
17 (Dinsky, C. L.. R.inhd C M..(1999), {he Twin Cri*s l h. Causs of adking.nd B.lree of PqGnt Poblos" ,{rEfic@ E m'ic idvr'4 39, Amci6iIiconomic Assiarion: N6hville. USA. pp.4?3 t00.
13 Kdnolainen, Tuomas. Lul(keilo, Joh.nm (2001). Whar Dtives Financial Cri*! irr
Em.Bing Markes?" Id.r,i.,l Xe?o, 0J,r,/010. Econonios Wo*ine Pap$ Archivc !l
39 Dicbold, Ft?ftis X. Rud.bu$h, Gldn D.. ( 1939), "s.dn! rh. Ladine Indic'rod .
J.Mul of 36tre'\ 64t , lni|eany oachic.go Pes, chioSq pp 169-91
40 Shl, JH. warsotr, MW.. (1939), N.s lDd*es of Coincidenr ! Lc.dhglicotunic lndic.rou , ,'s.rntal R./o, /7a./. J.F. Kennely School ofcovehmcnr:
4l K.mimky, c@i.h, Liandq saul, Reinhrn, cmen M , ( 1997), "tading lndicrtouof Curercy Cn*s. f.chnicat R.po,97n9. ll.ten tto[l MoDet$y Fund:
42 Crlvo S. dd Reinhin C., (1996), lrpilal Flo{s ro EstSirrg Merds: h theEEvidenc ofconrqion ElTech? , In calvo C. otrd Goldftin M. /.t,/s C4p'al F/.rvxb Ek.tgihA MaA.4, t$tnn€ fot tnrcnario.ll Economics, USA. p.6.
43 (rugDm. P., (1993), salim Asir: lt s Tin to cd R?diBf , tnr!re, s.pr. 7. pp 74-
30.
27
.t4 Ftui, K.A.. o'conn.ll, P,G,r,. sd Sdltol6, M. s.. (2001),"The Ponrolio Flows orfnt.nolionll lnvdo4", JoMat ol Ftnffiial t@dtd 59, siBor scnml orBBin*, Univ.Eity of Rdh.n.i NY pp. l5l.lq,
.15 BoMsrein E,R md O.los R. O., (2001), "A Psieprcn. P&l? I1l. B.h.vior ofEmsaing Mdtet Mqrd Fun&", t'ortlrA P4prr. litcmlional Mon luy Fund
46 Kun.r, P,c, .nd T!.rscko!, C.P., \1999), Op. Cit , p9,44t.45t
17 P,rdy. R, (19t2). 'R.guhbry rnd lnllit(ional ImD..ls of S@uriris Mrrklcmpd.ft0tioD", Th. world Amt P.pq Sai.t, I 866, W.shingrot, p.4.
43 sm& J.. (192). Emrgin! Slet MrkB in th. ari.-Peific Regaoi", rdt,sx/ea 9( l2), P.$!on Boob NTC Publilhirg Csp: C.lifdir USA. p. 36.
49 Bons-N..I. c, .d D.*qt r, KL., (1999), o'. at, pp, J7G380
50 K$'ka\ H. .nd MoEy, M. R., (199), A. Enpid{l ExMin tioD of Fi'l@i.lLib.Flislrim .d th. Emqi.ey of Emrrins M.!ta Sroot Pri6", lre,M otFirNial net.mh,241),Sadtq Fi||re Asi.lioi ud South-Wcst n FiDueAssirio'l' Bhck{.ll NY. tp, ,85.41 l.
2E
This chapter b€gins with a dis.uilion on the rctum and risk concepts which
arc considered as ttE fo€al point of th€ study of investnenq and toSether
lhey constitute the fomdation of inv$tment decision Stated in snnple
rems, investors wish to eam a rcwdd on their monev for taking up the
challengc. These rewards are the motiva(in8 forcc in the investment process
d it is the retum for underlaking the ;nvesinent lnvesto6 always have lhe
desire to mdimize the exP4ted retums subjecl 10 constraints siead ofthem
The study has gone a step tunher and tried 10 explore the idiosvncratic
leatures ofthe emerginS market to suggest that fte relums for investoB in
ftese maJkets re characterized by unique features lt is also dgued thal
€xpected retums in emerSinS markets ed developed markels cannot be
treated as they are equally based on fteir distinctive tbalures
l-he other half of the investment de.ision fundamentals is the uncenaintv
about the expected etums. An investor mu$ alwavs look for and asss thc
ditrerent kind of vdiables that could affect the exp€cted outcome about the
return. Some of the variability of $c r€tums cm be elimimted by the
investor over th€ couNe by having multiPle investments rcfened to as a
divesified portfolio. On th€ olher hand there arc facto6 thal nise the
uncertainty about the a€neral economic and social cond;tions dd that cannot
bc eliminated away thrcugh holding a diversified portfolio refered ro as non
diversiiable or syslematic risk. Dive$ificadon issue, in case of emersins
mdket reums, is even more imponant and. as fie studv discusses in delail'
the inv€stor alwtys looks fo. \tays and me.ns to r€dDce the impacl ol
volatilily in the issues associated th inv€stments $rcugh divenificalion
.t0
Moreover, the chapter also sh€ds lidt on the €conomic groMh witnessed in
emersins economies in re€ent times which has led b heighlened ibrei8n
inlerest in these markets. The study undemcorcs thc fact that the curenl
siluation requires for modification of risk and re$m model and also to
include additional risk facto$ specific to emcrging economies This
inclusion will provide justification for the foreign investor's rationale for
their invesh€nt in emerAing econonies. Also briefly discussed ar€ the most
widely convereed models of pricing assels based on lheir risk and reum
fi'amework. Finally, lhis chapter tries to focus on th€ risk-retum trade{ff as
ir is s tundamental in financial €conomics thal ;t cot'ld well be de$ribed as
th€ "first tundamenlal law of findce." llle .isk/retum tmd€-orcould easily
be called the "Bood nighl sleep" ien as every investor would lik€ to be in a
posilion wherc he could exp€ct smaller valiations in his exPecBd relums
3l
l. r. fE-8i$!e$spl
It would.o1 b€ righl lo discuss investment alone and to ov€rlook risk
concepts. Gitnan (1996)' define risk, in the crudest scnse as the chance of
loss- However, more generally, the term is used to rcf€r unc€rtaintv or th€
variability of relums sociated with a Siven asse! or if,vestmcnt. The studv
is ofthe vi€w that the globaliation in rec€nt years has provided investors
with the prospects 1o look for opportunities beyond lhe eeo8raphical
boundtries because this will reduce th€ level of unccrrainly based on
broadening th€ sp€ctM of the invesrment- Sweeney (193)' po;nted oul
lhar imemlional ponfolios reflect h;8her rems wilh lower va.iaces than
purely domesric ponfolios due 10 low corelalions between differcnl
As the sudy discuss€s in detail in the following seclion, lhe uncenainries has
many .easons to grow dd almost each of these reasons have varying de8ree
of consequences on lhe expecEd relum of lbe investor' It is lhereforc
rcquircd lhat the inveslor must always look tbr ways and mems to rcducc
lhe impacr of volatility in the issu€s alsocialed ft decisions md their
exp€cted retms. Looking from a ditferent persP4livc all such vdiables
reflects bolh r€wards and challenges to the inveslor' Rcwards arise ih thc
iorm of finding ways to profit frcm the increase in the value of thc
invesme arising oul ofposilive mov€ment of concem€d variablds. On the
othcr hand, challenses entail from baldcing the possibilly for such sains
againsi tbe odds of losses arising ou! of advese movemcnl in the vdiables
Before going into further discussion, i! is felt important lo have deliberation
onthe ways to cldsiry the risk concem to have more insighl on $e issue
t2
r.2. B!$!!e$ir&de!!
I1 is also necessa.y 1o desdbe lhe various tyPes ofrisk which play importdl
role in the decision making. The unanticipated part of r€tum - lhe ponion
resuhing out ofa surprise - js the true risk ofany investment After all ifwe
do gel what we had expected,lhen $erc would be no risk. Wben d investor
makes d investment-decision, the retum on that investmenl cm be affected
by several variables, mosl of which are not under the direcr control ofthe
inveslor. Some portion ofthe risk comes directly from the investm€nl, some
lrom shifis in the sstor, some from volatility in the exchange rates, some
liom over all macrceconomic fac|oB and so on.
h is however poss;ble for th€ inveslor to €liminate a portion ofthis risk, ove.
rhe @uN of time by having mutliPlc investments, thar is, bv hold;ng a
d;versified ponfolio. Hence, dividinS total risk into two compon€nrs, a
geneml or mdket component and a sp€cific or issuer @mponent. in other
words, tolal risk m be categorized as systematic r;sk and non_svstematic
risk, which is additiv€ (Jones,2tl05)'l
Toral Risk ceneral Risk + sp€cific ftsk
Market Risk + lssuefRisk
Systematic Risk + Unsystematic Risk
Non Diversifiable Risk + Divorsifiable Risk
33
1.21. Ngs-D!3I!!!E!le-8i$
Non divcrsifiable risk or systematic risk is ey ftreat that atlects larSe
numb€r of assels, €ach to a varying d€gree. Uncena;nty about the general
economic and sial conditions such as GNP, inl€re$ ate, infrasrrucrure
facililies, inflation etci cd Sive .ise to non diveBifiable or svstematic risk.
ln olher words, thee conditions may arise due to 4y facto6 existe within
the slstem and have general influencing caPabililies on thc econonic
activities takinA place within a padicular markel.
In addition. variability in an invesiment's i,otal return, thal is dirccllv
associared with ov@ll movement in the a€neral econonv or market
variable, is what is known as the rhk of the system or svstematic risk.
Vinually all hvestnents have sode systenatic risk beca6e il encompasscs
fte inlercs! rate rEker md inflation risks etc. The investor cannor get awav
with rhis pan of the nsk ftrough diversification within the markcl as it is
very unlikely thai the invesment can circumvent the markel- influenc'ng
faclors while remaining in thd panicular m&ket{ Th€se mdkcr movcmenls
orcur regardless of what any single investmenr does and, for lbal reason'
systcmatic or non- diversifiable risk is significmt to all investors. lhc
slightest chance ofe$apingthis kind ofr;sk is through diversincation across
markers, but this also hs become very €m&iatd apprcach duc to the strong
impacr ofglobalization and world markel int€gration-
1.2.2. DiveBifisble Rbk
Diversifiable risk is the threat that sp€cifically affecls a single inveshent or
a small portfolio. An individual inlestment may have cash nows hisher or
low€r tha expected, eilher because lhe investor has not eslimated the cash
flows appropriately for that inlestmeni or on accounl of olher fac1o6
specific to that investmetu. lt can be said thal it is the variabilitv in an
invesbent's total retum not related io overall cconomic condition or overall
mrket vanability. This .isk is exclusive to a parricule secunly or
invesh€nt dd is associated wilh factorc like business, finmc;al, liquiditv
e&. h can be diversified away by thc invesloB and for thal reason, market
do€s not prcvide any comp€nsation for such tactors thal constitute towards
unsystemtic risk (Jones, 2005)r
Divesifiablc risk may lake diferc shapes and forms d€spile the argumenl
fial much of this is diveB;fied away in the nomd course of the buines
when investors iake a larS€ number of similar investmenls. One of the
rcdons for having $e sp€cific or diversifiablc nsk is lhe facr that inveslor,
while consid€ring a new venture. exposcs himself to eslimalion error - he
nay undeF or over estimate the cosl, lime and revcnues a.ising out of the
investmenl. However, i1 may be argued thal whcn the investor may have
several orher prcj€crs taken up, som€ or much of this r;sk should be
diversifiabie acrossvarious proiects owned by the same investor'
mErrratpr l-l
Sv't lrdc.rd Nor Svi..o.tic Rltko
d
Dird.tlc (Nd svcdic) rjrr
-- N!&llrinhb (sYMni.) Ris&
Nr&dsodli- b&r loEafrio
x
In addition, lh€ unsyst€matic or diversifiable risk cd also dise out of
compediive naturc ofthe market, whereby the €amin8s md csh flows on a
prcject de affected either positively or negalively by the actions of
compelilors. 'llere is much likelihood that where a Sood investmenl dalysis
is built on the expected reactions of competito6 into eslimates of profit
margins and grow*r, the actual actjons laken by competilors nay differ from
those expecl€d and can cause the variation in thc retums. In most of the
sludies, ir has b€en found that this h more difficuh to diversiry away in the
normal couBe ofbusiness by the investor, as this component ofrisk affects
more thd one investrnent or projecis.
The study tu.ther als€rl! that lhe industry-sp€cific feto6 rc also
considered as an imponant source ofunsystemaiic risk. I! has becn obseded
thal there m thEe prime causes for the ;nduslry-sp€cific risk to be presenl.
Th€ .isk refl<ls thc effecls of l&hnologi€s that chanae or evolve in
unexpecled ways when the investnenl was originally ,nalyred. Secondly,
the risk arising due !o the impact of changing laws and regulalions is the
legal dsk. Last, but not the l€asl, h the commodity risk, which rcflecls the
etIects of price chang€s in commodilies and seaices thal a.e used or
prcduced disproponionably by fte specific induslry. An inveslor cu only
diversit the industry-specifi c risk whilc diveEirying across industr;es.
l1
1.2.3. DiveNificrlion
lhe old dd well-known adage, "don t pul all fte eggs in the sme baskel,'
is fte underlying concept of diversificalion. Though the concepr is an old
one, but Prot Mdkowitz (1952) was the first 10 publish a fomal model of
portfolio seleclion that integrates the diversificalion princlples. putting
greater emphasis on conelation coellicienl between assets Besjdes. indeed il
is one of the most well known results in finance i.e. reduclion in ponfolio
risk due to sequential addition of asels to a portfolio. Risk lbat afiects one
ofa few investment aclivifies or the specific risk or utsystemaric risk ofthe
investment can be reduced or even eliminated by investors as they hold more
diveFe ponfolios due !o two reasons. The fi61 is thal each investnenl in a
diveFified portfolio is a much smaller percentage of that portfolio. Thus,
any risk that increases or reduces lhe value ofonly that investment or a small
group of inv€stments, will have only a small impacl on the ovemll porlfblio
The second is rhat the effects of firm-specific actions on the prices of
individul asreb in a ponfolio can be dther positiv€ or nesative for eacb
ass€r lor ey p€.iod. Thus, in larse ponfolios, n can be rcasonably arsued
that lhis risk will averag€ oui to be zero dd thus would not place a notable
affecl on $e ovcnllvaluc ofrhc ponfolio.
In comparison, risk that affects mosl of the assels in the meker ie-
systenatic .hk will continue !o carry on €ven in large md dive.sified
ponfolios. For inslance, otberthings being cqual, an increasc in inflalion rare
in the narket will lower the values of mosl assets in a porlfolio.
DiveFification can substantially reduce th€ unique risk of the podfolio bur
the elirnination of systematic risk is very much unlikely. 11 is for this reason
t8
fial this type of .isk takes central position in the 6s€t pricing. According to
$e study by Campbell, Lettau, Malkiel, and Xu, (2tl0l)r during thc last fou
decades of the twentieth century the mdkets overall volatil;ly did not
chmgc, whereas the volatiliiy of individual securities incrcascd sharply
Mdkct volatility was found ro be essendally lrend less, whcreas volalility of
individual security has risen. They suggested that in comparison 1o pasl. the
invcstors need more stocks in today's envirotunent !o adequtcly divelsify.
Based of,.ment studies caried out on diveBificadon, it seems rcasonablc 10
srale thal arcund 50 s€curities are needed to €nsure adequatc dive|sificalion
The number could possible b€ on a higher side, bu1 it seems ro be a good
working number. Apan ftom thh, the ponfolio vdimce dccreases rapidly
with an increase in the number ofsecurities, but il becomes stablc wben the
number of securitis becomes ldge. lhe intuirion is tha1, while individual
securiry s varidce matters for ponfolio th few stocks, ponfolio risk is
driv€n by coveide when the numb€r of seu.ities becomes large. The
low€r the covarianc€ between $e securnies, the smaller th€ variance of a
divcrsified ponfolio would be.
While the ;ntuition for diveBification-reducing .isk is simplc, the benefits of
diveNificadon cm also be shoun slalistically thrcugh siandard deviation 6lhc measur€ of risk in an investm€nt. when investors combine lwo
investmcnB that do not move toSelher in a ponfolio, the $addd dcviation
ol ftat ponfolio cd b€ lower than that of lhe individual stocks in the
portfolio. In other words, the savings thst accrue from divcrsificaton are a
function of th€ corelation coefiicienl. Other things remaining €qual, the
hi8hef the coefiici€nt of conelation between lhe retums of the two assels,
the smaue.fte potennal b€nefils from divereification.
1.2,3.1. EttetrdineDiv€Bificrtiorln.emttion.llY
Continuing the discussion from the previous s€crion, it can be safelv
expressed that the primary motive for intemational diversificalion is lo lake
advantage of a low @nelation bdween st6ks in differ€nt national markets.
Th€ study a8r€es to the view h€ld by Solnik (1974b)Nthat an jnvestor,
unaware of irtemational investment opponunities, will still base his decision
on sound medures of relative risk sif,ce the excess rctum he can expect,
should b€ proportional to the national systematic risk or F (bela) However,
even ifthe investor gets a perfect diversificalion on his national investmenr,
he is still left wilh some unique risk which could be div€rsificd away
Solink ( 1974a)' fomd rhat the risk for an intematioMlly divenified po(folio
is lower $an the one locally diversified. However, one of the problems for
eshblishing lhe gaids ftom int€rnational diveFilicatio. in Solink's (1974a)'"
and previous studies was the use oi historical risk md retum dala to show
how the tangency poifolio doninates in terms ofmem variance efficiency
ofthe domestic portfolios. However, Eun and Resnick (1988)" poinled out
thar using pasl findings to construct inl€mal'onal ponfolio is questionable as
under flexible exchange ratc regimes, previous stud;cs fail 1o offcr
operational help fo. intemational diversification deisions. Apan from the
above r€ason, th€n $udy not€d lhat the ea.lier studies ignored lhe istue of
risk estimation, becaus€ of lhe ex-posl natue of these sludies. This may
have resulted in oveBtating rhe gains from intematioml divelsifcalion.
Wilh the objccdve of demonstradng how fluctuatinA €xchmge Ftes can
diminish the ponfolio diveBificalion benefits. Eun and Resnick (1988)r'
examine lhe ellecl of exchdSe rate changes on the risk of intemalional
ponfolios. They focused on revealing how exchmgc rale affccls lhe risk not
only throuah its own vdidce but also thrcugh ils covariance with l@al
srock mdkel .etum. Elongalina the previous assssmcnl inlo a ponfolio
context, their work €oncluded that thc lo1al portfolio variancc rclies on thrce
(b)
G)
ihe co-variances mong the local st@k markel relums;
the co variances between exchanSe ratesi and
the cross co-variahces among the local stock market retums and the
exchange rate fl uctuations.
Eun md Resnick (1988)u exanine eighr ex- dre stntegies (four hed8ed and
four non-hedSed) in the presence of eslimation risk and exchdse rare
unceltainly. They are ofthe view thal once the investor hd controlled for
the exchange rate uncertain y tud for the estimalion risk. it can realize a
substantial gain from intemational diveFificadon, especially by the hedged
stmtegy. Due ro rhc fact thal lhc exchang€ rarc risk may fall mder lhc
cateSory of non-dive.sifiable. they consider the use of tbNard contracls lor
maaging rhis risk, €rd show that the hedging stralegics result in a lower
!didce od.oraridce rhm non-hedsed sra!e8i+.
1.2.3.2. lrtertr.tiotrsl Div.rsific.tiotr atrd Correl.tion
Meticulously evaluated tunher by Roll (1992)14, ihe behavior ofa mnge of
Srock Price Indices dd re@hed the conclusion that a significant pan ofthc
;ntemadonal struclurc of the retum corrclation among countnes cd b€
a$ribed rc $re€ expleatory intlucnces expressed asl
(i) the wide variation of market indexes regarding the number ol'
consrituenl stocks dd in thei. sslor rcpresentationi
(ii) county's indu$nal structure; dd(iii) the exchange rates.
Country indexes vafied in thei composition 6 these havc small number ol'
stocks, while olhers have ldge nunber. Like$se ftc same is lrue with
countri€s, eme @ morc induslrially concentmted than oftcrs aod thus local
mdkets reflect the idiosyncnsies oflhe comtry's industrial structure. Roll\
work implied lhat parts ofrhe benefits of intemational dile6ificalion arc duc
to induslrial diversifi cation-
Nonetheless, a diflercnr view from Solink (1974a)'J and Roll (1992)16 is
presented in the study of Heston and Rouwenhorst (1994)r' by using a
sample based on Morgan Slanley Capital Intemarional (MSCI) stocks
indexes. for lwelve European countri€s allowins thc decomposition o1'
excess re(um into pure induslry and cou ry eflects. I-hcy r€ileEled that
sinc€ fie variance of the country eff€ct ;s larger than the varimce of thc
industry effcct. the average corelation between securilics wilhin a country is
highe' rhsn rhc alerage \onelarion ber$een l'rm' rhar drc rn lhe qamc
42
indulrry. Their conclusion is lhat coss-sectional ditrerences in volatilities
across countries are explained by th€ cross sectional differences in thc
volatilily of country eff€cls, and nol by industrial specialization, alier
conecling the estimaled country (industryi retums by the induslry
composition (country effe€t).
Ir al$ neds to be mendoned here ftat Crillin dd Kmlyi (1998)rr. in a rc-
examination of the gains of inlemalional diveBification. using a dalaba*
thar allowed a more comprehensive decomposilion of country and industry
elTects, werc in support of previous conclusions obtained by llesston and
Rouwenhorst (1994)'', who found thal some of the deviation in the counrry
index can be explain€d by their industrial composilion. llowcler, ften
r€suhs werc considered morc imperative as they obsewe an imPonanl cross-
sectional dispeBion of fte industry effects va.iances. They Providcd thc
answer to why some srock r€tums in a Siven induslry have a Prcdominanl
indunry factor while in other induslry the domindl facbr is thc country
eifect. 'l hey also explained lhat the enor estimation due to industry effect
varianccs lends to be much higler in industries fta! arc less country
represented. Furthermore. ihere is possibility that portfolios for industry
havina a poor geoejaphical repres€nlalion could resull in an undcr
diversified portfolio aooss irms and a]$ due ro the mac.occo.onics
variabiliry from poi of view conceming fte tnded and non uaded goods
1.2.3J. lnte.prtio.rl Divenific.tiod ,nd lhe Home Birs Faclor
One empirical issue relaled to intemational d;versificalion thal has atracted
atlenlion is the "home bias" phenomenon refedng to a siluarion whcre
investoF tend ro concentrale heavily in the stocks and bonds of fteir own
conntry or, in oth€r words, investo6 do not dive6iry in such a my that their
ponfolio impersonat€s the word ponfolio.
Resdding the home bias phenomenon, Coval and Moskowitz (1999):i
pr€s€nt m interestina @ntribulion arguing that ;n the prcsncc of
information asymnetries, manageB tend 1() invest close lo their home
location reiteraring ftar home bias phenomenon is likely to be presenl within
counrry limils. This phenom€non also elaborates lhat information
asymmetries ar;s€ whenever g€ographic distance separates investor from the
investmem, or so to say that asymmeries eise cvcn in lhe absence of
counrry borde6. They daue thal other expectadons apart from those relying
on intemarional mark€ts mighi explain the investor behavior. I-essard
(1974)2', with reference to domestic diveFificadon. cxpressed fial low
corrcladon may indicate poss;ble b€nefi|s from intemational diveBificalion
baed upon the con€lations mong gfoups ofstocks in each market and lhe
ex-post eflcient portlblios ee the besl indicative ofga;ns.
ln addnion to them, French dd PoErba (1991)x and Shawky, Kuenzel and
Mikhail (1997)rr have also documenled the existencc of the home bias
phenomenon at an intematiodal level and advoca.ed the position exprcssing
the exj$e.ce of low corelalion ar country level.
1.2.3.4. DiveBificrtiotrUsioeEmerqipqMarkci!
A coutry is considercd as "em€rgin8" if ;ts p€r capila Sross nalional
product (GNP);s below cenain level that, howevef changes rhrough time,
spodights thc basic conc€pt thai €merging counlries dis fron lcss
developed darc lo joia the grcup oI d€velop€d countrics. In geneml, one
common characleristic shared by the members of lhe cmerginA countries is
that they all posses an elevaled degree of macroeconomic weakness thal
manilest itselfinlo a high level ofthe d€nominared country risk. Moreover,
one more ch@ct€rhtic of eme.ging count ies markct that differcntiates
them fron the develop€d countries is the low cross-coreladon among
themselves and also with developcd markets (ttaney 1995c)r4.
fie advdlages of intemational divereification cma.aling ftom the
conelations belwcen developed and eme.aina markels have been
demonstmted in a number ofsrudies. Herbert Grubel (1968)r' was one oflhe
lirst to document this issue applying the Markowitz-ShaQe risk rctum
aralysis to ex-posr dala on rhe field of intemational investmenr for
developed countnes. Using a macro eonomic model, he exam;ned the
advantages of intemational diveBification and found thal the divesification
benefits were substantial, but conshaining lhe i.vestmenl opponunities to
developed countries only lowes the benefits of divcrsitication. Levy and
Samcl(1970I" applying mod€n ponfolio theory, also ci{aminedthe benefirs
uom intemalional diversificadon of investmenl ponlblios usine dnual dala
berween rhe y€ars l95l and 1967 lor a set of 28-counlry indices calculaled
lhc Markowilz eflicienl ftontier. lhey explored that thc improvemenl in
diveFificalion, when they only used develop€d counFy indies, werc
nalginai b wnh lhe inclusio. of developins country indices, thc sains
from the diversificalion were subsbntial.
Hadey ( | 95ct' also norcs lhat. conlrary to developcd mdkel assel rctums,
the conelations for emerging mdkels are low, ed in some cases negative,
and conclud€s ftar the overall risk of the ponfolio cd be significantly
.educed through intemational diversification by adding securilics from
emergins market indices. Using a difl€renr dara, Bckaen ud Unas (l996ft
aho an..y/e rhe diver,ificarion benefirs ftom invc"ring in cmergins
economies, mor€ spec;fically, compa.ing uncondnional dd conditional
mean vanance spannrng rc$s.
Solink, Boucrelle and Le Fur (1996)r' specifically evaluatins the link
b€lween con€lation and volarility betw€en US and developcd markels
exprcss that despite the volatilily being intemationally contagious and
conelalion incr€ases in periods of hgh volaiility, such ;ntematio.al
conelalions remains at level that are attractive from the .isk diversificalion
point of view dd therefore, to enhmce risk diveBificalion benefits,
inveshrs could allocale part of th€ir funds in assets from emerging markers.
Furthermore lbey highlighted thar fte eains of the intcrnarional
diveBification mighr b€ overslalcd when looking at the risk measurcs thal
dsume const n! variances or conelations (uncondirional rjsk eariece).
Us;ng co integralion analysis, Gilmore md McMmus (2002)r" cxamine iflhere exist, for US investors, sorne diversification benefit through investing
inro Central European equity markels. The use of co inlegntion analysis
allows them ro see if stock priccs of differe countrics movc logether in
long run, while allowing for possibility of sho( tem divcrgcnce. Their
results show thal due to lack of co integration between Cenml european
markets and US markets, the (rclalively) low coftlalions of return indicate
the exislence of diversificanon benefils fo. bolh shon dd long horimn
However rhe study also obsenes one critical issue that since thc latc 1980s
and eady 1990s, emerging countries have atively and extensively been
involved in libenlizltion processes. Thes lib€ralizadon pro.ess€s in the
emerging €conomies especially in their capikl markets, could lead to a
greater inlegration with develop€d countries and could easily and
significally redue the benefib of div€Bification. l-here are evidmces that
some emerging markets where the yields of liberaliztion havc starled to
show present signals of greater integration, the conelation with develop€d
markets nevqdeless is still ar low levels, thereforc allowing tlF benefils for
risk divesification to be econonically significant.
l.l. &!t-!4sc!c.rcEs44E
Afier havins discuss€d the imponance of diveBificarion, esp€cially through
inclusion of *curiti€s liom emerging m&kets, i1 becomes impemlive to
discu$ the issues spccifically relaied to mcenaindes in valui.g securities in
emerging economies. Emersing economies of Asia and Latin Amerjca, in
paiiculd, have seen a nokble economic gro$,th over lhe 141 few yedwheres rhe d€veloped economies over the samc time ho.izon have
encountefed a set of economic issues including low intercst rales. low
groMh etc. resulting in emerSing mdkets being viewed as cxciting
inveshent altehatives. Th's heighl€ned foreian interesl in cmeraing
markets has not only restor€d local €onfidence in the equity mrkers, which
has helped in channelins liquidity into equities, but has also badc slocks
available at very attraclive valualions.
'lhe benefis of intemational diversificalion with specific advanlages of
selectins securilies from the em€rging market indices has resulled in them
beinS v;ewed as fundamedal pel of the ponfolio selcclion. l hc siluation
has resuhed in onSoing extens;v€ inclination in equities ftom developing
marke$ which however can be ;nterpreted in various ways. each havin8 its
ownjuslification and analysis. Sone ofrhe Mlysts feel thal bascd on their
evaluation ofimprovinB economic tundamenlals in ernerging @ononies, th€
cudent $enano ce b€ susrained. However, it must be kept in nind rhar the
global lmdscape does changes rapidly and factors like changes in oil prices,
fb{s of high inflalion dd low intereshte in developed makel harc the
porenfial to change the existing scenario dd lead lo che6p doney flo ng
bolh into dd out ofthe emerging markets. Ther€forc, ir must be und€Btood
in clear lerms that for the foreign investors to continue invesring h the
emerging riDrkeq broadly sp€aling" s lot of pt€-€minsce will lie on d|c
rist/retum pay ofr on their investn€nts. In addition, for forcign investors to
jusiit th€ir investnent raiionale in the energing economies, they have to
modiry e.ditional .isUr€tum modcl to irclude additioDrl risk factors
sp€cific to €rnerging €conmi€s. Thc host widely discuss€d models of
pricing assets ar€ The Capiral Asset Pricing Model (CAPM), The Arbitrage
Pricing Model (APM) 6nd Multi Fa.tor Model (MFM}
1.3.1. 8!!-Q!.e.ul!!!s!.ge!.:J!.e!4Bu-App!ec.s!
Th€ risk and relum model thal has lonS been used and is slill considcrcd 6$e standdd, is the Capital Ass€t Pricing Model. the CAPM, despne its
linitations, scor€s over the other models and is prefen€d by valualion
experts over others in order to derive Ihe expect€d retum on inlcslrnent
(hurdle rare)r'. Thc model crn be cxplained in th@ simple stcps defining
risk, clasiryine the risk b€tween 'narket
risk, non-diversifiable risk and
diveBifiable risk and fte b€ta is then plusged in the model to gel thc hurdle
As it has been mentioned eelier thar while. diversificarion rcduc€s rhe
cxposure of investors to fim specific risk mosr inveslols limh ftcir
diversification 1o holdins only a few dsets. 'I}lc p€culie behavior is
cxprcsed on lhe basis of two rcaons as to why invcslos stop diveBirying.
One ofthe €xplanations is the trdsaction cost as in ordcr availthe advanrage
of diversification, the inve$or has to purchae addirional stocks in his
ponfolio while rhe orher redon would be the credence rhal rhe invesror cdand have fte abil;ty to find undervalued s€curiti€s and would not get my
more benefits f.om holding more securiti€s. It h in these conlcxls rhat fte
capilal asset pricing model assumes that lhere are no lransaction costs and
that all assets de taded. I1 turth€r dsumes that everyone h.s access ro !h€
same information and that invesrors cannot find undcr or ove. valued asscls
in the mdket. By making rhese assumprons ir allows investoF ro diveNiry
withoul addilional costsr'?. Moreover, every one will include each and every
tEded ssl in one's ponfolio and thus have markct ponfolio- By having
such a portfolio, the risk to m inve$orofrn individualassel willbe rhc risk
that this aset adds on to thal portfolio. Sladstically thh added risk
nedurcd by the covariance of the asset with the ma*et ponfolio which
called as the betaofthe asset.
tfthe cumptio.s that lead to au investos holding the marker ponfol;o adneasurc the risk ofan asset with the beta being accepled, th€ expccled rctum
from an investrent would be:
is
Expected Retum = ftsk Free Rate + Beta (Market Retm - Risk l;.ee Rate)
tusk free Ete is estim.t€d as an interest mte on govemment securilies,
assuming that such s€curities have no default risk which may be true in
dev€loped coutries markers but may feel inappropriate in many emerging
mdkels where the govemments would be viewed as capablc of defaulting.
Th€ b.la is the only component in this model. which varies f.orn invgtnenl
lo investmenl lnveshenr, which adds more risk to the markci porrfolio, will
have higher beta. Bringing all lhese togelhe th€ CAPM to
esnmaF the exp€rtd retun on a stock fo. tie fuurc and wh€rc all rhe
mark€t risk is caprured in th€ beta, measrcd relative 10 a market ponfol;o!.
5l
13 2. B!!8-Q!sgEse!iesi-4!!9
The resrrictive assrmptions in th€ CAPM and the model's dcpendencc on
the markel ponfolio have long being viewed wilh vagueness and rwo
akematives to the modelhave been dev€loped overa pe.iod oftime.
1.3.2.1. Arbirdse Prici!! Model
In order to und€dand the &bitrage pricing model. o.e should fiBt a6sp the
definidon of arbitrage which states thal 1wo portfolios w;th the same
exposurc 1o marker risk should be priced ro eam exactly the same exPected
rerurnsr4. If they are not, then th€ investor would buy the less cxpensive
podfolio and *ll the expensive one and eam a.etum exc.edingthe risk free
rale. If one assumes that dbitr€€ is not possible nd no r@m tbr
diversification, then th€ €xpect€d retum from d investmenl would be a
funclion of its exposuE to markel dsk. While this slat€menl is in line with
CAPM. rhe arbitrage pricinS mod€l goes one s.ep funher and statcs thal the
markct rhk cannot be capturcd using single beta bul instead assumes thal
one can have mulliple sources ofmafket risk md ditrercnt exposurcs ro each
ER = Risk free mte + Beu for faclor | .. -+ Beta for t?rctor n.
'l-he factor dalysis does not, how€ver, ideniry $e facloB in economic tems
but rcmains just a nub€r.
52
t3.2.2, Multi Faclor Modcl
The arbitragc pricing model's failure to identify thc factors provcd to be a
big weakness and where APM left oII: the Multi Facror Model rcplaced each
of the unidentified factoF with macroeconomic variables which were
identified through studying historical data. Howev€., th€ costs of shifling
from the arbirrage pricing nodel to a nacroeconomic multj iactor model can
be traced directly to the erors likely 10 be made in idcntify;n8 the factors
con€ctly. lhc economic facrors can change over time, as does the risk
prcmium associat€d with each onc. Using a wrong faclor or missing a
significanl factor in this model can lead to inferior Blimates of expeled
reums md would increase the risk.
It is a long debate as to which model h better, bul altemate models 1o CAPM
may beuer explain fie differences in retums. Howevcr. one has to draw a
distinction betw€en the use of these mod€ls to explain va.iability in pasr
rc ms and their use to predict fulure retums. The competitoF to CAPM
definilely be superior at explainin8 pasl returN by not rcstricting themselves
to one factor. Ho*eve., this extension to multi factoF emerges as a prcblcm
when eslimatinA expectina future retums- Ultimrcly, lhc sunival of the
CAPM as the dcfault model i. real world applicalions is a lcstmem to both
its appeal and the tuilure of more complex models to deliver sisnificanl
improvement in estimating the future rctums3J.
5l
I.4. CONCEPTS OF RDTURN
Retum is one ofthe two imponant and tundamental concepts in the sludy of
investment decision-making. Togelhe. with risk, it conslitutes the foundadon
of investmenl decision as every verdict is being appraised in lerms of th€
rclum prcmised and the vdiabilily expecred in ihosc reoms. Stated in
simple tens. inve$o6 wish to eam a reward on lheir money knowing that
whatever funds available ro them have an oppodunily cost dd by holdinS
calh th€ investor forgoes the opponunily to eam a reward on lhat fund.
l'udhemorc, in an inflationary scentrio the purchasing IDwer of cash
djminishes and for all th6e ud morc r€asns, the concept ofretum takes up
a focal position in the investDenr decis;on-rnaking. When making
inveshent it must be kept in mind lhat the rerum pa11em may diff€r beiween
invesrments s for instane certain stocks, gen€nlly in the lechnolo$/ seclor,
do not pay my income (dividends) because they reinvest all profirs itr thei.
business dd in the case of these (gro\dh) slo.ks, your expecled retum is
srrictly the capital appreciation.
54
1.4.1. Retoru D.fio.d
R€lum is the reward fof undenaking an investmenl and is lhe motivat'ng
force for the invesbrs inthe investmenl process whercas inveslor's objective
is 1o maximizc the exp€cled retum$ subject 10 conslEinls ahead of them.
Retuc fiom investing are cdcial to investors d they are what the gdc of
investmenr is all about. The measur€ment of realized or historical retum is
necessary for inveslor to assess bow well they have perfo.med of how well
investment managers have done on their behalt Morcover, the hisbrical
rctum plays a consideEble pan in estimating tulurc unknow rerums.
Charles P. Jones (2004)r .
Furthermore return on an investmenl is the measurc of the loss or gain
cxperienced on behalf of the owner over a siven pcnod of limc. Giman, ct
al (1999)r' has defined rerum as lhe chdse in value plus my cash
distribulion, expressed 6 a percenlage of the begiming-of-p€riod
'investnent value'. The general exprcssion for calculating the rale ofreturn
symbolized as K, eamed o. any assel over a siven period oftime r, k can be
calculated as per followine formula:
P, P, r+C,K,=
P'r
K, : &lual. expecred or rcquired m1e ofretum
R = price (value) ofass€t at time t.
P, r : price (value) of a*t a1 tnne t - I
55
C, = cash r€ceived from inv€stment in time Deriod t - | lo l.
The retum Kj reflects the combined elTects of changes in value, P, P1 r,
dd cash flow, C,, r%lized ov€r a period oftime i. l-hc above equation, by
and large, is used to delemine the rale of retum ovcr a timc period of any
length i.e. varying between one day to l0 years or even morc. However, in
most cases, it is cqual to one year. and k lherefore reprcsents annual ralc of
rctum. Ihe beginnins of penod valuc, P( | and the end of pcriod value, Pi arc
not nsessdily r€alized values. 'l hes. arc often unrealized, meaning that
although thc ass€t wd not actually purchasd at timc t I and eld at tinc t,
tbe values P, I and P, could have been realized had they bcen.
It is critical in an investment to distinguish betwccn expected retum and
.ealizd retum where expected rclum is th€ ex anle retum expecl€d by
investors over some tutuE holdinS period- It is the cstimatcd relum from an
investment that investos mticipate 10 eam over some future per;od. An
estimaled return is subject to uncenainry dd may or may nor occur wbereas
realized relum, on the orher hand, i! lhe aclual retum over some pasl period.
InvestoE invesl for lhe tuture - for the retum they expecr to em bDr when
invesd.g period ;s over, they arc lcft with lheir .ealized retms. Whal
invesroB actually eam from rheh inveshent may tum our ro be higher or
lower depending upon various facto6. These factoB rclale to what investors
have adc;pated wheh the investment was initiated, that is whal we call a
risk. Hieher risk would be dsumed ifrhe difference bctween the expectcd
rerum dd thc ex posl (after fte facr) rctums, or returns that were or lhar
could havc bccn eamed, is on the higher side. Also highcr the numbcr ofiitcton neans that there are greater chances of changc in the c;cunstmces,
56
on th. b.si. of i,bictr th. irv.|ffi d.cisiod wrs trk€n, lhalhy nbiDg th.
l6v.l of rid( lllvc$or hs! ro nodn pcp.rrd for |'ly kiDd of ollega! in eyf.ltorls of inv.3tment ard drw harr !o fsce higher deg€e ofdsk. Th8l is
why the snrdy an€opts to di!€us! dr. fcdur€€ of emergiEg m!.k $ rlalm!
in th€ n€xt .cction to hove & bcu.. urd€.{eding,
57
1.4 2. glr.IrslIi$isljflryrsilsi4lll!!-Belcs!
The study is ofthe view that the emerSing maket retums arc characterired
by unique features- In this regad, it is a.gued thal exPecled retums jn
emerging markeB and developed markets camot be l.eated as being equal.
Therefore, il is considered important to discuss in delail somc ofthem in the
1.4.2.t. Libe.rlizttion Efic.s
Al the lirsr Slance, ir is not counter intuitive 10 think rhar emerSing markets
have to be teated different, even more if one is bearing in mind all the
issues concerning the emer8ing markets. Investor has always felt
apprehensivc while investina in emerging economies for issues like bmie6
lo investment and the political md sial instability rhat. in geneFl,
ch@cterize €merging markets. Such i$ues are likely to impinge o.
mdkets' financial and economic variables and fioally thc fctum behavior.
Besides, when governments lake up a {inancial libcralizarion process, the
spotlight is gcnerally on liftingfiese investnenl bariers, which also tends ()
effect economic and financial variables, thus affecting yct aaain the
variabl€s undcrlying dsets valuesrs. The study anempts al presenring the
nain characteristics of emerging markets slock retums, and reviewing the
issue rc!o1vin8 around predictability of rcrums.
It hd always been said that lib€raliztion especially of the pdvatired
mekets, hd th€ tendedcy ro al!@ate Gsowes most c,Iicicndy as supported
by Eichensrcen (2003t'who aeues thal financial liberaliation, in
58
paniculd, allows a country lo expand and diveni$, investmenls, thicken
financial nurkels and en@urage economic growlh. Howeve. it has bcen
obsew€d that when daelopinS countries open capital mark€ts to lbreign
investnent, they expose th€mselves io a large group of investors who face
consid€nbl€ infomatior 6ymm€tries. lf lhe informalion flow is poor,
foreign invesaors would find it very hdd to rcach a consensus on rhe
equilibrim price ofan sset and hmce the situation will lead ro significant
stock marker volatility.
Funhemore Rouwenhost (1999)€ obs€Res that th€ factors that drive cross-
sectional difier€nces in expected slock retums in emerging equity markets
spparently resemble qulitativ€ly 10 those that have been observed for
developed marke$. A detailed analysis of the r€tum premiums shows that
the combired evidence of develop€d and emerSing narkers stongly favors
th€ hypothsis thal similsr retum facton exist in markcts around the world.
59
1.4.2.2. Notr-NorDil Dist ibulions
Retur8 ;n emerging narkers cmot be treaied in the $me way as developed
mdket st@k retums for the r6on that the forner sccurilies exhibit a no.-
nomal (irregulaJ) behavior. Various studi€s have been conducted in the pasl
iicluding Hawey (1995)aL. Bekaen and Haryey (1997)" and Efb. llarvey
ad visketa (l996fr f@using the issue rclated ro rhe retum bchavior in
eme.ginS markels. All oflhem repon that eme.ginS ma.kets retums arc non-
nomal. Almost contempomeously, De Sdtis md Imrohoroglu (1997)ai
reporl leplokurtosis jn the emerging markets dara. at tb€ condirional and
uncondilional level while eslinaling hil-lhickness pammeteB. Erb, Hfleyand Viskanta (1996)" based their srudy on the encrdns markets rcrurns md
have found sisns of posilive skewn€ss and shown cxcess kurtosis, which
they found to pe6ist. Using a differenl database than thal ofErb, Ilarvc) and
Viskanta (199616, EstEda (2000)r' repons cocmcient of skeMss
indicaling significant depdture ffom normaliiy. and consislenr with the
.esult of above mentioned authors, Erunz4 Hogan and Hung ( 1 999)'! have
documented high level of skew-ncss and kunosis, as well as the rcjection for
normalit) hypothesis.
As mentioned throughout the study, the sources of risk arc diflercnt i.segmented or integmred markers. For this rcer rhe inregntion proce$ may
cause price chanses. inducing positive (temporal) skcw,ness and kunosis in
relums. If th€ process of integration leads to a market developm€nt ud as
more companies list, fte skew-ne$ dd kurtosis may deqease, ruminA the
counlry to be a nomal index rctum'e. Furthemore, as non,nomal behavior
characterizes lhe emerginS marker! retums distribution, the mean variance
dlysis remains no longer correct .nd prcvents to use ihem as an adequaG
tool to base an inv€stment decision. The impact on invesment decision,
when the retum disiribution presents excess skew-ness ad kuitosis, has
ben madecle@rby B€kaert, Erb,l{arv€y and Viskanta (1998)'".
As such, il would be reasonable to exp€ct that mtional inveslors will prefer
the assets b€aring positive skew-ness dd not ftosc possessing negative
skew ness- Hdey and Siddique (2000)' dsue that if 6sr rcrurns possess
non-diversifiable co-skew ness, expected Ftums must reward lbr it. In lhis
conl€xt, they presenEd test of an arbilrage pricing model wilh a dynamic
masure of skew-ness. Apart ftoln this, lhey have also perfbrmed cross-
sctional tests of the single factor asset pricing model dd concluded thar
systematic risk, as measured by the covarimce or the beta with the markel
md othcr faclors, does not ethfactorily explain the cro${ectionsl variation
in expecred exces rerums5':. Howcver, when Harvey and Siddique included
the skew-ness factors in the models, they found that, in 8ene.al. the
explanation power of cross-secdonal vdialion in the assets relums was
Having discussed the importance of the nomality issue, lhe study further
relates that depanurc f.om the nonnal distribution is crucial. Thc hditioMl6sel pricing theory works in a world of In€an and vdiance, and lorcmost
problem thal emerges, is the porifolio op1imiz.lion. lhis is so because it
cmot be prope.ly solved in presence ofhisher momeds likc skewness ddkudosis as nghtly point€d our by Bekaei, [rb, Hdey and Viskara(1998)51 10 show how portfolio weiShls chmge in rhe prescncc of skewness
and kurlosis- Likewise, another problem rhai gushes in is 10 dcrcmine ihe
rFlFiltr discotet r.!. for a! itrvcs€nt in .d cm€rging nekcl In
g.nc.rr, Foplc itr rlcvchFcd ndt..r roly m tu c4itrl ased Fiohg nod.t
H6/!vrl, duc to th. frc! lhai CAPM .rsm€s | ftlly i €grd.d mdk€ts tldbajority of cnergiog Er*€ts 1! mt tuly iatlg.ar€4 Btrds (2000I'
.@a d.r! arg'E 6d CAm{ b ma fu aF.lprie dod€l fa rhe
esliEltid oftt€ c..t of .qdty in .m.tgi!g mltd&
62
1,4.2,3. Predict$ilitv
Anolher importat issue with .espccl lo emerging market rclurn is thejr
predicrabiliry. Amlysis of the expecl€dn€ss of retums reveals that €merging
market r€tws are morc likely !o be influ€nced by local informadon lhan
lhosc of lhe developed countries. Predictability of outcomes in developed
mdkets have ben well documented by seveFl authors including HNey
(l9l)r', cmpb€ll and Hamo (1992)f6, Ferson and Harvey (1993):'.
However, the issue has not been ignored for the emerging markcl as well
md has been acknowledsed by Haney (1995)13. who finds lhat cmerging
markets retums de more pdicbble ftan rhos oflhc devetoped countriesre-
In m attempt ro explsin the expectedness of emerging market equjly relums,
Harvey ( 1995)* app)ied the same modelas Harvey (1991)"' did to dcvcloped
ma*e|s, altain;ng succestul results. Howeve., whm the model is applied !o
em€rgjng mkets equity retums. contrary to prev;ous cvidence for
developed m&kets, the model fa;ls to explain stock retums. Hdvey (1991)u
sr*es lhat expected retums in developed na*el appea. to be gcneraled by
the common factors. whil€ Hary€y ( | 9956r, 2000d) prcse.red the evidcnce
that emerSinS markets expecred returns de dominaled by local facton,
however, these local inforination fsctors d€ not found ro be integrated with
world market. D€ Santis and Imohoroslu (198?)6r aho researched the issue
and found that country specific.isk does not explain conditional expected
relurns whereas Canieri. Emnz and Hoed (2002)66 suggesr thar the
explanation for the different rcsulrs can be due ro the model as il was with
Haney ( 19956?, 200 ld.).
6l
'Ihis study €mphasizes that relum predictabilily can also be €valuat€d by
analyzing the stock market efficiency like Kim md Singal (2000)d appraised
rhe pr€dictability around Imk€! lib€mlizlion by testing the tudomness of
the stock reurns. lhey expressed that ifthe stocks prices follow a randon
walk,lhe vdiance ralio should be equal to one. They also noted ihal after
libemli?rtion, some ofthe counlries sl@k retums exhibil more randomness
or have lqs p.edictsbiliry than in the period before the mdket l;b€ralizalion.
l he augment in mndomness is consistent wilh an incrcase in integradon with
world markets and it may be related in this regard lhal when foreign
invcsloB slart ro prcfir frcm mafket inefficiencics. these inefficiencies *illdisapped ud pnces will BFDnd more quickly to new infomation. Bekaen
and Hwey (1998)'0 arsue that an inc.ea* in effici€ncy will tum emersins
ma*€ts nore atractive to donestic and foreign invcslors and will lcad 10
morc frcquent tFding. They also argue (Bekaert and Haruey 2000b)rLlhat
the p.@ess of inGgdion should lead to eliminating mdket inellicienciB
and increding the predicrability ofthe €merging market retums.
1.42.4. Volatilitv
Il is a docum€nted fact that enerSing capftal markets are distinguished by
h;gh volarility marked by abrupr changes in varimce analysis. Aggarwal,
lnclan and Leal (1999)?') have dsued that penods of high volatility are morc
aswialed with imponad country evmts, irstead of intcmatonal affaiG
supponing the view possessed by Harvey (1995)rr and Bekacn, CR Harvey,
c Lundblad (2000)ta. According to this vi€w emfigina markels expected
retum arc dominated by lcal factoB not found 1o be intcgmtcd with wo.ld
mdket. Chang€s in volatility of srock rdums are imporrant in malyzing
benefitr of risk of c.pital msrkcl libemlirilion as these chmges are !crucial inpul 10 calculate the cost of capital aDd ale fo. effective assct
allocation. In a completely segmented mark€t. the risk prcmium is related to
the variance ofthe equity retums and highe. volalil;1y implies a Ngher cost
of capnal. As a result the nmber of invesrmcnr prcjecrs bcing accefled
cones down. The study therefore sugg€srs thar ir is rcasomblc ro
hypodesize tt8t, if the process of mdker inlegration gcnerates more
efficiency in lhe ernerginS markels, ir *ill rend ro reduce rhc votatilily in
these markers. but at th€ same time, il h exp€cled that the equity rcrums will
Afl€r having discusscd that €merging markers display a mucb larger
dispersion of expected retllm a sraddd dcviarion as compftd ro
developed ma.ket, il would b€ appropriale ro delibeEte upon the sDrce ofhigh volalilhy in eme.ging markeh which can bc very dillerenr liom thc
cconomic faclon, .he structre of the narkel, or polilical instability, ro
65
mention few. Bekaen and Harvey (1997)rJ explored four sources to explain
(a) asl concentmrion;
(b) stock marketdevelopmenl-economic integralion;
(c) microstructE effecls and macro economic influenccsr and
(d) polirical risk using a GARCH model io fit the volatility rhat allows for
&commodating the asym€tries in the volalilily of equity rclums.
In addition, it allows the vanance scaling pdam€lc. to depcnd on the past
values of the shocks, and of the scaling paim€ters, assuming that negative
sh@ks produce Breater increase in volatility lhan the posilive ones: by
auowine each kind ofsho.kstohave d;fferent effccrs onvolglility.
Given thal the volalility of each country index is link€d lo rhc degree ofdivers;ficadon, the sludy agr€es with Harvey (1995b)r'and Harey and
Bekaen (1997)'r to stal€ that there is significant negative relaton belwccn
the siz of the trade s€ctor ud volatility, rcflecling the fact lhar a more open
economy is linked wilh lower level of volarility. The volalilily of the
chdges in fbreiSn exchange Ftes plays s importat rcle in expl.ining
equity volatility. However, p€rhaps $e mo$ imponant conclusion mived al
by Bekaert and Har,r'ey ( 1997)rt was thal the market liberalizarion decrcases
lolatilily (i.e. for allfie specifications lhe posl-liberalizalion coefficient arc
lower lhan the pre-libemrion c@fficients). Tle evideme, on vohdlity,
provided by De Sands md Imrohoroslu (1997)r! supporrs rhat of Bekacri
and Haw€y (1997)ru and also shows that the markel volatility somelimes
ds@s€s with libeElizltion.
Ag8arwal, lnclan and Leal (1999)t' found that economic, political, and
socisl ev6ts hove a tcndedcy to bc 'lwialed
with sudd€n chmges in the
volatiliry. In orde. to a$€ss whether stock market volatil;ty increas$ or
d€crqs€s !fter libenlizatio& Kim and Singal (2000f gtinacd the
volatility around lih€ralization of the marker but neirher foud evidenc€ to
support or to contmd;ct their h)"othesis ftat if meket inlegration process
geneEt6 more efficienr markets, ir is r€ason.blc to exp€ct thar em€rging
markeB will face a de€rease in stock rehm volatility. Bekaerr and Haryey
(2000af abo fomd no panicular impact on volatility. Simil& to Kim adSingsl, B€keart ed H6dey (2000bF also found inconclrsive eviden@
about e incrcase or decrease in the level of volalilitv around caDital flow
61
1.4,2.5, Correlation rnd Marlct ltrtepration
coelaann and Rouwenho6t (2002f5 identiticd that intemational equity
conelations have choged drmarically thnugh the 19$ and the 20ft cenlury
and ev;dcnce implies rhar the diveBification beneiits are nol consl3nl. A
BeneEl fallac) is lhat highe level ofconelaLion betseen two counlrics or
markets can be ;nterpreted as d incrcde in narket integration. The fallacy
also gives 1o believe thal only looking at conelation coefficients to judge
how integrated is rwo economies or rcgion, cd lead |o inconsistent
interpretarions. Recently, many aurhoF have supponed rh€ srapmenr ofAdler dd Dumas (1983)" that conelation is not an appropriate measure of
marker inegEdon; it is only a measurc of markel linkagc or
;nterdependence. Ayuso dd Blanco (2001)rr, Canieri, Emnza dd Ilosan
(2002)33, and Leone ed Felminshan (2003)3'
Fair bit of research has b€en done in the past on rhe aspect that two countries
might be perfecny inlegrated, but due to a differcnl industrial composirion
their conclation could be low. Bekaert dd tlarvey (1995)q'supporr rhc
argumenl that conelation may not provide a good measure of market
inlegral'on. Errunz!, Hosd and Hu8 (1999), documented rhal
corelalions, in ways consistem with lifting of invesrment baEie6, laws
govehing tbreign inveshent and national events, tend ro change over rhc
Many of the shdies, like the ones discussed above, advocarc rhe common
point tbai grcaEr corclarion is indicative of bul not n*essarily implies a
greater inlearalion. Funhemore Canieri, E.runza, and llogan (2002)'or also
68
prEs€nt inponlnt widarce supporting lhe avowal lhat corrclation ofnational
indexes as a m€asure ol integration is inappropriate. So, thc study can easily
expr€ss on the bosis of lh€ evid€nce lhai canp6rin8 thc inoegntiod indel
widr |lle cor€lalion and m€asudng dF dcgrcc of integration ihrough
correlation with wide ftaiket ind€xes, will lead to underestnnaring rhe
d€gree of in&gration on a.coux of the inv€stoE ability oo make home
diveGification.
69
r.5. RISK-R.ETURNTRADEOIF
This value ofrisk-return in financial economics can be determincd from th€
fact that it could well be described as tle fi6t essenlial and decp seated
law of finmce. The rist/retum tradeoff could easily be called fte "ability to
sleep at nigh1" lesr Deciding what amouht ofrisk you cd takc on wh;le still
being able lo feel comfonable about your ;nvestrnenls, is a very imporlat
decision. Every investment d@ision;s usually evaluated keeping in mindthe
rctum or the reward for und€rtaking the invesment knowing ftat therc exisls
evcry chance that investmenfs actual relum will bc different than what had
been exp€cbd- Retums fiom investina @ crucirl to investoF as they arc
what th€ game of inv€stment is all about ad ar thc same rim€ poss;bility of
losing some or even all of the original investmen! cdnot bc ignorcd -definc,l as rLl,. rhis gi\es ro undebund rhar onc hd\ ro find rhe r;shr
mixturc berween thes€ factoB ro bc beftrotr
The risk md retum tradeoff is referred ro as the balance betwe€n the desir€s
for the low€st posible risk against the hiehest possible retum. A comonmisconception is that more risk cquals grearer rcrum. Low teveh of
uncerlainly (low risk) are generally associated with low polential rerums
whereas hish levels of unc€rtainty (hish nsk) are a$ocialed with high
polenrial rctutr. The risUrcrum rradeofftelk us the higher risk gives 6 rhe
posibility of higher retums. lhis implies that jusr as risk mcans higher
potenlial relums. ;1 also means higher porenlial losses. It is widcly acccprcd
that the major deteininant of the requircd retum on rhe sser (or the Fte to
b. applied lo a st.eam of receipts to €ap;lal;ze irs value) is its dcgrce ofnsk.Risk reftrs to ttE probabiliry rhat the ferum, and rherefbre, thc value ofd
asset or s€curily may have allemative outcomes interpreted in a differ€nt
way 6 the unc€rtainty surounding lhe ultimate oulcome of an event, which
willoccuf in the tutule.
Steve Gilberlson (2006)'r explains thal to many invesrore, the tem risk
appem negalive because they assume ;t means thc possibility for los$s. Not
denying from the f.cl thal it is tru€ that risk does imply the possibility of
losss, but al lhe same time it also means oppotunity as wcll. -lhc very idea
of having to tak€ on risk to achieve significant retums is known as the risk
and retum tradeofi The b6ic prcmise of lhe risk dd retum tradeolT is
rootd fron the f&l that no one likes 1o lose money. and in order for
inv€stoB to be williltg ro invest in rheir riskier investmenrs, they need ro
prodise in exchdge with the opponuniry to havc h;gher inv€s1men1 retums.
Wilhoul thh prcmise for higher rclums, in the finucial markels driven by
supply and demmd, no one would wul to invcst ;n riskie. asseb and the
laws ofsupply and demand. then, dictate in a way that riskier investmenrs
gene.ally have hign potential mles of retum whilc less risky assts offer
substandally lower potenlial retums.
The study can convenienlly r€ht€ Cilbertson's idea wilh srock and bond
seuines as wiftin th€ stck markel, small cap stocks tend ro be riskier than
large cap sbcks and within the bond market, corpomte bonds lend ro be
risker than the gov€mm€nt bods. r'ollowing the logic of the .isk dd rctlm
trad@fT, then, ir can b€ exp€cled ftat over rhc rime, the riskicr asscts willoulperfbm the less risky assets. However, this is not always the case 6 rjsk
and retum tradeoffhas veryoften histo.ically proven true ovcr rfic long tcm.
7l
The r€suhs of invcstrents sugaest that investing in income funds is lik€
enjoying the besl of both world's i.e. low .isk and reasonable returns ed as
far a! the equity fund inveslors ar€ conc€rned, the risk-retum trsdeoff has
clea y not workcd in the short period considered. In long term p€riod,
equity tunds hav€ outperfomed income tund! by substantial margins as
agsinsl the shodn€rm period when only a hddtul could &hiev€ this feat. So
we can sy lhat the risk dd reNm trEd€ofT is the balance b€tw€en the
desires for the lowest possible risk againsl lhe highest possible r€tum.
Applying this concept of the .hk and r€tum tradeoff to ih€ investment
s€lection, invstor cm ruimize lhe rerutr for a siven level of risk.
How€ver, it must be realiad theo th6l, ifth€ investor is or y willing to lake
on a very limiled amount ofrisk in investin& then ft will sisdficmtly limit
th€ lev€l of investrnent returns that ahe irvestor can achieve md will need to
readjust the expectations accodingly.
72
1.5.1. T$m Structure of Risk-Relurn TrdeolT
Campbell and Vicein (2004)q identified one impona implication of time
variation in expectcd retms ed expresed thal inves1o6, particuldly the
aggressive ones, may want 10 engage in market-liming or tacrical assel
allocation srrategics aimed at maximizing shon-renr rctum, bascd on the
predictions oftheir retum fo.ecastinS model. Howcv€r, the uncenainty aboul
the deg.ee of dset retum predicrabilily k $ ldge that it makcs dimcult for
invcstore to exploit it in practice. A second, less obvious implicalion of asset
rclum predictabilily is fiat risk defined d the conditional variance ddcovarioce per period ofdst retums may be significdlly different acros
investment horizons, thus crealing a lem strucrure of thc risk-rclum
Changes in investmcnt opponDnities have rhe imponanl implication rhat rhe
riskietum tradeof of bonds, stocks and cash may bc sisnific.ndy diifer€nt
ac.oss inveslnenl horians. The idea of a term strucrure of thc risk and
retum tradeoff is concepfElly rempting. However, slricrly spcaking, ir is
only appos;te fo. buy-dd-hold inv€slors who make a onc-time asset
allocation decision and are attracted only towards assts available for
spending al the end of a prdcular time horizon. Il has been ar8ued that only
sho.!-tem risk is peninent to the invshent decisions of long-horian
investoG who can .€balance idespective of wh€th€r the rilk and retum
aadeofi changes ac.oss inveshent horians or no1. tlowever. Samuelson
(1969)'!5, M€rtoo (1969'6, t972'1, and l9?3'q3) and othe6 have expresdtheir disapproval that this conclusion is nor accunle in a broader $ns. They
de ofthe opinion that if interest rates md expected assor rerums vary over
13
the time, risk averse, long-tem investon should also
hedging their long-tem sp€nding agenda aginsl
deterioration ;n investment opponunities.
Based on the modem portfolio which explains that inveslor tries to avoid
risk while maximizing expe.led r€tum, Capital Asset Pdc;ng Model
(CAPM), dev€lop€d by Harr/ Markowitz in 1952 and fine-tuned by others,
includine william Sharpe, over a decade later, dcscribes the relationship
between risk and expected retum. and senes as a modcl fof the pricing of
risky securities. CAPM, as be€n discr.rss€d later as well, emphasizes lhat the
cxpsted retum of a secuity or a ponfolio equals thc nte on a .isk-f.ee
securiry plus a risk premium- Ifthis expected retum does nor meet or bcat
fte ;nvestofs rcquhed retum rhen the investmenl should not be underlalcn.
'I-he riskjetum tradeoff is also dcfined 6 th€ condhional expected cxce$
relum on a brcad stock marker indcx divid€d by its conditional standard
deviadon, a quantity comonly known as the Sharpe ralio. The behavior ofthe Sharle ratio ovcr the time is fundanenal for asscssing wherhe. slorks
arc safer in the long run lhan th€y are in the shon run, 6 incredinaly
advocat€d by popular guides to investnen( strale$/ Si€gel ( | 998).e
Iiic, Pedro, and Valkdov (2004)r'i0 sludied the risk and retum hadeofi by
introducing M;xed Data Smpling (MDS) approach esrimato. thal forecasrs
monthly vaiiance with pdt daily squared retums. l hey found a sGnificandy
posilive r€lation b€tween risk and retum in rhe srock mdker. -l-hey
concluded that in compeison to negative sh@ks. positive shocks havc a
bigger impact ovc.allon the conditionalmeas ofrclurns, however. negarive
shocks have a la€e initial, but transilory effect on rerurns variarion. Manin
and Ludlisson (2002)10' point oul that financial market de often hard to
underetdd as secufity prices frequ€nlly seem unpredictable, md r$earche6
have devoted significant Esources to undeBtedina the behavior ofexpecl€d
retums relative to the risk associat€d wilh investnenl in securities but still
have !o go a long way.
To sum up, this pan has discussed exteNively the risk dd rctum
fundamentals dd easily concludes rhat the art of "inveslina" is defined by
risk and retum. lnlestm€nt ;s made keeping in mind cenain expected reurn.
Some may quantiry this numbe. as a percentage, while olhers just hop€ for
sme son of positive r€tum- An invcstor is always willing to assume a
cenain amomt ofrisk only as a rade-off to gening paid an expecEd retum.
Il is quile important for any individual, prior tojumping into the investmen!
arena. to understand the differ€ types ofrisk and thc ways and rcchniques
10 measure them. One of$e aspects that an invcsror should bear in mind is
lo balance out the risk rhrcugh diversificaiion by allo€adng assers among
major calegories, s€cto6 md even across geographical boundarics in m
investment ponfolio techrique. This is 1o be done as each 6ser class will
genemlly have dilTercnt levek of retuh md risk, thcir behavior will also be
difTe.enl- Dive$ificadon, d discussed at adequarc lenglh. is a r;sk
management technique fiat mixes a wide varieiy of investmenls wilhin a
ponfolio in order !o tninimiz the impact that any one securiry will have on
the oveEll perfomance oflhe ponfolio.
This study attenpts al identirying the featues of emcrging markct rcrums,
which arc considered to b€ different ftom tho$ of developed marker.
Arguing that €xpected rcturns in cmergina markels md developed markers
c.rmot be treated a if they w€r€ cqual, lhe study has discussd the unique
6Fcts like dle lib€raliation drive in such economis ard 6en r€al eff€ct
on the ponfolio holding s€curilies from €m€rging economies, tlle non normal
distribution of lhe r€hlns in emerSing sodolnies, the higb deerce of
volatility in expsted retums, lh€ complicadons in predicling the outcom€s
in such eonomies ad co.rclatior asp€ct to highlight the issue that the
portfolio should hav€ securities scross boundari€s to optimiz the risk and
Finally, the study concludes this disculsion by expr€ssing that the risk
retum tradeoff is the balanc. bctwccn th€ desir€s for th€ lowest possible
against lhe highest pGsibl€ retum.
!e!e-esC&&Ese!i
I Chmo. L.we I I 1996), Prrmitle: oJ Ma"!4*i!n f itue, ljagnn: A!tuti.
2 Swse]. F (1993), Mapping a Eurcpeli Prop€fry Invesl .m StacS) , ioumol oiPtope(} valnlkh ahd ln|erned, vol I I No.l, MCB UP Lldi LlK,pp 259-267
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a2
In the preceding chapier, altempt has been made to explore the invoshent
iundamentals. After having discussed th€ risk and return essentiak, il
b€comcs impemdve 1o describe in detail $e environment in which these
aclivides takes place. This chapter focuses on the definition of financial
markel dd its cldsification, the characleristics of the instilulion involved
and the component of forci8n s*tor in investment circle ln economics a
financial m&ket is considered as a mechuism which allows p€ople to
exchnase money for s€curities or for commodities such 's
gold or similaf
kind ot precious metals. Howev€r, in a more broader perspcctrve, anv
commodity mdket might be considefed to be a finmcial market, iflhe usual
purpose of rEdere is not the immediate consumPlion oflhe commoditv. but
rather as a means ofdelaying oracceleratinS consumption overthe tjme
Equally impondt is to mention that the significdce of finatcial markeG
ce be relaled to at great length and for lh;s retson fimcial markets can be
caregorisd into dilTer€nl sub-tyPcs The chapter focu$s on the
classificadon of financi.l marketi ro be thoroughly discussed on d;fierenl
kinds of markets, like the primary and secondary markets- Such discussion
should be elabonling a primary market d the one wh€re issuer-to-investor
transactions take place, whercas a secondary market is the one where the
exchang€ takes pl&e between invenoFb-investor' funhermore, the chapter
als discusses lhe capital dd money mdkets. A capital market is mainlv
conc€rned with prcvidin8 financing through the issudcc of shates or
common s1ock, dd enables fte subs€qu€nt radina ther@l while monev
ma*els deals in fnancing thmugh th€ issuance of shon lem debt financing
and investment dd the* marke6 enable the subsequent trading thereol l1
has also been delibented upon as to how money market and capilal markct
84
play a vital role in lhe mod€m day societies, like by making available
increased investment opponunities and improving the sGndard of living
thercof. Funhermore, they also provide an improvement in diversincation
opponm;ties, md allow for easy shiffs in inv€slrnenfuisk l€vels.
Tte role of financial instiiutions cannot b€ iSnored 6 it has beo
increaingly recognized that these institutions plays a critical rcle in the
pr@ess of economic developmenl. Besides, lhe exisl€nce of financial
instilution generally increases the efficiency lcvel of ooney and capital
mark€t- This study focuses also on the validity of the perception that lhe
direct impact of fndcial institutions on the real economy is relatively minor
but the indirect impact of findcial mark€ts dd institulions o. economic
perfomoce is exho.dindily signilicance.
The resarch has nade an attempl to shed liShl on dE existing litemture on
human, finmcial & s@ial capital formation 4d the role the forei8n seto.
cd play in nunuring the fin.ncial marke6 in emerging 4onomies provided
they adopt an open stance on econornic fronls. The inlent is to take a bird\
eye view of fte complex linkaSes berween the aclivities of foreign sectoB,
esp€cially in the fom ofmultinational enterprises (MNES) and their.ole ;n
rhe host coutry's financial market.
Ldl but d€finitely nol the least;the chapEr also highlights one ofthe most
crucial athbul€s of mdkel mechdism. that is, to lrdsfom infomation into
price. In ord€r to athct lh€ forcign inv€stnent, lhe host counlry must have
to take erion 10 reflsr that the markel posssss every chdacterislic to
safesua.d fie invesror from the ha/ards of risks ansing our of price
85
mechanism. The t€rm eflici€ncy is used to
relevant information is impounded inlo lhe
effic;ent market hypolhesis is concem€d with
desoibe a mdket in which
price of findcial assets. The
the behavior of prices in assel
86
2.t. Fimnci.l MrrkcG
So far ss fimncial markels are conccmed, Jans€n (2000)r proclaims rhat
Emnoftics deffne mark€t as an "institrxion or lnangement lhat facilitat€s
lhe purchase and sal€ of good and servic€s, and other thinSs" Th€ t€nn
financial ma*el can be defined as an organiation that facililates th€ trade in
financill products in a cont€xt simila. !o what we can observe at the slock
exchanges hciliunng the trade in stocki bonds and wana s etc ln other
wods, it cln be deffned as the action of bringing logether the buyers and
sellers to exchang€ financial producb, applying a number ofways including:
rhe use of slock exchanges; dir€.tly betw€€n buyeF and sellers elc. Markets
work by pulling toge$er many interested selleE at one place, ftu! making
lhem e$i€r to find $e prospectivc buyers.
h is also obseNed that the financial markets facilitate lhe invesmenr process
in a number of ways by raising long lerm financinS lhrouSh capital markets,
by transfer.nce of risk using the d€rivatives nark€ts or usinS i emational
$sde by way of curr€ncy maltcls. All thesc channels arc u*d to march
rhos€, who wdt capital, to rhose who have it. Typically a borower isues a
receipt !o lhe lender promising to p.y back th€ capital. These receiFs are
securities which may b€ freely bought or sold ,nd in r€tum for lending
moncy to thc bonower,lhe lender €xpecls some comp€nsation in the form of
a1
2. l.t. I]!$-e!-f!!!-!s!s!.-!4sks
The debate on financial markels crn go lo any lenglh becaus€ ofcomplexitv
as well d the significmce ofthe subject- It is for this reason that finmcial
markels can be categorised inlo different subl,pes. The study realizcs the
impondc€ to discuss about th€ financial mdker classification in order to
have the eale of und€rsteding th€ complex issues discussed in the laler pd
Dubil (1999)': classifies $e financial markets ;n1o primary markets md
secondary narkets, elaborating primary markels as th€ ones where issuer-to_
investor transactions take place. Here, inveslnent banks aciin8 as
inrermediaries in the secsities mafiets, and banks, insurance companies and
orhe6 perfom lhe same lask in the loan lmket' Wher€as a secondary
market is the one where the exchange takes pla@ b€tween Inveslor_to_
invesror. In such tresadiof,s, brokeN-dealers md exchanges act as
inErmediaries in rhe secwities markel ed mosily banks in the loan markets.
The orher way rc clssit the financial markets inlo caPital markets and
money markers. A capital lEket mostly consists of srock markeis thal
prcvid€ linancinS thrcu8h fie ksuance of shar€s or comnon stock, and
enable rhe sub*quent tmding th€rcol A money Imkel is the onc thar
provides financing drcugh issuance of short tem debl financing and
investment, and enables the subsequent trading thercol Anothef very
impodanl bd f6t grcwing markel classificalion is the derivalivcs markels
These m.fkets provide instruments lor the mamgement of financial risk, lbr
insancc, lhe Fulws mdkels, that is consider€d to Provide standardized
88
forward contracts for tndine ploducts ar some futue date Furlher
clalsification of financial markets could be Insurance market! which
facilitate the .edistribution of vatious risks, forcign exchan8e mekets
facililating the trade of fioreign exchange and commodity mfiket!
r€sponsible !o faciliiarc fic rading ofmmmodities etc.
However, focusing on |hc mle |hat a fin ncial ftarket can play in modem
societies. it is nol difficult !o observe that they perform the eiential
€conomic tunction of channeling tunds Fom p€ople who hlve a ssv€d
su.plus tunds by spending l€ss than $eir income to p€ople who have
shonage of funds b€cluse thcy wish io sp€nd morE than their income ln
addition, lhey increase the idv€$m.nt available opponunities and nnprove
the standard of living. Significance of thes€ financial ma*ets is thar they
improve the div€Fification opportunities, and allow for €asy shifrs in
investnent risk l€vels.
The linancial ma €ls in emerging economies do not seem lo be al p$ with
fiose of $e develop€d world and, therEfor€, ar€ not able to help lhe
€conomy as they should. Since savinSs of lhe economy arc not guided
properly, r€sulting in lower firds accumulaled do'nestically, cons€quendy
lower investments ar€ exp€ricnced. That's why th€ study has discussed the
importahce of financial narkels to win the confidence of the ;nvesto6,
esp€cially ihe foreign one, and lhesc markets can also improve the quality of
89
2. | :. E!!4s!rl-!4s!sEi!-Es!Igi4
It is nec€ssary to highlight lhe imponance of financial markets as they are
crirical rc the succes of o economy. The significmce SaiN momenum
when it cones to emerging economies becaus€ without proper chmeling of
surplus funds to oppofiunities needed, funds developme.t would be next 10
impossible. Money market faciliiates making transactions ibr shon-t€rm
liquidity requirements or to invesrlend shonrem tunds. This way,
eco.omic units are provided with a market-place to maage funds. Throu8h
lhis mdket place, surplus funds at th€ disposal of financial insntutions are
bid by bonowers comprising financial ;nstitutions and indiv;duals bu1
nostly by the govement, as a tool for maintaining m optimal level of
Capital mekels on the other hand, play a crucial mle in mobilinns donesdc
and foreign resoNeq md chann€ling them to mosl prcductive medium dd
longlem uss. Since $es€ funds ar€ not intemediated as being lmscted
betwen the investors. r€sourc€ allocatiof, tends to be more efTicient. In
orde. to provide better investment opf,onunities, at domestic as well as
intemational level, emerSing economies nust not ignore the importdce of
finmcial mdkels. This research overview the financial e.vironmenl in
Pakistan in lhe lat€r chapters bul it is pedinent to discuss the financial
institutionJ role in mobilizing tb€ finan€ial resources for econom;c
2.2. E!3!.siell4$lgge!!
-lhe financial irstitulions are the backbone of any economy and ii is
thcrefore essntial to focus on their rcle. Although imlitudons across
counl.i€s differ greatly, yel the need for financial sruices is universal-
Examples of developed econohies refl€ct the rcqdrement of efficient
financial institutions to facililate the c.eation and transfercnce of assets
And, while these financial services may b€ prov;ded throush differenl
institutional struclures. the lransfer of value among economic agenls across
space and time is a necessary and imponant elenent of the economic
while hishlighting the functions financial institutions crn perfom, Bholc
(2005)r argus that fimcial inslilutions are business oradiztions ftal act
as immobilizs md deposirories of saving and d pureyoN. They provide
various financial seNices ro ihe community while dealing in lnancial 4sets
like deposit lods, securities. However, the functional, Seosraphical,
scctarian scop€ of activities and the type of ownership m some of thc
qiteria, which are oft€n us€d to classify a lar8e variery of financial
insdtution. According to Glenn Hobard (2005)a finmcial inslitutions maoage
a sizeable share of the assel in financial system categorizd as Secufity
markel institution, lnvestment institution, Conlract savin8 instilution,
Depository institutionand Govemnent financial instilution.
Michael R. Baye & Ds Kovenock & Caspe. G. Vries, (2005)5 dalyses the
finmcial institufion from a diflercnt angle md takes a brcader pe6pect'v€,
defining ;t nom the liew-point ofa markel, as e institution or anangemeni
9I
thar facilitates the exchange of financial assets These asseb include deposil
and loan, corporate stocks and bonds. govemment bonds and nore exotic
instrument such as option 4d futurc conmct He is of fte oPinion that
financial system cd be categorized as public md pnvale intenncdiaries
seding to chmel l(n able funds from save. to bonower.
Thc exi$ence of a financial institution generally been f@u*d as t@l for
increding the effrciency of money and capilal maJkel. As financial
insrilufions also provide inveslment banki!8 seraices, these organizations
help thc corporation design securities with fealure cunentlv altractive to
investor, buy these securities from the corporations md then resell lhom io
the bonower. F;nmcist instilutions not only trmsfer ihe monev fiom firms
and sav€n, but they also factually cr€ate products- Since thes institutions
are generally ve./ larse they gain economi€s of scale in malvzing rhe
crcdirwodhin€ss of potential borlow€rs, in Prcccssing md collecting loans
and in polling risks ad thus helping ind;vidual saver dive6iry' Thev hcnce
enable ihem not to put all their financial eggs in one basket- Furthermore, a
system of specialized fitacial instilution can enable savitg 1o do more than
Michael P. Toddo (2003)6 argues that findcial sector guides financial
transactions betwen svers and investo|s, and financial intemediaries are
inrroduced to Fansform th€ dir€cl obliSatioN of inv€sto6 i o indirecl
obligations of fiImcial inte.mediari€s having atributG thar save6 Pr€lbr'
Irinancial institutions can improve both the quantilv md qualiry of real
inveslnent md the.€by increse if,come per capila H€ tunher tnenlions ftat
lechnological trends in compulslion nd lelecommun'cat'ons seem ro
92
increase the ease with which users and providers of financial services can
circumvent burdensome rcsulations. This, howeve., has led to call for
r€duclion in the ovemll restricrons on findcial firms, as well 6 for
int€mtional hannonization of regulations regarding saf.ty and sundness,
insider uadjng ed tdation. An efiiciert financ;al sys€m .equires
confidence. This confidence encourages investors lo allocate their savings
tb.ough financial mekets dd institutions rather than to buy non'product've
assets as a storc of value- This discussion logically dictatcs the study 1o
discuss the impoftance of financial institutions in the economic upln ofboth
developed and the emersins 4onomies.
Financial inslilution and financial markets take place due 10 non_exislence of
meket fiiction which includes informalion costs. cosls of enforcing
conrEcts. and exchanging 8@ds and financial claiins G.eenwood and Smith
(1997)t rclate the p.inar/ fiDction of fimncial systems as to facilirale the
allcation of resources. More specifically, financial systems may facilitate
risk mdagem€nt. They help to diversiry liquidity risks. Bencivensa md
Smilh (1991)3 provide an extension io finncial s€ctor macro efficiencv
Kemeth W. Dam (2002)'g egues lhat slrcng, efficienl financial inslitutions
re esential for the develoPing countdes seeking to posl Produclivitv gains
and prot@t their economies against global sh@k Financial institution\
opemess mcans establishina an environme in which fo.cign-owned
financialfirms can compete on equalfooting with the domcstic oncs.
Acco.dins to Sanromerc (2002)'" the univeBal ned for fi.ancial s€rvices is
driven, not surprisingly. by simple economics. Financial sector is m
essential infrustructure for trusfeninS resources across people and over the
!ime. Oqn€rs of r€sources us€ the financial i.stitutions to transf-er rcsoNes
10 those who will allo.ate them 10 their most efficienl and Produclive use
The rc$urce own€rs can then r€clai'n them in the futurc along with
compen*ion for fteir contribution. And along the way, $e iinancial
iNtitutions will allocate the attendant risks lo thos most willing dd able to
betr them. Resource allocation, wealth &cumulation and .isk mdagemenl
are all sewices performed by the financial institulions.
Traditionally, financial institutions used lo b€ limited to banks, but now they
have br@d€ned and categmized specifically into two larse sroups These
grcups rc depository inslitutions and non-deposilory if,stitutions which
funher son inlo specific institutions that provides specific kind of service
lik€ mutual funds facility, pension funds faciliry, insurance f&ilily, saving
and loan association facility etc. The study believes thal financial inslitutions
offer two fundarnental benefiB. Fi6!, a more open and well-rc8ulated
financial secbr as ;nstitutions are more efficient, morc robust ThB acls as
an "engine ol growth" for the entire economy. Thc financial sector ha! an
economy-wide elTect. All other seclors rcly on finmcial intermediation ibr
gros,th. S€cond, perhaps nore than in uy other economic sector, a stronger,
de€per financid institution can protect d economy aSainst exreml d well
Silnifi caNe of Fiptrcirl rNtituaiors
ln pmctice, imporlance of lhe financial instilution during development
enlails two diverse views. Roben Lucas (1988)iL classifies that financial
sector does not mattef very much, and that dy coEelation b€lween financial
development and economic groMh is a result of grcwth lqding
developmenr. This sch@l of thought holds thc idea that financial
developmenl follows rather than spurs economic Srowth, and believes thal
the importd€e of financial matters is very awftlly oveFstressed- Levine,
Loaya, Beck (2000)" md dgues that filmc€ does noi cause 8rcMh, but
rcacts ro the d€mand fiom the real sector' Hence, cconom;es with good
gfoMh prcspecrs develop instilutions lo provide thc necessary tunds for
supponing those good prospecls. Favara (2001)rr finds that the relationship
b€tween financial institution development and groMh is weak, md dcs find
some support for $is relationship- Some enpi.ical evidence suPPorts this
idea like Shd and Monis (2002)'' conclude $e absence of cled evidence
that financial d€velopment leads 10 growlh.
11 is also considered that d eflicient filucial systcm is a kev to
development and argued lhat financial intermediation economizes lhe cosls
associated wnh mobilizing savings suPponed by Boyd and Smirh (1997)''
and Siri dd Tufano (1995)16), and therefo.e increas$ capilal accumulation.
The most imponant and thorougb qrly contribution, on conelarion berween
financial developmcnl and @onomic d€velopmenl, wa made by Jos€Ph
Schmpeter (1934)t7. who contends that finmcial institution develoPment
causes economic developme.l and financial markets promot€ economic
8ro*th by tunding enlrepreneurs ihrough channclinS capital to thc
enFpreneurs wilh hiSh retum projecl. Financial intermediation evaluates
fimq manageB and nark€t conditions, ar)d reallocales caPital lo ils best use
as argued by Boyd bd Prescott (19s6)r3, Greenwood and Jovanovic
(1990t', Allen (1940f". Mo@ver, findcial intemediaries monitor firms
and exen control lo overcome agency problems identified bv Townsend
(1979)'?1. Gale and HellwiE (1985):'1, dd Boyd and Smith (19911
Goldsmith (1969):a, Mckinnon, (1973)'?i, and Shaw (19?3)16 assen ftat
ditrer€nces in the quantity and quality of services Provided bv financial
institutions panly explain why countries grow at different ntes Whercas
Gurley and Shaw (1955)':r, Gr€€nwood and Jovanovic (1990)':r and
Acemoglu md Zilibotri (199?)" are offte view rh.r financial inrermed;ation
diversifies investme nsks, which enhaces the outpul dd, in 1um' the
Kins and Levine ( | 993a)r0 do.ument thal the level of financial development
detemines long-run economic grow1h, capital accumulation and
productivity gro*th. Furth€rmore, th€y suga€st lhai findcial internediaries
can evaluate, finance md moniror Potential enlrepreneurs in fieir innovalrve
acliviti€s. They also show that the relationship between finance md grotr'th
is likely ro be dynamic md endogenous. Levine and Zervos (1998)r'hav€
found that initial stock mdk€t liquidity and banking developmenr are both
posilively corelal€d with future rates of economic dd producdvitv 8rc$1h
Aghion, Howiti and MayerFoulk€ts (2003)rr show whv the cxisie'ce of
technological traf,sf€rs is not sufiicien! to put all countrics on paEll€l long'
run grovib rate paths- They find lhat n is not.just financial cons!'aints that
male some couatrics poo., but, that fin.ncial costEims inhibit a
bchnological lransfer dd thus lead to m everincreasing technologv Saprr'
Michael Tiel (2001I' is of$e view thar well developed financial syst€ms
allow €conomics to r€ach their potential since they allow fims, which havc
successtully identifi€d profibble opponunities, to exploh rh€se
A large body ofevidence exisrs to suppon fie th€ory r€lating lo the strong
lintages between fin$cial innitution dcvelopment dd gro*th. Goldsnith
(1969)" finds evidence ofa relationship bctween economic and financial
d€velopment and groMh over long periods, and that periods of rapid
cconoftic gro*'lh hav. ofter b€cn acconpanied by an above-average mtc of
financial development m€asurcd by the value of finarcial intermediary
a!s€t! relative to CNP. Inde€d, Goldsmith concludes his study by claiming
thar €cononi$s will never b€ able ro s€ttl€ the question ofcaus.tion one way
or the other. This, however, hes not prevent€d major res€arch effon since.
Following Coldsmith, Ronald McKinnon and Edward Shaw both (19?3f6
explained lhat financial rcprcssion aflecb the quantity and quality oI
investmenr. They show that financially repressed counries are characterized
by cr€dil rationing and anificially low real interesl rates have a lower
s{vings l€vel. H€nce th€y have crert€d a bias in favor of capital-intcnsiv€
investrnent. However, these contributions do not demonstrarc thar financial
institution developm€nt c.us€s economic development rsther than fi€
It is also observed that many oth€r, oRen t€chnically sup€rior empidcal
analys€s, of thes€ issu€s have be€n und€rtaken since then. Mosl of these
provid. tunher evidcnce of the positive rclationship betwen finddal
instirution dd srow$. Kins and Levine (1993!)" studied 80 @untries over
91
the period 1960 - 1989, controlling for olher factoB afecring lonS-run
groMh, exarnininS th€ capiial accumulaiion and produclivity growtb
channels sepamiely, and using various differenr ncaures of the lelel of
financial development. They consqu€ntly find evidmce ofa stron& positive
relaiionship between lhe vdious flnancial development indicators and
8roMh. Becsi ed wane (1997tt, Pasuo (1993)i' and especially Levine
(1997)4u sive excell€nl suweys of lhe fDctions of finacial markeB and
how they help improve economic development.
Accordins 10 Michael P- Todaio (2003)41 it is incrersinsly recognized that
the findcial institutions plays a cril;cal rcle in fie prccess of econonic
developnent. The govement help makes th;s posible by dopdng sund
macroecononic policies, including a sound fiscal as well a monet-3ry policy
acting to establhh financial markets wh€re they don't exist ye1, and by
providing pnd€nrial regulation ofth€ finucial system. World Bank, world
development repon (1996)4', declares "The success of other mark€r reform
depends on the h€alth of the financial system or institutions aDd helping
investoB fhd the financing lhey need, taking inlo account the r€1ums ddrisks on fte projects they wish 1() undenake". In carrying ou. fteir functions,
financ;al insiitulion reduces rmnsactions costs for save6 md investors and
helps reduce probl€ms of dymmetric infomarion ftat are inherent in the
relalionships belwe€n investors and entepreneurc. Moreover, ftedevelopment of sophisticated derivative insrrumcnts in recenr times b6s
helpcd financial instilutions improve rhe allocation ofrisk in the economy,
and incree the efficiency of th€ saving-inveslment process. For a gilen
level of svine, mor eflici.nt finocial intemediation incrcses rhe
98
productivity of investment. It thus seems obvious thal lbe more efficient the
financial inslilution, the more rapid $e growlh nte.
The direct impacr of financial insttutions on the real economy is relalively
minor.'l he indirccr impacl oflinancial markets ad inslitutions on econonic
perfomance is extaordindily importmt. Hdoon Shafif (2001)" identifies
th€ impo&nce and tunction of financial institution as providing paymenl
seruice: it is inconvenienq inefiicienl and risky ro cany arcuhd enoush cash
10 pay for purchase good md seN;ces. Finucial ;nsilutions provide an
efficien! ahemative sd als mobilize savings md allocate crcdit aooss
space dd time. In addition, they not only provide payment serlices, but aho
enable firms and households to cope with economic uncerlainties by
hedgina, pooling, shdna dd pricinS rhks. Financial institutions SeneFling
md distributina the information and alloc.ting the cred;l elficiently increase
the ds€r liquidity. An elficient financial institution reduces fie cost and risk
of producinS md trading goods and seryices and thus makes an imponet
contribution to raising the standard ofliving. Fin$cial institutions as lender
conlinue ro monilof the operalion of project dd comc up wift bail oul
strab$/ if needed. This tuncfion is impondt b safeguard the inlerest of
small invesror. Financial irstitutions develop a capacity to €valuate risk
as$ciare wilh project findcing, and n .educe nsk ftrougl diversification
md insurance financial instilurions
99
2.2.2.@
The siudy broadly exanines fte claims made by pr€vious stljdies bascd on
the evidence found that there exisB a suong. positive r€lationship belween
the various findcial dev€lopmeni indicatorc dd srowth. How€ver. in order
to snsw€r as to why the r€lationship is positive or how financial seclor's
openncss leads to arc*th, it is gmerally believed that the world's best
findcial institutions rc b€ner able to idendry productive investmenl
opponlrnities md then morc quickly mov€ domestic savings into them. In
shon, on the shoulders oftheir better performance in the fom oftheir capital
intermedialion funclion, the economy can experiehce a faster growth.
As financial institutions aggrcgal€ capital, they must movc i! into lhe
businesses dd industry sclors wherc they can eam the best r;sk-adjusled
retums for thei. save6. That means investina in the business can make Oe
best use of rheir capital or, in o$€r wo.ds, otle6 the highesl productivly.
RaisinS productivily outpur per worker is at the rcot ol iaising living
standards. The sme fact can be h;ghlighted by the fi8ure beiow which
clearly indicates thai lack of an open financial sv;ronment can lead to lower
lcvel of ssvings 6 they will fail to atracl the savers to channel their funds
for productive meds. This will then result in low business activity wh;ch
could othe ise be posible, and will hmper the econonic growth in the
country and, finally, the blde falls on the rcle of the financial seclor's
100
Illultrrtiotr 2.1
lrcl of f,coronlc Olerrclt Cvcle
taeLafFtorafficidf
Ifistfueiotts
Sfuw / NaWottotttitgrufin
[sw6rrsnrcst
trtrves'h$erst
[,@v)
.9ovml4s
l0l
The posir;ve effect ofecononic openness has been docMented in the World
Bank repon (2001)_ stating that countnes wiG open financial service
sectors 8row, on average, one p€rcentaae point laster than olher counlries.
These rcsults conoborale d edli€r wodd Bank study which cstimated lhat
moE opm md competitive financ;al servic€s markels in developing
countries helped incr€ase grorrh rares 6y 2.0 to 2.So/o-
Op€n economic srance helps financial sector get stronger, ahd thus enhances
economic stability in a way ftar a financial institurion r€duces risks for
savers and investoB, and acts as a hedge against global economic cycles. In
view of this study. Ihe growine inrerdependenc€ b€twen emerging mdkets
dd developed narkets, i.e. globaliztion, brings new challenaes to all
economics, even as il opens new opportunities. Increasing cconomies pedal
in tddem which in tum inoeases the demand of efficienl findcial
institulions. For em€rging mdkets, the consquences of economic
integation N profound as th€y will have access to markets abrcad,
resulling in great€r expons for developing economies and grcater profits for
their tirms. However, ;t mu$ also be kept in mind lhar this econom;c
integradon als has its downside. and the iurbulent winds of rhe Blobal
economy cm swing a boom hed, fast md unexpectedly, bu1 the benefirs
ovetueigh the wealne$.
Fudhermore, mainlaining consistenl open-door policy makes fi nancial sector
8rcw stronger which in tum cm cran an sonomy more resilienr to qtemal
shocks by helping lo sustain domestic demdd when expon demand falls onConversely. a weak and inerficient financial scctor gene.ally based on
conservative economic policy, may limil a govemmentrs abiljly 1o run
I02
counter-cyclical macro€cononic poli€i€s lo otrsel shocks considered true for
developed and develop;ng econonies alike. ln some 4onomies, mosl
norably Japan, a significdt easing of monetary polici€s h6 no1 trandated
into significant credit growlh because the banking seclor is already
supponing too much bad d€bl, and is unable or unwillinS to add new loans
to balance sheers. By cont6l, a healthy finmcial seclor h able to injecl new
crcdit into the economy 6 the centml bar* expands the money supply.
Foreign-backed financial institutions in developing mdkets often have
stronger balmce sh€els and a grcater ability 1o lend, especially during
'lhe research work also adds that, in all possibilities, efficienr intemediation
will be even more crucial in the years ahead. as economies become more
reliant on capikl-intensive pMesses ed innovative technologies. -tlle
financial system dcs not op€rare afod film the €conomyr5. Il is in facl dintegral pan ofthe economy where rhere is interplay between rhe financial
sector and the economy. Besides, for the financial seclor to function
properly. it must be supponed by soud sial institutions dd busif,ess
l0l
2,3, foreien SKtor
This work synthesizls the exisring litemture on humm, financial & social
capital fomtion and the role liorcign sector can play in fostering the
financial markets in emerging economi€s in c6e they adopt an open stance
on economic frcnrs. The intent is to take a bird's eyc liew ofthe co'nplex
linkages between rhe acrivities of foreign sectors and their mle in rhe host
counrry's fi nanc;al market-
Th€re always remains need to conducl a comprehensive study md fomulate
a model thar should atFact foreign inv€stnent in emeraine economies that
on account oflow capital fomation at domesric level need forcign sectols
participation !o boost the economic gro*th*. A bigeer economic revival is
possible if, money, technolog/ and human exp€nise are imponed on a much
larg€r $ale. This cd only happen in a favorable and conducive environmen!
for foreign investor through economic opemess. However. ttte iirst part of
th€ model should focus on the fact that sound govemmenl policies are
imponant dererminants to attzct foreign inv€sro6. llost investmenl climate
such as mdkel access and availability ud quality of factorc of prcduction
afe other key factors sffectinS inwafd fore;gn investmenl. Ai:ef succeeding
in attracting foreign investmenr, a host developing country should also make
it feasible to nobilize 6d enourage lhe foreign panicipanB so rhar rhe new
technologies that they brought into the coutury arc hnsmifted to other (ims
and industries- This objective is usually achieved throueh forcign fims'
links wilh domesric fims as well as throush their own human resource
development activiti€s.
104
In nut3hrl, it can be 3aid thar msjority of ttle .bovc a.gumenb favq th.
pociiiir iqds of forctn iorldDlot. Howcv.r, lf,6c posidvc inp€c6 .rrsrb.i€rted 1o r cor|!tsy'! cddiriG!. Io sb..t, foEign irvt3M kingr with
it exp.rtisc, which is ar much inpqtint as tho c.pital it!€lf end it could lerd
to r npid !@io- eocdic developocol
105
2.31.@
It ;s imponan for the study to discuss the rcle of fo.eian scctor md markel
development as foreign invesrnent flows de m imponant source of
economic gro$th in deleloping counties. Foreign sector. csp€cially in the
form of Forcign Dir€ct Investm€nt (FDI), pav€s th€ way for any state to
boosr ils development and lead towdds progression. Foreign direct
investmenl is th€ movemenl ofcapital across national ftontien in a mmner
that gEnts the inv€slor control over lhe acquired asset. Thus il is distincl
fron fte portfolio investment, which may crcss borde6, but does not offef
such controi. Firms which surce FDI arc known as'hultinational
enterprises' (MNES). To study the rcle of forc;gn $dor in terns of
economic development in emerging economies on le8er horizons. il is
necessary to ddyz the €cooomic developmeni from the penp€ctive oflDlthat Aives .n explicit compr€hension for srnooft working of economic
Various studi€s have been perfomed conceming ihe impacl of forcign
'nvestor in lhe form of FDI on economic developmenl ih eme.ging
economies. Some ofthese favor attracting FDI wheres others h;ghlighl its
ttaws in a very conhsrina way. To exarn;fle lhe role of foreiSn investor in
emergang economies & its imponance in rcce.t times, ir is significmr 10 go
through previous studies and researches conduclcd in the dea.
Charles Omd "1zOOO; "-pt'us;s"s rhe d€velopmenral impacts of FDI
incenlive policies. Ile observes thal, while thcrc has been a global increase
h FDI incentives b€cause bmiers to investmenr have fallen, mos( incenrive-
ba*d competitions remain intra-r€gional. The rcpon recommends a broad
refom in policy-naking including rcsulatory reform, privatharion and
liberalisation of lnde polici€s, both exrehal and intemal, as a key element in
a developinS country's strategy to attmct forcign invesros. lt funher
underscores the ne€d to raise levels of accountability and lransparency in
orde. to limil the .isk of dishonesr practices develop;ng in connection with
investor arraction strareSies.
For $e counties in lransifion. one of the reasons why foreign *ctor is eatlracrive is fte need for deep restructunn8 in firms. wallne. (199S)r3 shows
theoretically that if transiiion econom) is characlerized by sofi budget
constra;n6. forciAn diNt investnent might b€ us€tuI in achievine this goal.
The presence of fo.eign inv€stoB gives policymakeB some incentives to
reduce subsidies to firms and evenhally causes fims reslructuring.
Another imponant reaon why foreign investon are invired io rhe hom€
countries is the fact that FDI @ generale posirive spillov€rs to the domesdc
firms ftrough a trtusfer of know-hov and technology.le However, such
spillovers can be positive or negative.l'or example, in the casc ofimperfecr
compeiilion on the product marker, FDI cm cause a subsrdlial reducrion oflhe ndket share of the dom€stic firm and eventually lead ro exil of $edomestic fim from the meket. Spillovers of knowledge from affiliated
loreign nrms .o donestic ones ar€ an often-claimed benefit to inward
tbrcign investment. So, ;t k wonh outlinhg possible spillover chmels. -Ihe
general idea thal interaction mong firms can generate spillovers, dates back
to edly cishtis whetr Caves (1982)50 who have had d early and ongoina
interest in analyzing this possib;lity for mulrinationals intemc ne wirh host-
107
countsy frff, I,f.nsffeld and Rom.o (1980)l prcseat some oarly srrvcy
evidrocc id l^4ich U.S. nultiE&nb ft?orted the ffEquacy .nd po.€ dr/hid thcir Lclllroloor drdoJ€d in fu€ign r6lid€s ra.hed hoct-courEy
comFtilor!, all consirtcot witl dultir.tional lpillovers.
r08
23'2. Spil!e!s!i!eJ!erIee!!r-I44&4
Many results conceming sp;llovers from forcign investnent suggest ftat
spillover effects de not automtic. They de influenced by various e@nomic
dd rechnological facto6. Economic literalure indicates the existence of
some factoN lhat d€termin€ abilily ofdomestic fims lo benc{il from foreign
investmcnts. Findlay ( 1978)5'z constructed a dynamic model, which explains
how technology trasfeB thrcugh FDI frcm the developed to the developing
comtries. Findlay and Gerchenkom (1952)ir formulate their catching-up
hypothesis of a positive comeclion between fie distance to lhe world's
tehnoloAical liontier md the mte of economic grow1h. According to this
hypo$esis, the wider the tech.olo8y gap bctween a devcloped md a
developing country, the larger thc potential for technological imitarion
would b€54. This porcntial will &celerate €conomic arc$lh. I lowever, d it
wts menlioned, the large l€chnology gap may also consdtutc an obstacle 10
spillove.s. Technologies developed in the hiShly dcveloped counrries rnay
be mor€ difijcult to apply for conditions in dcvelopins counlries. wh;ch
could prcvenl t€thnolo$/spillov€rs.
Kokko (1994)55 and Borensztein, De cresorio and Lee (1998)Jd shows thar
positrve F'DI spillovers re only genemted if the technology gap berween
foreign lims dd domeslic ones is not too large dd if there exists a
minimum lhreshold of human capilal in the host country. I:mplrically
positive spiuovea ale foud in Ausbalia (Caves (t974)'), cmada
(Globernan (1979)13), M€xico (Blomstrom and Penen ( l933)5') and
Indonesia (Bloftstrom, Sjoholin (1999)d). No ,pillovers afc found in
Moreco (Haddad and HendeNson (1993)''). Nesarive spillovcE arc found
in Veneaela (Aitken, Hadien (1999)d), Romania md Poldd (Konings
(1999)6r). wans md Blomstrcm (1992)a construcl a model of straiedc
interaction betwe€n FDI-fims and the dom€sdc enterprises which no1 ohly
uses the 6sumption of a positive rclationship between the tcchnology gap
and spillovers, but also sresses the imponanc€ ofcompelition. Ifthe foreign
enlerprises face strong competition lrom domestic firms. they have ro bring
in more adveced tehnology from lhe pai€nt cou ry in ordtr to mainlain
their market shares. The conclusion is thar thc tougher the competition, the
ldger the potential positive spilloveB.
Howeve., one important hsue which should be add.essed beiore making any
funher itroads into the natter, is !o find dswer 6 lo why mulrinationals
invest ;n specific locarions as lound by Dunning (1998)65, (1993)6 and
Shapirc and clobenran (2001)d'!o say rhal fo.eign firms are mainly
auEcr€d by strcng economic fsdarne als in rhe hcr economies. Some offte most imporlanl of fundanentah ee mdker size and rhe level of real
income, \tilh skill levels in the host economy, the availabiliry of;nfiastructure and other resom€s that facililate emcienl sp@ializrion ofproduclio., t€de policies, andpohicaldd nacroeconomic srability as orher
central detemindts. This hie@hy of host country's chamcte.istics ldaely
assumed thal FDI was market-seking; il was recognized rhar forci8n
investors seekins an export b6e would be less focused on local mdkct size
and more concemed about the .elative cost ofptlduction.
Dunning (1981)63 forrnalized a framework in which forcisn fims were
considered as the on€s po$essing rhree panicular sers ofadlmrag€i known
toAelher as OLI" (Ownersbip, Localion, Intemalizarion) FiBt is the
lt0
ownership advantage, i.€., the ownership of a firm-sp€cific asser- Second is
thc l@ation advutlgc, i.e., it musl be cost-€mcient fo. the firm lo exploit
the asset abroad rarher than in just the home comtry. And third is th€
i clnolizrtion advant ge, i.e., the firn nust be bette. off 6ing it! ass€t
its€lf rather than contacting wilh another irdcpendent firm. Blomstrom and
Sjoholm (1999)" studi.d the eff€ct of the pres€nce of fore;an inveslors in
Indonesia and rec€ivd positive and statistically significant coefiici€nt
measurinS industry spilloveB. They suggest that donestic establishments
b€nefit liom the pres€nce of for.ign establishmenb in rhe s@e induslry.
They ale find ihat spilloveB wer. r€stricted !o non-€xponed tocal fiflns,
probably because export-oriented firms already tuce competitive pr€ssure
from lhe world narkel. This sugg€sts that technolog/ spillovm @ mainly
du€ to increased comD.lition.
lll
233. Sp!!!E4I!-|!!c-D9EEd!lIg!.ssqr!g
It is noticed thal Sjoholn (1997)'0 exmines the etrecl on productivity of
liDl by using delailed mic.o data liom Indonesian rnanufacluring seclor. The
results suggesr that FDI benefiE locally owned establishments. Thc etTect
differs among sroups of industries. Spillovers from FDI are found in seclors
with a h;gh degree of compeition. The result shows thal the d€grce of
conp€tition affects fte choice of rechnology transfer to multinationals'
amliates and. hence, the polential for spillovers.
However Airken and Harison (1999)1' have studied the situarion in
Veneaela and find thrt the productivily of domesicallyMed pldrdeclines when foreign inv€stment increases. This sugAests negative
spilloveA ffom foreign to domestic ederprises, which is interprered as a
marker$ealing effecl. They have also studi€d if rherc are regional spilloveB
in Venezuela. In this regard, the authors conclude that therc is no empirical
suppon for the h)"othesis that lechnolos/ ;s lransfened locally nom joinl
ventures to domestically owned firms. Konings (1999)?? uses firm level
paneldara to invesligate empirically the efects ofFDI on domestic finns in
Buladia, Roman;a. Hungary nd Poland during the 90s. He found thar in all
countries thc eflect of !€chnological spillovers a1 th€ sector level is negarive.
However, it was found to be statisiically significanl only in Romania and
Poled- In the case of ttusition econonies fiis 'business srealing eflccr
might be rationalized by the fact that domes c fims have been mosrly
privalized by inside6. These inside$ often block restruclurinS md hence do
not Bpond to competitive pBsurc nom forcign fims. The advdrage ofusing pdel data approach allows conlrollinS for potential endogenous bias,
ll2
which arises because loreign ;nvestors de usually atlracted to better firms
and sectors. Comparine the magnitude of the nesalive regional spillovers
acrcss the four @untries, the author finds that these spillove.s ste sp€cially
imponant in the less advanced transition counties ofBulgaria and Ronania.
'l his may bc explained by the prcsence ofsoft-budSet conslraints: when ftey
arc present, local fims do nor have an incentive to imprcve their effciency-
Masnus Blomst(tm& Ari KoRo (2003) (200i)'r discuss€s rhe overall pfos
and cons of offenng forci8n irveslor's incentivcs md &gucs that the Ec of
investmenl incentives focusing on loreign finns is not a rccommendable
slmteg)/.'Ihe nain arguftent in support oflhis op;nion is thal the strongesl
theoretical notive fo. financial subsidies to inward foreign investment tends
10 b€ extemal effects such 6 spill over of technology and human capikl,
whicb do nor follow aulomatically from foreign direct inveshenr In olher
words, it is nor clear that for€iAn investmenl has an advanuge over other
kinds of investments. Also. the quality of the enabling envi.onmenl fof
investment which affeds a counlry's ability to atuact foreign iNestmenl
and to benefit from it - is equally signilicmt lo domestic invesros. Ilence,
ralher than p.oposing ndowly defined foreign investment policics,
attracrv€ lenns to investors should be seen a! parr of a country's overall
industrial policy and be available on equal terms to all investoF, foreisn as
well as domeslic. Incentives should, following the samc logic, focus on
tho* aclivities thrl create th€ stongesi polential for spill over, includinS
linkaaes b€rween forc;gD-owned and done$ic nrms, educarion, lraining and
R&D.
ltl
Magnus Blomltrdm & Ari Kokko (2003)'' suggest thar the us€ of
inv€stment incentrvcs focins cxclulively on foreigr finns, ahhough is
motivated in some ca!.s fton a dEorcticrl point of view, yet it is g€osdly
not an efficied way !o tais€ national w€lfsre. It is so b€caus the stronS€st
lheoretical motive for finmcial subsidies to inwrd foreign invcstnent
spillov€n of foreign t€.hnolo$/ and skills to looal industr/ is not a routine
cons€quac€ of foreign investnent. TI|e potentid spillov€r b€nefits ar€
reslized only if local tums have thc ability and monvadon to invert in
absorbins foreign tcchnolosies and skills. To motivate subsidizntion of
forcign invdtnent, it is ther€fore neci6s.ry, at the same tire, to support
€3ning ad invelin€nt in lcal ftlns rs well.
lt4
2.3..1.@
The positive developmental .ole of forcign investment, in general, is well
d@umented by chen (1983)'5 who analyzes thal foreisn investmcnt
produces a positive effect on economic growlh in hosl countries. One
convincing argun€nt is that foreign investmenl consists of a packaSe of
capilal, lcchhology management and marker access. Forcign inv€$menl
tends !o be dir4ted at those manufactunn8 sectors md key inlistructures
that mjoy actual dd potential comparative advantage- Fu.thermore, in those
sectom with comparative advotage, foreign investmenl crcates economies
of scale and linkage efTects dd raise produdivity.
Studies acce ualing the rol€ of foreign sector in bringing ;nveshenr to the
hosl countries in relalion with lhe impact of lbreign investment on
productivity of domestic lims have bcen made wnh sorne $udies that kcpl
their tixus on estimadng diect productivity spilloven for developing
counlrier while the olhers did the same for developed ones- The former
genmlly produce mor€ ambiguous rcsults the the latter d, in padcular, a
number of studies for developinS counlries show thar a foreiSn presence
leads to higher prcductivity of domestic enlerprises, while some sludies find
no significa spillovers or, at times. ev€n negativc spillovels.
The earlier highlighted views ofvadous scbolan give binh to the queslion;
whether lhe host country's costs for providing rhe incenrives in tems ofgrmts, subsidies, and other expenses are justified or whether investmenl
incentives ar€ likely 1o yield boefits thal aJe al least d large as the costs.
115
h is convenient to begin answering 1be questions by considering a
hypothelical case where foreign multi-national companies do no1 differ in
any tundamental way from localized firms. Even in this exc€ssive case, il
may be phusible to construct theoretical argm€nts in favor of investmenl
incentives b6ed on various kittds of e emaliti€s or ma.ke! impcrfections
l-he cosls ofthe initial investmenl incentive could arguably be recouped over
the time as rh€ economy dd, $ercby, the tax-ba* grows (thdks to the
foreign investment inflows). Flamm (19s4)76 and McLurc (1999)",
however, have formd that lhefe are at least two argments againsi lhis lype
of incehtives. Fnsdy, it is dimcuh make reliable calculations aboul tbe
expected luture benefits in lerms of 8ro\4h, employmenl. or lax revenue.
which is n€cessar/ to det€rmine how large rhe subsidies should be Tllc
situation becomes particularly complex in cdes where foreiSn inlestment
projects m driven by ineeshent incentives mther than cconomac
fundmentals of the host country. The reaen is thal the* invcsrcrs arc
likely to be relativ€ly f@tl@s, and could easily decide to move on to olier
locations offerins even morc generous ince.tives before ft€ expccted
benefits in the first location hav€ been realizd. Secondly and most
importantly ;f foreign invesiors do not differ in my fundamental way from
local investors, subsidinng foreign inveslors may distort compelition and
generale significdl losses arnonS local firms. I1 should be noted that fie
simple corelation between incentives and foreign investment ;nflows tnay
be neaalive even if incentives arc significmt deteminanls of foreign
investment inflows- A croses€clion analysk is likely to capture many cases
wherc coutdes prcvide substdrial incentives withoul significant inflows,
because som€ other counfy has oifered a more attractive inv€stment
package. Swenson (199s)r3 id€ntifies that a senercus incentive package may
I t6
som€times be motivaled by w€ak innows of forcign investmenr. lt ther€fore
may not s€em suryrising that many of lhe studies focusing on the effects of
foreign investment incentives look at competition betwe€n lhe United Slales
or thc European Union countries. Compelilion is not only inlensivc between
ihese two, but lhese days, in Asian block, India, Pakistan, Bangladesh ctci
e€ fighting for forcign direct investment and, mongs( all, China is the
biggest @eiver of foreign investm€nt. ln nulshell, it cd be said that
majority of the above n€ntioned argumenb favoF the positive impacts of
FDI & these positive impacrs are subjected to lhe counlry's conditions.
A good inveshent climale, however, is advantag€ous for all invcsloB in the
country. As reaulatory reforms strcamline prccesses thal benefit foreign
investoB, domestic enterprises likewhe gain from rhese improved
procedures beeuse this often provides an incentive lo move out of the
infomal ecof,omy. Lau Alfam, Areendm Chmda (2005)" argues that
foreign investors can generare posidve prcduclivity eff€cis for host
counties. The main mechanisms for th€se ext€malities de the adoplion of
foreign t€chnolo$ and know-how, which can happen via licensin8
agrcemenls. imilation, employee training, and the inlroduction of new
processes ed products by fo.eign fims; and the creatioD of linkages
between foreign and domesfic fims.
Eichengre€n (2003)30, along wid' rhose who suppon thc policy of
libemliztion to attract foreign investors, streses that privarized markets
allocate resources most efficiently and promote rapid economic gro\\,rh. ln
particular, financial liberaliralion allows a country to expand and diversiry
investmenis. thicken finucial markets and €ncoMge economic gro$,lh.
I l7
However, Stiglitz (2002)3' arSues ftat if financial acro6 de3l with p€rfed
informalion dd rransprent economies. lhen intemationally competitive
mark€ts de, ;nde€d, Par€to oplimal. However, if invcslors fae infomation
asymmetries and incomplete risk markels, d they oRen do in develoPing
countries, liberalizllion may usher in debilird;ng financial volatilily. A
markel that tends to cut down the overall risk profile of the invcshent
usually Aels a huge chunk of forcign inve$me s and il h6 been obseded
that with d incresse in findcially developed counlrics, foreign invcstmenr
leads !o hider groMh rales as compared lo the rates obseNed in financially
poor counlries. Inves.oF would not like to inve$ in a counlry wherc the
economic findamentals are so weak that it is unp.edicbble whal the
Sovemment would do next to prcp up a sgging economy3':.
Srislilz's (2002)3r argumenl ha! several implications for nnancial
lib€raliadon. Filst, even if invesrors d€ ntional, infomadon asymmerries
wiu creale enatic tfends;n their behavior. Second, infomation asymmelries
are greatest for foreign investors in r€cently liberalized emerging financial
mark€ii. Foreign investoE de panicularly vulnerable due to languase
baEiers, cultuml banie6, reliable information, and a lack of familidity
with the market. As a result. a developing coutry thal opens up ro foreign
investmentwill also experience increased stock market volatility.
Based on the faci fiat both schools ofthoughl have rheir oM jusrification ro
prove fieir point fight and fte issues identified by Stiglitz's (2002)34, rhe
sludy believes that it is imponant 1o discuss efilciency ofthe local finarcial
market in t@sfoming tud translaring all the relevanr infomarion inro the
price / value of inveshent. B€caus€ of the imponanc€ of the risk profile
lt8
associated with investment in developina €cononies, the study feeh thal it is
necessary to spend some time on assessing the inportace of infomation
processing for the investo. in dev€lop;ng mdket and the rclevan! Efficient
Market Hypothesis (EMH).
lt9
2.4. E$cie$-!44r!e!gIle$sE
One of the most crucial attribute of mdket mechanism is 10 tmsform the
infomation into p.ice. ln order ro artFct the foreign anvcstment, th€ host
country must take action to reflect thal lhe meket posses every
chreteristics to safeguard lhe investor from the haa& of risks arisinB out
of price mechanism. The term emciency is us€d to describe a mark€t in
which rclevanl info.mation is ;mpounded into the price of financial assets.
'lhe Efiicient Mek€t Hypothesis (EMH) is concemed with the behavior of
p.ices in assel mekels. EMH is an idea panly develop€d in the Eugene
Fama (19?0)35 subsranliate that il is impossible lo beat the mdket because
p.ices alrcady incorpomte and rcflect all r€lcvant infomarion. Under fieElficienl Market Hypoth€sis. dy lime one buys rnd sells sccdries, inv€stor
would be engaged in a game ofchance, not skill. lf markets arc efficienr and
curent, i! means thar prics always refl€cl all information, and therc's no
$a) inresror is able !o buy a nock al a bffgain price.
-Ille t€m 'eIficient markeC wd initially appli€d to rhe stock marker, but rhe
concept was soon generalized ro other ass€t mdkets. when the rem
'efiicient mark€f was intoduced into the economics literature thify yea.s
a8o, it wa! defined as a market that 'adjusts rapidly lo ncw infoirafion'(Iama er al 1969)". It soon became clear, however. thar while rapid
adjustnenl to new information h aD imponsnl elemenl of rhe elncient
market, it is nol the only one. A mor€ modem definirion is ftat asset prices
in an effrcient market 'fully r€flect all available info.narion' (Fma l99l)3?.
lhis inplics thal tbe ma*et processes informarion mrionally, in lhe sense
lhat relevant infomalion is not i8no.€d ud sysremaric cro6 do not occur.
120
Th€ concept of mdket emdmcy wls mticipated by ealier economisti, wbo
r€cognize that past pres€nr md even discounted tutue events re reflected
in market price, but often show no apparent relalion 10 price chmges. This
recognition of the informational cfficiency of markel lcads economisl lo
undeBtdd that "ifthe market, in effect, does nol predicl its fluctualions, it
does 6ess them a beinS more or less likely, and this likelihmd can be
evaluated mathematically". Howev.t such conlribulio.s were overlooked
until Paul Samuelson chculated it ro economists in thc lale 1950s and
subsequemly published in English by Cootn€r ( 1964)3'. l he early lite€trrrE
followed the path of accumulating a veiery of empirical obserations thar
did not sil easily alongside the paradisms of economics or the beliefs olp|actitionels. Bachelier (1900)a has concluded thar commodiry prices
fluctuate randomly. and lal€r sludi€s by Working (l934f0 and Cowles md
Jones (l9l?)'r we.€ 1o show tha( US slock prices and oth€r economic series
de shee thes€ characteristics. These srudies, howev€r, werc ignored.
ln m effrcient findcial market, an assefs price should be the best possible
estimate of its economic value.
t2l
2.4.r. The Rrndom w.lk Model
A new connotation was added to series of which consecutive rclums are
serially ind€pendent- ln the *ly 1950s, rcs€arche$ werc, fo.1he first time,
able to employ €lecl.onic computed b conduct study of the behavior of
lensthy pricc series. Kendall (1953)" having examined 22 LrK sbck and
commodny pric€ s€ries, was flabbergasted by the resuh and concluded ftatjn series of prices examined ar reasonably close intervals, the random
chdges Fom one tem to molher were so outsizd as to swarrp any
syst€madc effect that may b€ prcsent. lltc dala behaves almost like
wanderjng series and fte ned-zero serial conelation ofpricc chdses was an
exmimtion th.t app€ar€d not consistent with the views of economists.
Neverthel€ss, thes empirical obs€rvations came to b€ bnnded the "random
walk model" or even the "rudom walk theory". lf prices walk rmdomly,
lhen this poses a major rest 1o markel ualysts who Fy 10 forcsee the futurc
paft ofsecurity prices.
Despite the emerging evidene on the mdolnne$ of stock price changes,
there were occasional inshnces of inconsistent price behavior, wbere cenain
series appcared to follow predictable paths. This includes a subset of the
stock and coffnodity price s€ries examin€d by Working (1934)'r, Cowles
and Jones (1937)'a and Kendall (1953)'5. In 1960, howcver, there was a
realiation thal aut@onelation could be stimulaled into rctums series 6 a
resuh ofusins tim+avemsed securny p.ices s independendy discovered by
Working (1960)'q6 ad Alexander (1961)'r. The mid-1960s was a lurning
point in r€search on the tudom characte. of slock prices 6 in 1964;
Coomere3 published his colletion of papers on the topic, while famab
122
(1955)e dodor.l dafu wr! ftIllduce4 i! it3 eotir.ty, in th. Jound of
Bwin.3!, Fan rcvidld lhc €xidiDS limrc oo slod( pric6 b.l|!vid .ttlll tinc abd .xalnil|.d ftc di*ribuifur .nd r€rial d.p€d.ncE of stock
ma*d rtnmrs, [d rEarbd r oGclulion LooUtrg 6t his wo.iq it qpce!lafe to cxpre$ tllai had pG!.nted stong and voluminous evi&nc. in favor
oflt rlDdon wilk hyporhdi$
123
2.4.2. !IE-g9ss9p!ef-!4e4e!-E$iic4r
With a betler uhdentddinS of price fonnation in compctitive markets. the
random walk model came to be perceived as a se( ofobseNations thal can be
considered conJstent w;rh the elficient markets hypothesis. The change of
emphdis began with obsewations such as that of Samuelson (1965)rrir',
who's claim that properly mticipalcd prices randomly flucluale, b€gan to
prove wilh the obsenation rhat in competitive mekets there is a buyer for
every seller and if on€ could be sure about rise in price. ir would have
already ris€n." Samu€lson 6*ned that a.guments like the above are used to
fisure out thal competitive prices must display pice adjustmem and they
p€rfom a random walk with no predictable bias. He tunler explicated the
hope that people in rhe marker place, in pursuit of ardent and intell;g€nt self-
inte.esl, will lake account of thos elements of tuturc events thal llprcbably be differentialcd to be casting their shadows before them- By
presenting his proof in a general form, Samuelson has added fimness to the
nodon ofa well-firctioning mark€t.
Based on Samuelson's approach along with taxonomy suggested by Hany
Rob€rts (1959)i0r, Fama (1970)10: presented the theory and evidence ofna.ket efliciency. Theory was supponed by empirical evidence thal
develops a coflcept defining an €fflciem market as one in which trading on
available information fails lo provide any super normal profit. A marker cdbe deemed efiicient. Thercfore, only ifw€ posil a model for retums md
fron there on, tesli of market efiiciency becomc joint 6sessments of markel
bchavio. and models ofa$set pncing.
t24
Considerins the levels of markel emciency. the wak form of the €fiici€
markct hypolbesis claims that prices tully reflect the infoanation hidde. in
fte sequence of past pric€s. On the other hand, the semi-$rong form ofthe
hypothesis asserts that prices reflect all relevant infomalion publicly
available or no one can take advanl.age on the bds of publ;cly disclosed
i.formation as n is already md tully reflecled in the market prices. Whereas
strong fom of market €mciency alserts that informarion known to any
panicipdt k rcflected in markel pdces ed thus limiting the individual of
taking advantage ofhavina ioside infomation.
Fama (1970)r0r summarized the early random walk literature; his own
contributions and olher studies oflhe information contained in rhe hislorical
sequence of prices! dd concluded that the rcsulls slrcngly sripporled the
weak form of market efliciency. Furthernore. laFr on hc reviewed a number
ofsemi stronS and strong fom tests, and concludes rhat being pr€cis€, the
evidence in suppon of the efiici€nt ma*ets model is exlensive, ddontradictory evidence is spde. However, he concedes that much remains
lo be done, aod indeed, Fama (1991)rs subsequenlly r€tumed ro rhe liay
wifi a reinterprelation ofrhe efficient markets hypothesis in the lighr of later
However, the emphasis now has fallen on the study of qenrs ad th€ifjnpact on the market prices wher€ an event study averaSes fte cumuladve
pertbrmdce ofslocks over time. Studies ofthe semi-strona fom ofcilcienlma*ets hypoth€sis can b€ categorized as re$s ofthe speed ofadjustmenr ofprices to new infomation. Using capital asset prjcing Dodel as the
benchmark, these event studia provide evidence on the r€action of sharc
125
prices to srock splits and eamings amouncements fespectiv€ly. In both
crses, the mrrket app€ris to anticipare the information, and nosl ofthe price
adjustm€nl is complete beforc thc event is r€vealed to lhe market. When
news is r€l6ed, the renaining price adjushent rales place rapidly and
In his srudy ofthe price effects of srcondary ofTerings, Scholes'(1972t'r'
exmined stock price movemenis wher the seller may b€ in possession ofnon-public information. Oo ave.age. share pnces lall by an mounr that
reflects the valu€ of this inforution. The impact of a secondary distribulion
on the stock pricc is larS€ly unaffecred by the size of the transaction, which
contirms the deplh ofth€ market and the substitutabilitl ofone securiry for
another. However, there exist som€ €lenen$ ofposl-event pricc dnft, which
may constitute a violation of mdket efficiency. Sincc th€ fiBl elenr sludies,
numemus Fp€rs have demonsrrar€d thal early identifica on of new
infomation can provide subsrotial profits. Insiders. who trade on the basis
ofp.ivileged information, can thercfore make exccss rerums, violatin8 rhe
slrong form of$e eflicient markers hypothesis.
'lhe concepl of mark€t efficiency has to admit fic possibiliry of mino.
market ineniciencies. Evidence accumulated during the 1960s and I970s
appean to be b.oadly consisEnr with this view. Wh;te ;! was clear that
markets couldnl be ompletely emcient in the slrong fonr, there was
slriking support for th€ weak ud semi srrong foms and even for versions ofstrong form effici€ncy that focus on the performance on professional
investment mdagers.
t26
2.43. Stock M.rkel Aromalies
The earlier event sludies (Scholes' 1972)i06 used capital asset pricing model
as the benchmdk f@usina ro provide evidence on rhe reaclion of sh@
prices to stock spl;B and emings announcemenls respectively and
concluded that market appwed to andcipate the informalion. and most of
ihe pnce adjushent was complerc before fie evenl revealed 1o the ma*et.
I lowever Basu (1977)10? applied a diffe.ent crilerion and documented th€
use ofprice/eamings ratios.o forecasr s.ock retums. In a sudy of 1400 firms
over the period 1956-71, he obs€rved lhat low P/E scur;ties outperfonn€d
their bigh P/l: counrerparts by more than seven percenl per year in a study
focusing on fourteen hundred firms covering a time horizon of | 5 yea6 frcm
1956 !o 1971. Though his resulii could b€ interpret€d ai a challenge to rhe
CAPM benchmark, Basu r€serded his r€sulls a, indicatile of market
inefficiency and concluded thar securities radine at divcN€ muhiples ofesrninss, on averase, s€em to have been imprcperly priced in comparison ro
one another and opportunjties for eaming super normal retums were
Banz s (198llrB followed rhe foorsreps of Basu (|977), sludyine s1@ks with
low P1E slocks dd worked on the lona-run rare of rctum from invesrin8 in
smaller companies. Focusing over the period between l93l and 1975, Banz
analyses monthly retums on sharcs listed on th€ New York Sr@k Exchange.
He finds that ov€.this interyal oflim€, ona risk ad.jusred basis, fifty smallesr
stocks outperfomed fiRy ldgesr by an avemge ofone percenlage point per
montb. Thc small fim effect d@umenred by Banz gave rise ro a plethora of
\21
ln addition to eamings- and siz-related ireguleities in retulns. there arc a
number ofothe. puzzling obserations thal pose a challenge to the efiicjenl
markels hypothesis. A phenomenon that h6 nor yel b€en explained
salisfaclorily is lhe negative long-run perfonnance of new issues.
d@umented by Riue. (1991)i@ and Loughran dd Riner (1995)rr0. Riner
had found thd an innial investment in these shares ar the end ofrhe firsl day
of lradin8 would have generated substatial uderperfomance over the
rollowins lhree years while using a sanple of 1526 initial public offerings
over the period 1975-84. A cenral difficulty in iderpreting sludies such as
th€se is the joinl h}?oihesis prcblem. The magnilude of over or under
performance depends critically on lhe choice ol benchmark. and ftis makes
il difficuh to ;nterprel th€ results. t_ama and french ( 1988)rrr show thar rwo
vdiables, market capilalization and book-to-marker equity consider the
effect of nor only ofthes€ rwo vdiables bur also of pncdemings dios and
papers exmining this phenomenon and had been conobomled in many
128
2.4.4. Teits of Furdrment.l Valuatiotr
Event studies and mny slrong form lests, indicate that security prices
rcspond efficicntly 10 new information. lt remains possible thal assets ee
pe6istendy over or unde.-valued over long pe.iods ol lime. It G morc
diflicuh to test. whether prices conform 1o tundamental values, than to lest
whether pnces rcspod appropriar€ly to information. Nonetheless. despne
fte dillcuhy of testinS corredness of the level of security prices, the
Ulcralure has evolved in this dir€ction. The two major challenges b rhe
ralional efficiency of the market are lhe variance bounds lne€turc, and the
noise trader lheratur€.
Despite havinS faced plentitul controveBies while examining rhe fi81
challenge ro the Etional efficiency of rhe market, Shiller (1981) r: cxamines
the variation in stock market pric€s, ad concludes thar pric€ nucruarioB
were too large to be justified by rhe subsequent variarion in dividend
Thc second challenge, associated with the rarionat etficiency of mekelfocusing the noise mder effecl, was discussed by porerba a.d Summe6
(1988)'rr, togethe. wirh Fma and French (198s)rra. They srudied fte
linkage betwccn short-horircn posilive serial corelarions in slock retums,
accompdied by negativ€ cooelarion over longer intervals. Based on lheir
findings, Poterba nd Sunmers reported having found sisns of a market
inefficiency founded on noise rmdins. This rEding by investors, whose
demand for shares is derermined by factoB o1he. than thcir expecred retum,
provides a plausible explmrion for the transirory componenG in st@k
t29
Fic.€. InFvaryiog o,sct d rctr8 could dso .Nphin 6... p{t m!,
withod EquitinS u! to alalo€ thd Ficls dcvilte frur ftDd@.atal vlhtover s(qd€d inGnrh. Nevcrth.l6s, inc{e.siry lit (ltr€ re€k io €'plain
ob6€wdi@s $rc,h r! 6.!. in tgtd of tb !.dih.d of ncntiod trd*
130
2.4.5. Eullllldls4lielai!-E
Discussions on lhe ovemll economic eftci€ncy in emersins markets can
approprialely lead us to conment lhat firdcial mkets, esp€.ially capihl
markets, in the emerging economies de generally incfficient. The reason
behind lhis discrepancy as compared to markets in devcloped e.ononies is
that it iakes long, rath€r hardly nt all somelimes, for markel informalion lo
be transformed into price. The market forces play diversified afe.1 in the
infomational handling, leading the infomadon prevaricated in the markel
scenario. The lransfomation of information is loo long ro rcflcct the p.ice
and in tum affeci the retuhs. Most oflhe times, a markct operabs in a fom
of isnormce ed lherefore it crahes doM making high volatiliry noms oflhe day. At times, ndket in emerging €conomies do 8€l the commenrs rhat
lhey have one ofthe b€s! performing indexes, bul such performance does not
reflect proper transfer of infomation inrc price.
Ther€forc, implications of EMH for emerSing economies capiral markcr
hold that they have weak fom of market efficiency for which, throughout
the wodd, most of the rcsearch work has been deumenled; however they
are dostly conducted in the dev€loped economies whereas in emerging
*onomies, cornparadvely little anention has b€en aiven on fie subject. Iior
ins&nc€, few sludies have been made in the conrext ofPakislan, gen€rally
using tmditional serlal corelarion tesr and fte nns rest. such as, Khitji(1993)rrJ, Mangla dd Uppal (1996)116, Jun and Uppal (1s93)rr', Huein(2000tr3. while Khilj; (1993) and Husain (1997) found thc presence ofserial depend€nce in stock r€rums, Ju fld Uppal (1994) avcred thal rhe
independence hypothesis usually holds i. the Pakisrani marker. Sone ofrhe
t3l
studies lik€ Mustafa and Nishar (2002)r D exanined the relar;oEhip between
aggregate stock market trading volume and serial coFelation of da;ly stock
rerums during Decemkr l99l to December 2001. Abass (2004)r'10 focused
h;s work on KSE 100 index d4 based on his nndings, suggesrs thar KSE
100;ndex tbllows randoin walk in bolh its wcckly and monlhly retums.
while studyinS the €vid€nce of ma*ei efiiciency of the K&achi Stock
Exchuge by usins thc Ausmenied Dickey Fuller (ADI), Ljuns aox Q-
slaislics, autoconelalion, Durbin Watson md Vdimce ratio tesls, Yasir
Kamal (2005)D' analyzid Ihe impact on market behavior. particulely pri@.
Ihis he did in the aflermath of rhe event of 9Al and the consequenr
infomation thal obviously is the weak fom of efficicncy. The results
sugaest that pre 9/l I data st exhibits Alimpscs ofaut@oFelalion implying
markel inefiiciency while fte posl 9/ll data sel exhibits urbanized weak
forn of Darkel effciency. Madhumari Chakraborty (2006)11', investigating
the weak forrn emciency of the Pakisre stck mdkel using daily closing
prices of KSE-100 Index for the period from I Jmuary 1996 ro 15
November 2005. comes to two basic conclusions inlerpr€ted d reflecr;na
that there k rcjeciion of the mdom walk hypolh€sis during rhe enrire
sample period and that the stock price movemenl in Palisran is gradually
paving the pa$ towdds efficiency. She devcloped one predicdve model,
focusing on th€ possibilhy to forecast future price movemcnt and,
acco.dingly, builds up future hding straregi€s.
The srudy finds sp€rse literature inthis fieldofinterest and rhis isduero lack
of financial experts ih developing counties. Moreover the dala requircd to
analyre $e market mechdism is also unavailable. Thc cmci€nl markeis
hypothesis is sinple in principle, bul .emains elusiv€. Bvolving irom an
l12
initially p@lina sel of obserarions aboul the rddon chamcter of securily
prices, it became th€ dominant pandigm in fi nance during the I 970s. Dudng
its heyday, rhc efficient mtrkets hypothesh cm€ to be supporred by a
g.owinS body of empincal rcsearch demonstraiing the d;fiiculty ofb€ating
the markel. whefter by snalytng publicly disclosed ;nformalion or by
employing professional inv€stment advisors. The ld1 rwo decades have
wihesscd a targeled stance against the efficient markels hypothesis. The
hitheno dominanl p€Jadigm in finocial markel rescarch, ihe Emcienl
Market Hlpothesis (EMH), has been pul on rrial and subjecred to critical
review. Yet as Roll (1994)r':r observes, it is remakably hard io prcfir from
elen the most extreme violations of market eftlciency. Srock mdkcl
momalies ee only too olien chdce events thal do not pesist inlo the fiture.
The importance of the efficient narkets hyporhesis is demo.slmred by the
fact lhat appaently profitable inveshent opporrunilies are still refened 10 as
anomalies dd the efficienl markets model conrinuesro providc a ti?mework
wideu used by financial econom;srs
Mmy research€rs have documented ample.esearch on mtrket efilciency for
both of ils weal and s€mlstrong foms, but less work is done in lhe past on
emerging mark€ts ofAsian coul.ics. Considering the case ofpakisran.lhe
cnpilal market emciency had not been tesred with thoroughness and purpose,
po$ibly for lack ofboth $e bEins and numbeF todelemin€ lhe progress. tlis therelbr€ required in emerging economies ofAria ro study aboul capilat
evolulion in order ro mould the forces thd indicale infonalion io sharc
prices. Covemmen6 in rhese counties arc however ryjng to csrablkh an
efficient meke( where infomarion is indicared in rhc sharc price. Much
atiention is b€ing given lhese days so thar Markelbased financial syslems
cd be devised to promote efficient allocation ofresources, lower transaction
cosl. provide liqu;dity to inveslo.s and p€rfom effrcient projecl monitorine.
Il is a well-known fact that meker basd system provides grealer incenlives
to collect information because tradinA €kes place on the basis of tbal
information. Conseq@ntly, the emerSine economies markel mDsi respond to
To sum up, ahe $udy safely concludes that a
suppons the theory relatjng to the strong
insdtution development and growth with few
Ia.se body of evidence today
bondage between financial
studi€s posing chall€nge this
As for the role of fl|fucial sector. the study discusses that, in all posibility,
ellcicnt intermedialion will be evcn more cruclal in thc years ahead,6
economies become more reliant on capibl-inlensivc proce$s and
innovative technologies. The financial system d@s no1 operate apan ftom
the economy. h is in fact an inregral pal1 ofthe economy wherc rhere is
inteelay between lhe finecial s€ctor and the economy. And as regdds
proper ftnction ofthe financial sector. il musr be suppoded by sound social
inslituliors and business practices.
Funhemore, while evaluating the role of foreign sector, the res$rch
conveniendy suggests ftal the use of investmenl incenrives focusing
exclusively on lbrei8n firms, allhough motivated in some cases from a
theorctical poinl of v;ew, is Aqerllly not an cffic;e way ro mise nalioml
welfar€. The main reason is ftat the stronSest theoretical motive, for
iinancial subsidies ro inwdd foreign investmenl spilloveF of foreian
lt4
lechnolo$/ and skills to local industry, is not a rouline consequence of
foreiSr inv€stment- The potential spillover b€nefits m realized only if local
iians have the ability and nodvalion ro invest in absorbing foreign
rechnologies and skills. To modva€ sutsidiztion offoreign investmenl, it is
thefefo.e esscntial, ar the same !ime, to support lemin8 and investment in
local firms as w€ll. In briel it ce be egued thal majority of the above
menlioned argumenls are in favor of th€ posiiive impacts of forcign
investment but lheir affirmative effects are subjected to economy's local
The study has nade an attempl lo focus on the issue of market efficiency
and adnits th€ posibility ofrninor ma.ket inefficiencies. While it was cled
that mdkets can t be completely efficient in the strong fonn,lhere is sl.jking
support tbr the we.k and semi strong foms ed even for vcrsions ofstrong
form efficiency that f@uses on the p€rfornance on prcf€ss;onal investment
managers. Much atteniion is being given these days on the market-baled
financial slstems to l,€ devisd so d .o promole eflicienr allocarion ofresources! low€. ransaction cosr, pfovide liquidiry ro invesroG and perfom
emcient prcject moniloring.
The imponance of the €fficienr markets hpothesis is demonstraled by the
fact that appar€nlly profitable investmenl opportunities arc srill refened ro 6anomalies and the efficient markers model conrinues to provide a franework
widely used by findcial €cononists. h is a well known facl thar market-
based system prcvides grealer incentives to colled information because
lrading hkes place on th€ basis of that infomarion. Conseq@nrly, the
eme'ging economiei markel musr respond lo rhe c-...
|]5
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l16
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t42
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l4l
After a detailed delib.ration on thc components of financial envimnment in
lhe previous chapt€r. il is now considecd necessary to discuss about a risk
dd rclum model 1o elaborate what hd been thrashed our in the prelious
chapters about the risk and rerlm fundamenrak and ihe fDucial
enti.onment. lt is equally important to examine the various lypes and
souces of risk concems that affecr rhe decision of d inve$or, cspecially E
fbreign inrestor because ofthe p€rceived importflce of foreign investment
in economies like Pakistaf,. The magnirude and impact of each risk factor
varies with the tme horizon for the invesrment and every lype of risk can
iniluence d investor's decision to invest in a market. depending on the risk
ass€ssmenr of ft€ tdgel marker. The common rypes of risks invotved in
making m investment decision and their magnitude of influence on the
'nvestmem ar€ elabonred in the following discussion. How€ver, rhe debate
on various risk concems has intenlionally be€n kepr focused to hishlishi ihe
view-point ofth€ forcign investors.
Let i1 be kepr in mind thar atl variables discussed in the chapte. identiry
opponunities for both rewards and chatlenges b the invesrore. Rewards crop
up in fte fon of finding ways to pmfit from rhe increale in ftc vatue ofrheinvestment dising out of positive movement of concemed veiabte orvariables. On the orher hand, chaltcnges enrail fiom batdcing rhe potential
for such Bains asahst rhe possibitity of losses adsins ou! of adveGe
movenent in lhe vdiable associared with investmenr.
The research makes an effon b shed light upon some of fte fisk cohcems
which are pivotal in the risk and rerum dalysis dd ro consider country risk
as lhe stardng poinl for the invesrols analysis. Exchange rare risk is another
l.r5
risk concem which the study has discussed and firdamentally this kind of
risk emdates fron changes in th€ exchange ra.e, which may happen du€ to
political idstability, in addilion to other rclat€d f.ctors. Afier the exchange
rate risk, the rese{ch focuses thc interesl rate risk -- the snsitivity of a
debis price !o changes in interest rate -- and rhis response of rhe debr's
value in twn dcpends on the security's tim€ 10 marudty and its coupon rate.
Funhermore, it hes also b€en ass€rred lhar th€ risk concems like flucruarions
in economic perfomance, marker variations, infiation factor, financial and
polilical circumstances in addition lo seclor specific scenaric are significant
for assessing the conditions on which $e invesror woutd be able lo decide
abour investing id the econodyr. Th€ level ofvolatility and ihe nagnitude ofeach factor may be different for each inv€slor, but rhe study hs tr;ed ro painr
the pictre on a broader sp€ctrum.
A Brord PeBpRtire otr lnvertmetrt
Thc inflow of inv€stn€nt ftmds into th€ market mainly rests on certain
determindls, which define the level mdket capitalization md gros4h ofcapital irflows in the economy. As ob*n€4 rhe situation becomes even
more complex when it cones to the foreiSn investors. Economic
det€rminanls are not the only influ€ncing facrors when cvaluatinS ! foreign
dir€ct investnent or ponfolio investrnenr'z. Potirical stabiliry. law-and- order
situalion, rcgulatory hsues re some of the many k€y facbrs having a direct
beaing on the level of invesune.r inflos from doin€sric s well as foreign
companies and individud investors. Illustrarion 3.1 below smmarizes the
differ€ot omf|onetrts of risk dd the dtions ftar can be taken by the
invenors to reduce or eliminare lhis risk:
t47
llo(rrtior 3,1
Conporetrt! ofRbk epd Actlons R.artre Ellnlr.tid th. Rn k3
'i-1P1i,_
.Fg
!I
I
i
IDiIElsE!r8dohry
l,l8
Another dimension to rb;s issue is the wietal dispdity, espec;ally in the
emefSing economies. that aiT€cts the inveshent decisions. ln the case ofnost of th€ cmerging economies. s€cuity of investmenl hd bcen a fairly
rroubling and one ofrhe leading causes of low capital inflows. Domesric
v'olence ,nd a panicular tageting of intemational inl€rests in th€ country
has been a regular fearure of day-loday lif€ in such economies. As the
problem not bcing tackled seriously dd efT@tively by the conc€med
authorities, rhes€ economies, consequently, have been a fairty u.arhcdv€
mvestment cndidate for both domeslic and foreian investmenrs. However,
the counlries havina tracked down rhese problems wirh success have found
invesloB inclined more rowards contriburing jn rhe cconomic developnent
ot ihe country. The key delermininA facroB .s postutared in the Unir€d
Nations Confercnce on T€d€ and Developmenr is vjewed as seneratguidelines for evalualing the feasibility of a foreign invesrnem These
suidelines provide a bsic ftam€work for fie eme.sing economics to fo ow
'n order 10 atraci the foreign invesrment as it would appreciare the domesrjc
investoB in their inve$me decision a wetl. Th€ chart is beina itluslmrcd
lllurlritioF3.2'
I{ost Cou0tw lht€mirrnt! of FDI
TyD6 ofFDI P.bcip.l E ononicD.t mim.t! b Hcr Coont y
Policy frme$orL for FDI
Ruld ESardine mlly md
Standids of lreah.nli of
Policis on tutrdiooing al(|
(especially coqEtitior mdpolici€s goleming hdg€n
Inremlrional agdhe onFDI
Tmde Policy (ladfls &d
coh€rence ofFDI md rade
L Em.onicD€lemiMb
('nclnding imge - buildingmd ole$henl gsenting&livnis qd inv.srrn€nr
adDinisLative emcicncy)
.xdpl. bili@ual $h@ls!
Aner - inv€shenl snices
Mdkel sie dd per capira
Acss ro Egional .d globrl
couq spdfic consmer
hw cosl unstiu.d labou
Tehnological, innovaliv€ andolhe crcstive eis (btudnm*), ihclndios s enbodiedin individu.ls. fims dd
Physical inf.anrucrur (D s.o!d5 rel€o@mistioN)Crst oa Eew6 srd @Glist.d qbove. adjusled for labolr
Olher inpuls costs such stEnspon dd connuiadon6r ro/ fren or wifi in tne h6taonony dd od.r inremediate
Membership in a egional
onducive to rhe d|.blishn.nrolicgio.al corpor e nerworks
150
J.2@
when invesling in a financial ma*e| Mjor incentive for an inleslor is to
max;mize the reum of the inveslmenr dd b minimize the risk rhrough
dive.sificalion and hence optimize the value ofporlfolio. Howeve. ih the
context of diveEification dd laking an advanbgeous position. an investor
looks tbr celtain indicalors from rhe rargel ma*e!. 'Ihese indicarors include
economic perfomdce, political slabiliry, legal enviroment, prospects ofgrc{,th in addition to lmking at fte srenSrh ofthe cuncncy in intemalional
mdket and exchenge ml€s d well, if foreign investment is ajmed al.
Even though there is a higher risk factor involved whcn invesling in a n€w
or in m emerging marker, yet th€re is also a Sreaer opporruniry aor
exploiting the market for higher benefits. This is due to lhc diferenlial
corelation in rctum on investnenr bawecn th€ developed md energing
mark€$. Emerging markers potenrjally otfer subslantiat diversificarion
benefib lo inve$oB holding U.S.-only or industriatiz.d counry portfolios.
Barry & Lockwood (t995)J
The .isks involved i. an i emationat ;nvesrmenr can also b€ v;ewed from a
d;fferent pespecdve as they prov;de opportunities for rhe invesror.
However, for the investoB. panicularly inremarional investors, such risky
opponunities cn eitherlum outto be meds forprofir-making or can burden
them with capital loss as well. As prepamtion, invesroF musr took fo. a
sorls of approach towards mitigatin8 foreign ;nveshenl dsk and Lo
incorporale nodem md sophisicared capihl budge(ing tecbniques beforc
naking the investnenr. h may cosr comparatively morc lhan orheNise
l5t
possible, but the payback is much more worthwhile esp€cially when d€aljng
with a volatile and uncenain mdket environment. Unc€rtainly and volarility
de inherent features ofan €merging market. which leaves rhe window wide
open for a .easonable investor to capitalis this attribule ofthe marker.
Sundem ( I 975)5 argues that the b€n€fit of sophislicated merhod! is Srearer in
environments of grearer underlying uncerrlinry. the implication is ihat
companies facing a@ter risk should be morc willing ro incw rhe cosrs ofnorc sophisricated capital budgering methods. UsinS these nerhods implies
ftar investing in such venlu.€s is ofter more desirable for a new foreigr
investor. The application of sophisticard capital budgeting rcchniques by
investmenl means that the invesrmenl is fai.ty prud€nt in ufilitng the
inv€slor's confidence. This cautiousness gives ou a positve signat for
inlemational and local investos, providing them wirh more conaol over
Followins rc rhe major concems dd .isks when invesriq in an emeryina
t52
3.2J . gsglta-Blsl
Country risk in a nost elem€ntary sense may be defined as the risk dising
out olinvestment b€ing made in a panicular country. In the back-drop ofthe
general obsrvation the study ca express thal coutries wirh slable political,
economic, so.ial md reaulabry fi"mework provide a more shble climare
for investment and therefore entail less country risk. Bhalla (1983)rpoinls
out that country risk incorpoEt€s polnical, economic, fimcial and socio-
cultuml €l€menb, and refen ro the uncenainry caused by polilicat,
economic, tinancial dd social instabiliry of a country and ilJ anhude
towdds foreign opemtons.
This risk concem has a v€ry wide Enge bearing and the eurces ofcounlry
.isk may also include the uncerkinl;es arached wirb the changes in rhe
rcgulatory framework like witb rhe raxarion syslem, law md o.der siruafion,
conuption ]evel. curency conversions and exchage fates etc. I.urthermor€,
country risk also includes the risk thar p.operry owned, €specially by the
ibreigr investors, will be exprcpriated wirhout adequale compensarion. Itmay rlso be considered that counlll risk h4 ils influence from th€ situation
eising out ofnew host country sripularjon about lcal produclion, sourcing
md hirins practices dd damaSes or destruction of fac;lities caused by
intemational friction3.
The sludy is of the view rhar when considering investing in a new emerging
meket, investor's prime concem is ro have a thorough assessm€nr of rhe
coDtry .isk in the first plae. Any mi$onceprion or miscalcDl.ionregardinS tbe assessmenr of the couffy risk may lead to loss or financial
t53
dhlress fo. th€ investor. There are however some g€neric guidelin€s to
follow when ass€ssing county risks for investment purposes. In order to
present country risk ds€ssmen! generul guid€lines are prcsenled in the fom
of the following illustration:
154
The.esea.ch b€lieves that mosl investors undertake country risk assessments
when investina in a foreign dlarket, especially in the case of corporate
invesiments. These ass€ssmenB can be canied out either by r€sido1 risk
muagen for the company o. by mens of oubourcing risk assessment
consuhmls in $e foreign counry. Such activities help lhc investoB gain an
insight of true potential of the investmenr and to have an undeNlanding
aboul the degree of instability and voladlity thar exists in such economies.
more imporkndy, for new investors or investoB cnlerinS new emerging
makels- However, Baird (1993)i0 argues that no assessment technique is
considered to b€ completely r€liabl€, and in some cases, econoni$s have
been known lo misjudge countries. In addition, manasers often isnore
wamings in th€ir zallo srowglobally.
The research feels that it is nol always most appropriate ro solely b6e on
6sessments frcm lhe falysts panicularly if they are local-based in the
comry. The enviromenl on ihe ground inay be misleading or ev€n
somelimes the analysts may have biared opinion towards the environment in
some countries that is why the study obserues thal ii is belter to have a
second opinion before embarking on an investment outinS in a new rerirory
in order to count€r the short comings of rhe assessmcn!. In evalu ing the
comty risk, many methods or models c.n be applied rangins from a hishly
quantitaljve approach to a very low qualitativ€ one and in order ro make a
final alsessmenl, the study ;s ofrhe view that differe!1 modcls and sources
mry be used togethq d differenl me$urcs of counrry risk arc nor murually
exclus;ve. The exercise my seem ro rake up morc time and effortr bul ;r
would se^c ;n building a hisher level of confidence of rhe invesror.
r56
Moreover, a s€cond opinion is always the prudent manager's option as it is
not neGsary that the alses$n€nt is consciously bia*d.
The study also obswes that for creating a better undeBtlnding of the
country risk, lhe foreign inv€stors should divide the risk concem into four
ma.jor cal€gories which include financial, political, economic and culiuml
risks. Eacb of $ese calegori€s is imponant in its own sphere dd h6 a
sigh;ficst impact on lhe value and profilability of an invesment. Any
desr€e of vdidce can only sdd to th€ risk profile of investnents in the
country under review and ther€fore before making any inveshent decision,
risk Mlysts must la.ke a lhorough look at lhes€ influenceB, so as to avoid
It is believed that, by appmisinS the country nsk based on thes .isk
categon$ individually, an investor or hh ealyst can easily detemine the
magnitude and intensity ofcountry risk thal is involved sepantely. This kidof study altows the inves0ors to take preventive medures dd devise
cushiom €ainst the spec;fic risk h€nce minimizing its eff4t on the
investnent. However, keeping fie discussion aside, it has ben sen thal the
most common approlch to ass€s the country dsk has been to develoP
country risk sco.ing models based on key economic ralios. for each country.
designed in a way similar 10 the do'nestic credit risk scor;ng models.
Important economi€ ratios include the Debt SeR;ce Ratio (DSR), the Impon
Ratio (IR), Investm€nt Ratio and Domestic Money Supply Gro*lh (MG).
The combined wdght of all there country sks will then pre*nt a brighter
ed clemr picture for the inveslor d |o e;ther invesl in the foreign m&ket or
look for alt€mative av€nues for investm€nt.
151
3.2 2. Ers!s!se-B!.!e-8i:!
Another important source of risk concem for the inveslor, especially a
foreign investor is the presence of v8riations in lbe cunency valuaion
Exchanse rate risk emanates fundamentally from changes in exchang€ rate,
which Inay occur due to poliiical instlbility in addition to olher related
facrcrs or it can be rhought ofas the volatility of the exchoge mle ofone
cunency for dolher. Pul with a differcnt combination of words, it is lhe
pric€ of ofle currency r€lative to ano$er and it is known lhal fte currcncies
of lhe major couniries arc lmded in the aclive marke$, where mark€1 fiorces
It is gen€rally known thar th€ cunency of tnd€ is usually difte.ent when
invesrins in a foreign ma*et. Thereforc, there is always the risk ofcuEency
volatility and its strength in intemational markd bringing thc problem of
exchanBe rate risk into lhe scenario. h can either be a meus for cxploibtion
or a risk of s€tbrcks for the investor as the perfomanc€ of fie foreiSn
cun€ncy has a direct impacl on th€ value of the forcign invcstment and
hence on ;ts profitability. h ;s commonly ob*rycd tha| the exchanee 6te
risk is hiSher for the emerging economies 3s compared to that of stagnanr or
developed ones. Jacque (1996)rr is of the v;ew lhal the rerum fiom an
inte.national ponfolio is expos€d !o cunency risk as a resuh ofthe investor
owningaclaim in a foreign cunency-denominated, time-defeEed cash flow.
ln the process ofth€ evalualing exchange mre risk, the study is ofthe view
that the exchdAe rate risk can be classifi€d into thrcc types of exposures 4t@slation exposur€, lransaction exposurc and economic exposurc- For an
investor, il is equally important to aive consideration to all of the thrce
158
exposur€s. Tte economic exposure, however, s€€ms !o oul-weigh the other
two. Econornic exposure is the change in the economic value of investmenl
that accomprnies as 'unenticipated' change in the exchange mte where it
must b€ noted that ther€ is a distinction beMeen th€ anticipat€d and
unaniicipated changes. Anticipated changes in €xchange mles must already
be incorponted and reneded in lhe markd value ofthe investment. h must
be not€d herc thal economic exposurc do€s not lend ils€lf wilh ! pr€cis€
description lnd me.suremenl, as the olher two exposur€s, and hence ;t
depends on whal happens !o rhe exp€.t€d futurc cash-nows snd thus
subjeciivity n€cessarily involvedr:. Tr.nslation exposurE rclat€s ro the
accountin8 lr€aunent of the chang€s in the exchrnge ntes while transaclion
exposure involves the 8ain or loss thlt occurs when seding a sp€cific
The $udy can confidendy argue th8t il cln be argued lhat currency or
exchange risk can be minimizld lo insignificant proportions by m€ans of
wide diversification in $€ ponfolio across boundaries. Jorion (1990)''
b€lieves that from an invesb/s $andpoint, exchang€ Ete exposurc would bc
important only if it r€prese ed ! systenatic component of an asset's risk.
This is predicated on rhe assumption thal curredcy risk may b€ diversifiabl€
through broad country divcrsifi cation.
Radcliffe ( l99a)'' is of the view thlt when investina in for€ip markets, the
most risky optiotr for an investor would b€ to invest ;n a single rnark.t rather
thm a number ofdifTcrcnt foreiSn mar&ets; !o be able to diversiry away nost
p6n of $e exchanee rclat€d risk. By invening in only one market, the
currcncy and exchanSc late risk! l€nd 10 increas€ substotially without a
t59
rcasonable or proponiona& nse in rdum on investrnenl. Hence
diversification is rhe key to avoid un-necessary exchange rate risk while srill
beinS able lo benefit from inveslina in a foreign marle!.
The exchese rate rGk ofinvestm€nts made in a single foEign country can
be substantial wh€reas it ha heen obsered over a fa;rly long period that in
casc of a fairly diveBified foreiSn investmenl ponfblio, the cxchange mte
risk is negligible and hence ils elTecl on ov€nll investment retum ;s
nominal. The reason for this effect is thal lhe depreciation ih value ofone
cunency tends to b€ balanced oul by increase in the other.
There arc a number of looh available rc manage exchang€ rate risk,
diveBification being one of them as discussed above and in the previous
chaptels. Another means for minimizins cunency risk is by hcdsing the
;nvcstment dd derivatives instrumenr here plays a key role in such
siluations. The imponance of the de.ivative mdkets in lhe modern financial
world i5 hard 10 ignore as in a very shod span oftime lhey have Epidly md
comprehensively iransfomed the melhodology of invesrmenr analysis- Ifany marker looks for the opportuniry to anmcr invesrment ro irs respective
econony, then il has no other option but to mould ils trading pauem on lhe
lines of lhes€ derivative instruments. The more quickly and efliciently they
do so, the gEa€r rhe chances they have chucc of havin8 major share in
global investments. One messag€ rhe study ofthe emerging market gives, is
thal the development ofderivative mark€l is compulsory for the tbrrificarion
of the confidmce oflhe mrker panicipdls wirh rcference to .isk mitigation
opponunities. With the availabiliry of a d€velopcd d.rivarivc markel edwith a sound regulatory framework in pl@e, thc market participanrs would
160
be more than happy 1o remain attached to the markel as their d€cisions will
have lo comter fewe. ucertainties and drus prcvide opportunides for a lona
term relalionships amonA the mdket panicipants md the market.
The point of consideration for an inveslor is to walch the level of rclative
volatility in exchange rates between the two cudencies. Fo. the foreign
investor, the higher the valu€ of rieir home cE€ncy. rhe more atractive
becomes a foreign investrnent. This phenomenon is attribulable to fte fact
thal ahere it becomes more costiy 1o meage a large-scale operalion, lhe
inv6lo6 will have 1o pay less in account for manufacturina and labor cosrs
in lhe forcign country than in their home country.
The study finds evidence io show that al any given point or even in the long-
run, lhe invesh€nts in €merging markeb, al any levcl of rislq eive a higher
rctum lhm thar in developed economies, alluring investore to l@k b€yond
their native country when making investment and hence have ro face
€xchmse rate risk. Addae-Dapaah & Loh Hwee (2005)15found rhar a
ponfolio of rcal eslate investments in the emerAing economies provid€s a
hiSher retum at any aiven risk ftan a conesponding ponfolio in rhe
developed economi€s.
l6l
-].2J. Interst Rrte Risk
Next imporirnl dsk concem for the inves.or is the id€resl rale risk which
arises ou offto uncerlainty in the yields, thereby changing thc value ofthe
debl. Il may also b€ defined as the sensilivity ofa debt's price io chang€s in
;nterest rate. and this sensitivity ofthe debt's value, in rum, dcpends on the
se.uriiy's maturity tine and i|s coupon mte.
The effecr of intercst Fte movements is one ofth€ most profound influences
on the finmcial mtrkels md fie int€rcs( rates aie generdlly considered to
have neSative relationship with stock ma*et perfomance. Rising inleresl
rates m€an thar the investoB having fixed income securiti€s in their portfolio
will lose the worth of *Eir investments. On the oth€r hand, the stock market
wiil also lose investnent, as investos will be athctcd lowards higher
inerc$ paling instmenrs and s€curities, which provide the,, with higher
retm at lesser degte of risk. 'fte interest rate fluctuations are a major
influencins faclor for fixed scurities dd equity prices. Dow Theory
Fo.ecast (2005)'' suggests thal the higher interesl rates drive up the cost ofbonowin8. potentially stifline busin€ss investmeni. High€r rates also make
deb! inveshenls more attr&tive felatile to stocks, which can push inveslors
The study also rciteEtes here the facr already menrioned fiat hightr int@st
rates offered al a lower .isk means thal the investor will oDr for the Hsher
relurn. lhis trcnd ecunutates into a market trend hence leading to lower
inveslmenr in the equity in$rument in the capital markel. One more
implication would be that the cosr of borcwing d4 in rum, the cosr ofcapital for the corponlions will also ircEase. This means that the negarive
rcsults would b€ rcflected in lhe profitability wbich will lead ro increas€ in
inveslor's uncenainty. The ov€nll cycle t€nds to diminish the performance
over the time, ultimaEly making lhe financial markets a much more risky
The study adds that liom a foreign invslor's point of view, interest rale
volatility ;n the desi.ed mekel is a Dajor indicator to monitor. The degrce of
volatilily of interest rate signifies the level of risk involved in the
investment. However, it also presents an opportunny to make a prolltable
investmenl after evaluatin8 dd observing the latest maikel trsds- Bank of
England Quanerly Bulletin 2005r' signifies that when exp€cled consumption
gro$,1h is r€latively high, agenls may whh to borrow 10 smooth consumprion
over rhe rime, qhich would pul upward pressLre on inrcresr rdres.
In a economy. inleresl rat€s vary with dE degree of volatility in the
consumption Browlh ove. a pe.iod oftime. When therc is expecudon .har
consumption will grow at a high rare in the economy, it lends to push
inleresl rates upwards due to lhe inveslor's inclination to borrcw at a fa;lystable rale. In order to prcvide a stable or reasonable rare while takinS
precaulion for future u@.tainty, rhe lender offers higher inlercst rales.
Declining interest mtes also expose the investor ro re,invesanenr risk wherc
in situations when the investor, not being able 1o repatriate all ofils profits
due to company laws, will have 1o re-invest the prollt locally. l. a srate ofdeclining or volatile inierest rates, rhere is a high nst that the investor will
have to invest at a low inlercst Ere. In addition, inr€resl mte volarilily will
ako expose thc investor to the risk of bono ng ar a hieher rate rha,
oplimally possible. This ucertainty aboul the changes jn interes! rares adds
up to the overall interest Er€ risk ofthe rarg€ted markel.
I6l
J.2.3.1. f,ffets ofl.t rest Rrle Risk
The resemh, at this point, elaboraEs that changes ih the intere$ rale risk
can have adverse efieds both on the €amings and lhe economic value ofthe
investnenl, fiereby aiving rise 10 two divese bul complementary
perspstives for judgiry the inlercs! rale .isk. Th€ fi6t one is the lraditional
approach to interesl raie risk assessment where th€ inv€srment is lmked
upon fion lhe persp€ctive of the eamings, focusins on the analysis of rhe
impact of chda€s in inleresl mie on the inve$menl eamings. Variation in
eenings is m important aspecl for interest rate risk analysis, as reduced or
an ouaighl loss cd threaten rhe overau slability of rhe investnent, thereby
shaling fie confidence ofthe market. ln addiljon, the study is offim v;ew
thal vffialions in the ma|ket inlere$ rate can also affecr the e@nomic value
of the investment 6 the e@nomic value peEpective conside.s lhe likely
impact of interest mle chang€s on the pres€nt value of all tuture cash flows.
This ullimately gives a more cohplele view ofthe potential long- rerm effecl
of intercst mte chme€s than €alculat€d otherwise. How€ver, when
evaluating the level of inler€st rat€ risk. lb€ investor prefeB to take the later
app.oach since changes in ne{ lerm earnings ud lypical focus of the
eaminS peBpectiv€ may not provide an accurate indication ofthe impact of
interesl ra& movements on th€ overall position of the ;nv€stnen!. 'lle util;ty
ofthe economic value perspecdve lies in considering the potenfial impact of
lhc pRsent od p6t inreresr Ees on lhe tuture perfomnce.
J.2.4. Ecorolnic Risk
Continuing the discussion of risk concems, the study finds that in ihe
process of assessinS economic risk for a coutry, lhe most imporidl
indicators are cconomic go",rh over a pe.iod of time, and the per capita
income. The level of volatiliv and the magnitud€ of grc$4h aie lhe key
deremindrs of economic performance. lhe h;gher rhe volarilir) in 8ro$dand per capita income. the riskier it is for the inveslor. Ano$er dim€nsion of
this ssssment is the magnhudc wherc, if fte nle ofercwlh is in a hiAher
raqe than parallel e@nomies. it would be quite anracdve in tems of profil
makins; howev€r. the risk is also proponionally greater.
Dichtl and Koglmayr (1986)'" have identified olher factors. having their
affects on ccof,omic risk with respect to tbe foreign investors. are the
entreprcn€ur;al frcedom with rcspect to transaclional busincss acdvnies.
basic prsondilions for business ventures, md macroeconomic conditions
and trends. The later includes: the si?€ ofthe populationi past dd projecred
economic growlh; lhe availability of quality labor md labor rela ons! the
availability of ener$/ r€sourcesi legal reiuirements and p.orelioni tralfic
systems and commmicarion chann€hi restricdons imposed on imports,
exporis. ibr€ign investrnent, monetary trmsfeB and ex€hange of local
money into ibreign cunencies; and rhe freedom 10 ser up or engage in
Furthemore, the effe€t of levels of pe. capira income is also eqully deep
tud significant on the economic risk. Low p€. capila income implies thar fteincome distriburion;s nol balanced among th€ populace, and inrhis scenario,
165
which is more prevalent in emerging economies; the economic risk can lead
1o political risl as well. In limes ofgroMh, ineq@lity in per capita income
may le.d |o distr6s for less pnvibSed sector of the e@nomy md caus€
polidcal issues and wonomic instability.
Burlon and lnoue (l987iL'idediry that the possible effect on govemmental
policies can be detrimental to the forcign firm. Tbe aovernment may impose
price controls, interest mte ceilings, trade reslrictions o. cxchdge conhols,
which could atrect lhe company's profils and/or the abilily lo rcpat.ial€
prcfits. The govemment polic;es implemenled by central banJc ddsecurities exchmae commissions also have a direct relevance to economic
rhks. Any policies that are enfofced by tbe authorities arc an ihfluencing
variable for the local mdket a a whole. In foreisn inveshenls, €sprcially ifthe investor is a multinational corporation, profil .epalriation is a key
concem. Any Estrictions or lawful conditioB would only add !o the
ln addition, the macro-economic conditions are also a point for
consideration, which i.cludes the size ofeconomy. level of indusrrialiution
and labor laws etc. In a medium-sized economy, policies implement€d by
govemment need to be lenient for for€ign investoB dd if the econorny ;s
moving towards a higher lev€l of industrialiation, then this is usually
considered as a fairly athactive ar€na for new foreign invcstoB. In rhis case,
the policies tend to be investor friendly, which in 1um allows thc €ompoies
ro collect higher profits fo. bearins the economic risk while operating in
t66
Rangan (1998F enphasiz! lhat orgsnizstioN operaling in economically
risky enviroffnents must be n€xible ib their economic md financial
$rustur€s. Multinational Companies (MNC) should rely on the informador
that they gather iom the Mk€ts to effectively manage lheir inv€stnents of
asscts, relationships, and labor in those markers.
Thc atudy, howwq, is of thc view dlat emereing €conomies such 6Pakist$ pr6€nt ! grqre. oppornrnity for the for€ign iov€stots to exploit dE
favourable €conomic incentive availsbl€ but they musl nor forget the
existence of high€r degree of uncenainii€s. One re8on, which ha! b€en
obserr'ed by the study, for the €xislence of higher retum opponunity, h the
fact that most of these economi$ were previouly not open for foreign
inv$tors and thus allowing thc rcw inv€stors to enter an unsatuli€d markel
thereby providiog them with the opponunity to exploit lhc new marker ro fte
167
J.2.5. Fir.ncirl Ri.k
Financial risk is one ofthe major risk concems for the invesloN, EPecially
the foreign investors, when evaluating market risk. However, very often,
finmcial risk is considered b be same as €xchnge rate risk probably
because financial risk also deals with currency aspects. But, the sludy wants
to make it cleai that this conc€m deals with othet issues 6 well and ftrther
breaksup inlo two main caregori€si the exchdae rale risk dd the
comm€rcial risk fi-om a micro€conomic persp€crive whilc considenng
foreiSn investors. wh€n making ar investment in a foreign currcncy, the
first risk factor that comes into effect is the exchmge rale fisk and, over a
longer time horizon, this can conslitut€ a substanlial porlion of the
investmenl being lost in exchange rate fluctuations belwe€n the two
cudcncie. Czinkota dd Ronkainen (1990f1 di$uss two factions of the
financial risk dd conclude that foreiSn exchmge rate nsk rcfers to the risk
asseiat€d with changes in cunency values, while commercial risk refe6 to
rhe insolvency ol or prorracted payment default by, an overseas buyer".
S.udy confidently sta.es that considerin8 the fact that it takes some time to
make financial tmnsactions, especially if it is a multinational lransaclion, ;t
involvcs a si8nificmt time delay. In this regard il is quire obvious that in
cas€ fte tirne elapsd between a8reement of a rimsaction and fte aclual
trdsaction itsele th€r€ is a possibilily ofall kinds offinecial implications-
However, lherc may al$ arise an opportudly to exploit this volatilily or
uncertainty to the advdlage of lhe inv€stof because there are such tme lags,
some onc suffe.s while the olhers Bain. By assssinA the perfbnnance ofthe
168
Shapiro (1986)D identifies thar whenev€r a firm enlers inlo any financial
trosclion, €sp€cially if traNdion is denominaled in a curency other dm;l! own, it will face financial risk dominated by exchanse rate risk. However.
the stldy is ofthe view $ar such financial risk musr b€ evaluar€d fiom rwo
differcnt msles i.e. from th€ view-poi of trasaction risk and econonic
risk wherc ttusaclion risk r€fers io the possibility of incurinS exchange
losses on t€nsacrions already entercd inlo, ed denominated in a for€i8n
cur€ncy! upon setdemefi at a future dale. H;ll (t997)r dSues rhar findcial
risk exposm refers to the long-term effecii ofchanaina exchange mtes on a
tirm's future eminS power.
The study suAAests tlht in order ro avoid lmmcial r;sk, rhe invesroB cd Dse
differcnt financial instrumenr for hedging in an effort to safeguard against
this kind of risk exposu.e. However, fte other faction ofthe financial risk,
the commercial risk, is not 6 €sy to handle where rhe investor hrs no prior
idea to hav€ guannleed bener performance of rhe securiries !ha! he./she ;s
invesling in. The investnenl manager has no oprion bur 1() evaluate the
inveslrnent decision on the basis of informafion available and incorpora.ing
them in a mtional model to be abl€ !o predicr the perfoMce of rh€ retevmr
mdket sector Md the securiries therein covering a reasonable timc horizon
to even out the fluctuations over a period ofrime.
brger curency in the intedalional mdkel. the investor can make a
Drcfitable decision on the timins and volume ofthe financial ransactions.
1.2.6. Politicsl Risk
Friedmann and Kim (1988)'?5 whil€ givins a gen@l definition of political
risk express that political risk for an irvestor is rhe busincss risk brcught
aboul by political soures or environment. This k;nd ofrisk-concem is not
something directly or solely r€sponsible for chang€s in the investment
horizon since political risk only manifests itself as a by-p.oduct ofeconomic
or financial risks or bolh. However, it must be kept in mind thal any negadve
chdSes in fie environment can also con$iue political risk. Mo@ver, rhe
policy changes due to relations belween rhe investor's country, and the hosr
country can have a direcl impact on busin€ss dealinss which also belongs ro
The study is oflhe opinion that one way for esrimating the poljtical risk;sro
obseree fte pasr evenrs itr th€ polirical arena, esp€cially when considenng
emeraing economies, there is hish probabiliry ofpolitical upheavats in shod
periods oftime. Polilical volatilily is a major indicaror for polilical rhk and
in cases ot polilical scmdio in emerging (onomics: numerous
unpredictable chanSes in the environmenr take place abruptly and
mexpectedly. This puts such economies in a high risk cateSoryt therefore
the investor needs lo be very cautious in dsessing rhe polirical risk of
Berumen! and Dinc€r (2004)'6 b€lieve that dle objative of mosr nationat
policymakers and govemme s is senerally to direct the; economies
lowards a stable line ofpositive gro*rh. As menrioned here, the objecrive of
Sovernment policy making is to facililale economic grcwlh by implemenring
cof,trcls on companies and investors. This can either be a meds ofprofil
making o. a discouragins influenc€ for investors-
Political dsk can prove to be a phenomenon that can cndow with substantial
profits to th€ invcstoB having insight into the polhical scenario of the
cou ry'1r. For the forcign inv€slols. in 6s, where they find it dificult to
ass€ss the polilical stability ofthe tlrgeled cootry. risk factor is asumed lo
be considerably high as it camor be gu{dteed that the govement polic;es
wiu ne@ssarily prolect foreign inrerests in lo.al markels. On the olher hard,
easing of.estrictions or capital flows ud foreian investmmt could be one
of lhe policy lools that can anract intemadonal investment Epidly,
especially in emerging counlries. Inded, in Southeast Asia, it had rcached
unprsedenred heights as pointed out by Huang and Yang (2000)'i| thal
inl€malional investment &counted for sizeable ponions of nadonal cDP:
I l% ror Malaysia, l0% for Thailand, 5% for Indoncsia, and 4% for Sourh
Howe!e., too much relide on the foreign invesrmcnr by nold th€ policies.
acco.dinsly, could also serve d incrcasins the wlnenbility ofde economy,
because the confidence ofthe foreign investor is more fragile than fte local
inve$or md the policy ofthe govemnent snetimes backfires. According
to Krugmm (1999)". the sudden vuln€rability ofAsian economies did nol
slem Aom the ralional fea6 ofinvestors, mther vulncmbiliry stemed from
the fact thal "the new d€bls, ulik€ the old ones, werc in dollars". ln orhe.
words, the opening of capital markets to foreign invesrment ush€red in
unprecedented financial volarility.
l7l
Nevenheless, the idea prese ed by Kruglnan and ream did nol escape ftom
criticism like any other issues in life, as anofter study by Sebaslian Edw'rds
(1999)10 exmines Chile's experience with crpilal conrrols and how lhey
affet $onomic perfornanc€. His study is based on differcntiating betweeD
contoh on capital inflo{$ and outnows, md according to him, contrcls on
capilal outflows are largely ineff€ctive, while conrrols on inflows have linle
or no effecr on if,lerest rates ed exchange rales, but they do reduce stock
mdkel instability. Regardless of which point of view may be taken, one
thing is universal that investor ha' to face the uncerlain envircm€nt in
lems of the policy formularion and implemenration. This uncertainty
increas€s when the investor under consideration is a foreign one udtherefore the investment must provide sone cushion for ir in tems ofhigh
172
3.2.7. Mrrkel Risk
In the proc€ss of assessing risks associated wilh investmenl acdvities,
perhaps the most imporlan( concem is that of market nsks. lhis tem
essentially refers to the risks that prcvail in the oveEll mdkel due 10 macrc-
economic conditions. Like a slowdown in retail. gro$rh affecls fte whole
economy, in sene.al, and the linancial markets, in specific. The same kind of
nsk can ale be defined in th€ contexr offinucial mattm s the possibiliry
rhat the financial markeB will decrease in value and create a ripple ellect in
a podfolio. For example, iflhe srock meket as a whole loses value, il cm
generally b€ assum€d that clienfs stock or stock tunds will ,lso find a
decrease in value until the mark€r rcrums to a period of grourh. Market risk
expos€s i.veslors to potential loss of pn.cipal in periods in rhe marker
taking downtum. In contrast !o marke. risk, th€ non- market risk is th€
unsystematic .isks that are localised ro a particular slockrr- Such risks ca be
effectively avoided or mitigated and the main avenue for mitigating
unsystematic risks is diversification of the portfolio. However, th€ m€Jkel
risks tactoF camot be .voided or cof,trcll€d in a similar fashion. and such
risk faclors fallinto the domain of systematic .isks or nondiversifiable nsk.
The market risk aris€s out of a variety of distincl influencc.s. aenerally
resulling increase in the risks, and the inveslols are always very much
concem of lhese influencenr'?. Some of such concems havc alrcady been
discussed and one major influence is the rising inreresr €tes. When inrercst
mres rise, the attracdvene$ ofinvesting in the mrtker d€creaes due to rhe
higher degree of risk involved. As a resull, the overall meket stlns moving
in a downward direclion or the grov'th stans ro slow down. Consequenrly.
171
the .isk for a new inv€stor, €specially a foreiSn inveslor, increases
exponentially. Schiffres (2005f points out lhat the capital nwkers can fall
for many resons. HiBh prices, by them*lves, dont signal when stocks will
fall bu1 add tothe amounl ofvulnerability-
FunhermoR. high inteEsl rares ale affecl thc profilabilit) of large
corporations by increasing thei int€r€s1 expens€s. The logical respons€ lo
this phenomenon is thal stock prices are also negatively influenced due to
the fact that these iend to respond 10 new infomation that bsomes available
to the investor. As a result ofdeclining prcfitability, it would eenerally be
speculated thal the company is nol p€rfodinA well dd the nEk€l would be
receiving a negative signal and the risk quotienl for rhar specific compa.y
goes up. When this happens b all companies being lraded in tbe marker, the
oveEll ndket becomes inore risky and volatile and this volatilily will, in
tum, expos€ th€ inveslor lo a high degree of nErlet risks.
Market risk is a broad{pectrum phenomenon. which is influenced mainty by
every such faclor that has got a dhect inpact on rhe whole economy. Oilp.ices, labor costs, chdges in company law, curency movements. bankina
criss and numerous oth€r factofs, having an ;mpacr on rhe eonomy. bear a
direcl impact on the market, and movemenls in the economic grotrth
indicatoBhavea direct influenceonthe market risk for the inlesrors.
t14
!,2.7.t, Mrrkel Lib.hliz.rioo
However, for lhe emerging economies, market liberalization could be aryued
as one of the most impondl factor influ€ncing th€ irEket risk, in the back
drop of increased globali?.tion and privatiation drive, especially, in such
economies. Levine and Zervos (l998fa €xamine the erTect ofcapital control
lib€ral;zalion on the fiDctionins of slock mdkets whereby fiey review the
effects of liberalization on stock markd size, liquidity, and intemational
inteSrarion, as well as volatility. They €stablish a date of lib€mlizrtion, and
examine variations in the above mentioned variables before and after lhe
date. Iheir result shows lhat after libeGlizlion, markets become bigaer
mofe liquid, mor€ integated, and as Stislitz (2002)rr mighl expec! more
Dani Rodrik (1996)! reaches a different conclusion in his rep€aGdty c;ted
study on capital accounl liberalizadon. Using a sanple of over 100
economi€s, Rodrik constructd thre€ scatter plots with capihl markel
lib€ralizalion against arowth, investment, and inflation, respecriv€ly, and
concludes ihat the scaner plors reveal no discemible .elationship be$een
lib€raliarion tud the resp€clive dependef,t veiables in addirion to claining
lhat long tem economic p€rformances re in e$ence very much
uncorrclated to capital codtols.
While supportins.he study liberalir.tion, Bekaert and HNey (2000)17 have
perlbrm€d a cnoss-sectional time-series analysis in oder to examine the
impact ofcapital mdkel libeGliution on the cosr ofcapital, volarility, beia,
and correlation with world harket rclums. Similar ro Levine ud Zewos
175
(199813. Beka€n and HNey (2002)3'g €srablish a date in which a country
becomes libeGlized, and then exatnine chdges in the relevml variablcs
before and afier lib€ralizrtion. Th€ir linding suppons the facl thal markel
l;b€ralization process incrcdes market volatilily by an insignificdt amount.
tlowever, they also found that liberalization reduces the cost of capilal,
probably suggestinA more efiicient capital allocations"- Kim dd Sif,gal
(20001r ha\e aho srudied $e ;ssue of slock mtrler openinss ;n emerging
economies. They find that volatility in the years after liberalization does not
sisnificdrl) differ from fie pre-libemli4tion level..
Continuing the argument on the r€lationship b€tween ma.ket risk and
lib€ralization more recently, Miles (2cr02)ar discusses the effect of slock
market openings on the market dsk dd tsts the relationship belween
measures of liberal;zation and stock markel volatilily. As rcgard to empirical
rcsults, Miles points out that lib€ralization efTect tends to be outry_sp€cific
and does nol suppon the h)"othesis of decreased volatiliry in emerginS
markets. Followingthe rcfoms in fact liberalization events have tendency 10
increase rather than to lower stock markel volalility- Ldison, Klein, Ricci,
and slok (2002f find more or less the simild results when they comParc
and conrasl the majo. empirical liieraturc on liberaliTzlion md economic
Howeve., Eichengrcen (2003f' ch.llenges tha! Rod.ik (1998}- is engaSed
in "fail-safe econom€trics" wherc the deficiency of coneltdon is laken as
satisfaclory evidence that none actually exists ignoring the fad thal onitted
vaiabl€s could camouflage significdl causal felarionship. Besid€s,
Eichengreen oppo$s that the prevalence of economic rheory suggests thar
t16
mdkets all@t€ efficiently than govemmenl, and thal
financial markets are no excepiionlT. If inl,emar;onal findce is nothinB more
than inleFtempoEl 1mde, then financial liberaliztion should havc the equ3l
benefits as tmde libemlization-
In addition, Abiad, Oom€q and Ueda (2004)" pr€dict thal financial
libeGliztion enhances all@ative efficiency usins a firdcial liberalialion
index and fim dat! from India, Jordan. Korea, Malaysia, and Thaildd.
They conclude that strong evid€nce exists indicating rhat findcial
liberalizalion improves allocative efficiencyt cro$ah and volatiliry,
however. are not found as being mutually exclusive. By libeElizing capital
markcts, narions may sacnfice stability for increased groMh providin8 a
tmdeoff situation belw€en groMh ahd volatility whfie the wisdom of the
tradeoff depends on the magnitude ofchanges in Srowth and volal;hy, dd a
bulk of the debate over fimcial libenliztion rcvolves around which
Apan frcm this, anoth€r d€a having contribured towdds ll)e es.aladon ofnarket risk is the apprcciation in real estate prices as these 1€nd ro assune
having an effect on lhe stock market pe.formance. Hisher pfices mean
higler prcfiis for selleB, which mean greater investment llowing into rhe
market. As an oucome, rhe marker ;s arowing rhcrefore, marker risk is
reduced. On the othcr hand. ifprices fall h the real cstate sedor, the ovemll
aro\th of th€ economy slows down. This in ium affects the financiat
markels in a negalive mamer. Regardless of whar rhe maa.irude ofrelarionship berw€en mdket lib€.at;zarion dd mafket .isk, rhc srudy finds
lhat one point where all the studies have reached is that lMkel liberaliarion
177
does have its bes.ring on market risk and th€refor€ should be consid€r€d by
lhe investor whil€ t king inv6t1lcnt decision5o. The study is very confident
lhat liberalizrion drive in einerging econordes docs have bding on m!*dnsk ,nd if anyon€ wishes to contest tlis vicw they must provide
incontrovertible evidence, a there is no . priori reason to reject the effects
of financial liberalizstion od its imDacl on I@ket rhk.
178
3.2J. Ses!grsEsi!!i-Bi.:!
One of the risk conc€ms for the inveslor could be the vulneEbilities oflhe
speific sector in whicb he nay be interest€d. The issue may have ben
panly discuss€d in the previous *ctions, bur the study s€eks lo shed lighl on
the issu€ morc explicitly. Sector priorities do have ft€ir beeings on the
investmenl decision, €specially in case offoreign investors where ftey may
be intercsled in specific seclor of the mdket nther than the whole mdkct,
and in such cases, the investmenr becomes exposed 1o sector/indu$ry-
These risks mainly sren ion govemment policies and regulations s there
might be a situation where govemment wants to prcmole one seclor and thus
giving fiat sector more room b f'lourish ed, on the olher hand, $ere mighl
b€ eme sectors rhar @ considercd estlblished dd the govemmenr may
wmt to have morc contribulion from rhem, and the investor may take ;t as a
d'scouraginS faclor. For instance. due ro the polenlial fo. exploirarion or
olheNhq thc phamaceutical companies may become subjecr ro touSh
regulations by the goverinnen!, affecting the whole pharmaceurical ssror in
the economy dd especially in rhe market.
Schitlres (2005):r argues that any s€ctor subject to Sovcrnnent rcgulalion
could surcr because of adverse govemmenl decisions wherea5 there could
be olher sectors facins much favorable *o.kins envircnment, like a decline
in oil and gas prices wonld udoubredly affecr rhe srocks of mosr erergy
compmies. Then 1her€ de secloN which nay be considered morc sensitivc
to fluctuations in interest rates rhan the sro.ks in other scctors. fh;s way, the
179
study belicves that conclusion can be draM that sector-specific issues do
affect the stock profitability and r€tums dd dEr€forc must be evaluated
thorcughly.
On the hsue of mmaging rhis risk concern, the study is of thc view tbal
information disclosurc plays a significanl role in determining the sector
specific-risk involved in opting to invest in a panicular sector oflhe market.
However. this depdds on how strict the rules are when it comes !o
disclosing company infomalion to the public. Choi (1973)'r dgues that
incr€as€d finn di$losu.e tends 10 inprove the subjective prcbability
dislributions of a seurityrs expected retuft streams in the mind of an
individual investor by reducing the uncertainty associated with thal relum
slream. For firms which generally ouFerfom the induslry avcla8e, ;t is al$argued that improved dislosure @nds 1o increase the relarive weight which
an investor will place on favorable fim statistics .elative to other
infomation vectors that he util;zes in makin8judgmenrs with respect 10 the
The sludy acknowledges that there is enouah weighl in the saalem€nt made
by Coll;ns and Simonds (1979)Jrreflecdna that disclosurcs are likely to
place inlcstors in a much better position ro evaluale rhe op€€ting risk ofeacb segment ud, therefore, the firm. Fudh€mote. if segmenral disclosurc
auows one to associate each segment ofa fim wirh a w€lld€fined indusrry,
it is possible to develop a better appreciation (vis",iL-vis havins only
cohsolidated data) of how price changes wilhin given indusrdes woDld be
likely to affect the risk of an individual fim.
180
TIte nor€ thorough disclosure r€quired,lhe less unc€nain lhe investor would
be. In rhis regard, the investor fecls hore confident 1o invest in such
segments of thc market thar are more forthcoming in disclosinS rclevant
inforrnation to the investoF. However, the most suilrble solution or cusNon
for such an evcnt for the inves.or is diversificltion. When inv6ling
overs€as, lh€ mosl apprcpriaie .pproach is to ulilize maximm possible
diveBifi.alion in the given budset. This allos the investor ro baldce oul
the poor perfiomanc€ of one seclor by making a prolit from the oth€r well
performing invcstnen!
tEl
3.2.9. Infl.tion Risk
Another very important risk-concem for th€ investor is the erosion in lhe
value of m investment over a p€riod of lime, an dpect of the eco.omic
scendio, which can influence the iDvestmenl decision. In order to counrer
the impacl of inilation on the economy, the goverment may fine-tune the
fisc.l policy, adjust lhe monetary policies and may chanSe rhe inlerest rates
thercby funher intensirying the impact of chmgin8 int€resl Etes on the
invstment a the value of investment gainverodes and value of rcpaymenl!
Inflation rale risk is conside.ed as one of the major rhk factoF that
influences the profirabiUty of an invesment as ir has alrcady been stated
above that il is straightfoNardly related to the movemenls in the interest
mtes dd bas a dircct impacl on the cash flos for fixcd securily holdeB
such as bonds. For instdce, a bondholder may end up with minimalvalue ofhis,her inveshent if lhe security is held to the time of matur;iy in a hiSh or
risinA infl arion economy.
lnflation Ete uncenainries hinder fte econonic gmwth while instability in
prices unde.mines the investing as wellas saving activities. Uncerlai.ness in
tems of the future prices undercuts the confidence ofthc investor and his
decision-making ability, especially with rcference to the present and future
The issuc is asumed 10 ha!€ been .elatively ignorcd. paniculdly in the
emerging economies, and not much effort being madc to quantiry fte impacl
t82
of inflation Bt€ fluctuations on the size and tunctioning of the slock mdket.
Evaluation of litemturc reveals that inflation creates uncena;nty aboua tuturc
mtes of retufr ed exace.bates the stock meket liictions. Enough literature
exisrs 10 support that inflation strengthens frictions in the slock mdket,
decreases rcal rare of retm on fiDdcial 6secs, and consequendy, decredes
tnding and capitalizarion in rhe stock mark€ts. Inflalion can also be viewed
6 a situation of excessive money supply in the market. Dhakal el al.
(1993)1'po:nt out dut indir€ctly, increase in money supply rcsults in
increased demmd for soods and servic€s from the real sectof, pushing up
price level in the short run. The increase in price level resuhs in agenls
.evising upwards th€ir inflationary exprctations. consequ€ntly, faced wilh
higher nominal interest, the invesbn rcallocale their portfolio.
Najand (1991)Jr has tested thal increase in unanticipated inflarion causes ihe
markel risk premium to rise, which in tum low€rs curren. $ock p.ices. This
is based on the egumenr that sexpecled inflation probably do€s depress the
stek market by depressing real business profils. However, he is not very
sE aboul th€ .elationship tretween sr@k reth vdjability and market .isk
Dokko (1989)", while €valuatins the rcdistribution effecB ol inflation ftonbond holdeB to sharcholdere, sludied rhe nominal conlracring hypothesis.
This hypolhesis argues that changes in subsequent inflalion expectations
caus€ adjustme in the market value of fixed-nte debt insrruments,
esp$ially long tem debt, which, in rum, should duly be capiralized inlo $emdket price of equity. Found lirde, if ny, suppo.ling evidence for lhe
theor€tically mticipat€d wealth rcdistiburion effecB of intudo. from
l8l
bondholdeN to shareholders. Wei and Wons (1992)r' also fail in their €ffod
to gel significdt results to suppon fte hypothesis. Abdullah and Haywonlr
(1593) find that stock retms are positively related to inflation and money
growth brt, negatively related to budget deficil, tIade deficits md ako the
shorl-lem and long-ierm interest rates. Cochru md Defina (1995)" while
using the eFor-corrcc.ion mod€l to have an insighl into the effects of
inflation on real s|ock pdc€s, find a neaative relationship belween inflation
and real stock prices similar ro what w6 found by Cochm, Defina and
Mills ( 1993)".
Kual, (1987)d te$ed fte hyporhesis that th€ relationship between the stock
rerums and inflation cm b€ explained by the equilibrium process in the
monelary sector. Theh effort hd resulted in conciudinS rhat the relalion
could be negative, positive or insignificanl, d€pending upon the influence ofmoney demdd and supply factors. Hess dd Lee (1999)"' ried 10 explorc
the same issue, but using a difercnl path focusing on rhe hypothesis that
wbether the observed rclationship betwe€n srock re(urns and inflalion could
be explained as a combinafion of two shocks, supply dd demand
dislulbmB- Baled on thei. study they express rhar while rhe supply
dislurbances are rcal output phenomenon, they bind ro reflect that a negarive
relationship between inflation and slock retum, whercas the demand
dislurbances arc conJdftd as a nonerary phenomenon, tley explain a
posilive st@k retum-inflation relarionship. Funhennorc, applyina Blanchard
and Qual (1989)': method, they decompose the shocks and find rhar their
results are pointing towards the facl rhat lbe.elariofthip between sto.k
retums md inflation cm eithq be negatle or posilive. d€pending on the
soune ofirflation in the economy.
134
This chapter comes to conclude &ar investm€nl projects in emergrng
ma.keb arc generally p€rc€ived riskier than otherwise similar proj€cls in
developed countries. The added risks may srem lrom variety of factors but
they reflecl one poinl very insislently that inveshcnl in emerging ma.kets
has to face more volarile condilions tho in developed economies 6 lhcir
business cyclcs are more inrens€, inflalion md curency face more
fluctuations. Besides, there rc probleins of civil unresl, iNli.utional
instability, expropriadon and widespread corruption. Furlhemore, tbe study
expre$es with confidence that al any given poinl or even in the long-run, the
;nvestments in emeraing markets, at any level ofrisk, eiee a higher retum
than that in dev€lop€d economies allu.in8 investore to l@k beyond fte;native couniry when making inveshent, md hence have to face the
The $udy can easily conclude that emerging markels have long posed a
challenge for finance as studies and models develop€d in modem world are
often ill suited 10 deal with thc specific cii:umstances arkinS in thes€
marketr. However, the interesl in emerging markels has prolided impetus
fo. both the sdaptation of cunent models to new circumstances in these
meke$ ud the development of n€w models. While keeping a focus on fte
liberaliztion and integration drive in thes economies, th€ sludy has also
tried ro explore lhe financial effecls of mtrkeq differenl .isk concem and
their impact on lhe @l economy. However, there are other issues d well
that tend to affect the deision of the inveslors bur nor considered such scontagion, corporate finance, mdkel micrcstructure and slo€k selection in
185
Apan from suneying the literature, the sludy has lried to bring to light n€w
Mys of looking at the investm€nt arena in emerging economics regardinA
country risk. exchage rate ;sk, market risk, political risk dd finmcial nsk.
Ar the same time, the sludy has nor relinquished 1o nolice the liberalization,
the vobtility of capital flos, dd rhei. performance in eme€ing markeb.
The sludy would like, however, to add one imponant point over here that the
invesror, considerin8 the instability ofdsk facior, musl know eslimatio.s of
portfolio risk, bsed on historical corelations, is extremely questionable as il
has been obseped und€r various studies thal in emerging markets tbese
conelations ofrisk factoB have a tendency 10 quickly go beyond eslimal€d
The study would conclud€ this chapter by expressins that whcn considering
inv€srment, €specially in emerging econonies, |he invesror should evaluate
risk b6ed on four major rcas including financial, polidcal. economic edcultu.al fisks for rhe investors. All of these categories have a significanr
bearing on the value and profitabilily of an inveshent. Any degree ofv&idce can only add 10 lhe risk profile of invesrmenls in the country und€r
review. Before making any invesrmenr, .isk analysts mus! rakc a rhorcuSh
look at these influencers, so as b avoid umecessary risk.
186
Notes rnd Ref€rerces
I H.vkins J.. Khu. M, {2000), *M6uri4 Pturirl Vulrcmbilita.s ln Eme.gi.g MskerIi.ononieJ. B.nk For lnrcmaridnil S.nl.nens, Mondary and Economic Depar.menrB6e| S*irzerland, p 2 ww.bis.org.
2 Bilo- C M.. Bmilsfo.d. T. J.. Hdp.r. V.1.. (200 | ). The Explrn.rdt Powr of Politi€lRb* in Em.rying M&.ta S.fupt .I Fn@. atd Applied 9dhtics, Th. AlshliuNltioml Univ.6ity, Canbcft, p. 2.
3 pages.ifln.nyu.ed't{damod*Nev Hom. Prae/invlablesrhkcomponent.hrm
t UNC1 AD. ( I993)- UriLd N.tios. Cdfcbe on Tnd..nd tlvrlopm.nt.5 Blrry- C B. and L. .r. Locksdd, ( 1995). "Ns Dietions h R€smh m Eme.eiq clpibl
Mcrkeb'. rinlncial Mar*.ls, lnsridions& lnslrume.h,. vol4 No.5. pg l3-20.
6 Suid.4 C.L. {1975} Ev.lurins Cspit l Budgeling Models l! Simulared Envitunmenb ,Jotul oIFiM. Arcriqn Fitu@ Assidion: USA. Dp 97+980
7 Bhallo B (1933). "How Com.Frions shsld yeigh Dp Country Risk,tu, tdc],Eurcmoner llst ir!.ional ln vestor: uK. DD.67-69.
3 lulio Nogucs rnd Mttin Cmd6 (2001 ), Countr), risk: @tMic potic),ConhgmtionEltatd Politidl Noi*I. Jootd oJ,adied E tnMi.r, Vol tv. No ,.UnileNi'lad d.l CEMA, Bu.nos AiB, AB.ntiq pp. 118 145.
9 EEvelle$ Sunil M, Hotun v. & Mdinova A. (2005),.,'r'hc Ttiadic Modet: AConpEn Birc Tme*!* For Mdeiry counry &ast"- The |tt*zli,s
^tdaseM./,r,a/. Vol- I 5. No.2. Tn. Mlr*e.ing M.n4oenr Assidio.: USA. pp. t2, B.l0 Adlrd, lme (1993), Where Did Counrry Risk Anlty$s co Wron{. trtitutidut tnvsbr.
Instnu.ional |nk*o.. lnc. JolmlsCBup, NY pp. 228-229
1l tz.Ane. L L.. 11996). 'M@ase"E,t &d cornal o.f FMiAn Erct'hse Rht ,l.tN.\,KluftrAcndhi. Publisn di p.342.
12 tlusdn, Aasim M._ (Numb.! t! 2006), "Chosing rhe Righr Ltxohanse R e R*ime to,P!lnhn", SBP-Res€si Bllldin, Volume 2, Sdc Bmk ot Pa[isoi: patkbn. D.2tr*tr \bp olB.pl E!a^h^ull.rn,2lx\tch@s4 R'ghr Lrchlnsc_Rde Ree'm.
ll J6ion.P.(1990), The ExchrnAe Rate ExposuE ofUS Mutdnaionata'_Jotnd.f Blsi,?N.vol.63, Univctsity of Chicalo Presr Chi.ago, pp. 3t!13,1.
14 Rrdclirle. R. C 11991), ln|eimn| Conceps. rntlrgi, Sr.rss',.. H&pd Co ins Co e!-"Puhlishec: N.* Yo.lc p. 2l | .
It Add.e-Dlp€ah Kwmq L,oh Hre 1,. (2005), "Erch.n8e Rah vohitiry aid InicmarioDalRel l- EFDr.F.ficoron ACompmFonot t merg'ngondDeleop{dLonom,ei,Jo,zrlot R, ot Eade fa4toho UttuF"n rr. Vol.tt \o J, Amen-m R.rt Encr sor,erJ I \A pp227-224.
Dov Ti.sy fG.$, (2005). "Rni4 hnatio Hutu liverton.... voL6 t No 4tB.nk of EnSldnd Qunoly Bulletin, (2005). .Reat l eE$ Rar.6 ud MlcoeonomicVoldrilit"Vol-45.No. 41, pp. 30&109.
I37
13 Dlchrl- Eoin and Hms-Cslge, Koglmay (1936). Counrry Risl Ra[g: , MuqendlItudio"ul Rcri*. v 6126 (Fovdt Quaner). ln€nrtion'l Busincs hblierid llSA pp.
l9 8unon. F.N lnd Hishi Ino!e,{ 193?). "A Counrry Rkk Appni$l Mod€l of Foftign AsExprcpriarion i! Dev.loping Counties ,AryliedE ohonjcs,y.l19, Rourled8e, N* York,NY l00l6r llsA. p 10r0.
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tl
29
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13 t vine. R.. ad Z.Ros S. ( 1993), th Cir., pp. |177 I173.
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4l Kim, E. Har and Vijry Singal. (2000), Stak M&t l Op.nings: Expsi* of EfteBingE offii6-" Ik Jotu| of Baire$ 73.l. UniENity of Chiogo PE$: ChiFgo. pp. ,rt-46
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s.hifiEs, Mmrcr. (2005), @ .nChoi, F S (1973), Firmci Di$losur. in R€l.rjon ro r Fim! Capibt Co$s,. Accountins
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"nd Busire$ Res€mh, p, 235
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This chapter discusses lhe specific investment and financial environmeni in
Pakistan and aims at explo.ina the issuq in detail which affect the investols
behavior. Throughout rbe history of Paki$d, n ha been emphasized at all
fronls that economic envionment should be trmsfomed in a way so as to
enhance private sectols involvement. It h6 beefl observed that. especially
for the past two decad€s, Pfisran is actively found at all fronB to transform
the environmenl6 most conducive tor the investor. EconomisB in Pal;stan
have always maintained that in ordq to have optimum utilization of
abundant resourc€s herc, private panicipation is necessary. Those who
support liberalizion around rhe world egue that privatized markels all@ate
resources mos. efliciently. Eichen8reen (2001)r in panicular, holds up that
finmcial libemlization allows a country lo expdd dd dive ify invesrnenrs,
thicken financial marketi, and encourage economic gros,th.
However, this philosophy has no! been able to evade objection as rhere is
dother sch@l of thought that disagrees to ir. Mosi prominendy, Stiglirz
(2002)'] argues thar if financial acrors deal with perfect information and
liansparent economies, lhe inlemariomlly comperirive mdke|s a.e, indecd,
Preto optimal. In case where inv€stors face information asynm€t.ies and
ineflcient markels, !s they often do in developing econonies,liberaliurion
may resuh in debilitaring finencial volatility.
The chapler also attempts to evaluat€ Pakista's effort to tmnsform ;ls image
frcm an unattractive corup0ed economy into sn open, progre$ive ddtmspdent one for the sole purpose of encouraging capiial inflows in rhe
economy. Th€se efforls to facilitate the economic opemess prcdominantly ro
t92
lh€ int€mational inv€€tor have b€cn ongoinS aggr€ssively sinc€ lhe
b€ginning ofthe last decade.
However, with ihe kind of severity in lhe conFtition to atract $e foreign
inve3lors among encrgina ecomdica of dle rEgion, Frformanc€ of lhe
economy in the area of d€gr€e of openn€ss could only b€ evaluared by
having a compar.tive analysis. In r.gsrd to overcominS the inhibitions ofthe
invcsiors, the prEsent govemment of Pakistan, like mo6t govenunents of the
recem pa$! has madc adjusto€nti and canied out policy naking so as to
encouraSe gro*th in fofeign invesftents. This study h4 selected afEs for
evaluating lhe woft done to nrke the €conomy mor€ inv€sdncnt fiiendly
and to find @t vvhcrhcr overlomin8 th€se ohstacles would reduccd the
olemllcountD riskquolient for the cconomy ornor.
l9l
4,1
Sti8lilz's araument has quite a few implicalions for findcial liberaliation
as, €ven if investors ale mtional, information asymmetri€s will produce
194
ItrvestmeDts rd Mtrket Libemliz.tion
Foreign investment is consider€d by many as one of the key factors in
fostering an environnenl of €conomic groq'th dd Prosperity in dyeconomy. ln the early 1990's, especially mder the innuence of the
Intemalional Monetary Fund guidelines, a numbe. of emersins economies
eased their capilal controls md liberalized financial markcrs so as b promote
the inveslrncnl cullure md especially lo attrad the foreign itvestoF. In that
cont€x!, the lMf policy was based prinEily on the assumpfion that
privatiz€d markets allocate inv€slm€nt and resources most efficiently,
whether in lnde or finance, and by opening up financial markets, these
emerging economies cm expmd and diversiry inveshent, thicken financial
markels, and encourage economic goqth.
Those who support libealization, and Eichengreen (2001)r is one of them,
argue ftat privatized mekets allocate .€sources most emciently. In
panicular. financial liberalization allorvs a counry to expmd md diversiry
investmenls, thicken fndcial markers ud encourage €conomic gos'th-
However. Stiglitz (2002)4 disgree sayins that if financial actors deal with
perfecr information ad tEnspdenr economies, then intemationally
compelilive markets are, ideed. Pareto oplimrl. However, if investoB hce
infomation asymmetries md incomplete risk makets. as they often do ;n
developing economies, libemlizadon may result in debilitarins financial
volatility.
inconsisrent trends;ntheir behavio.. Besides,lhese informalion asymmetries
a.e highe$ for fbreign investors in newly liberalized financial markets.
Foreign irvestos arc p.rticul.rly susceptibl€ due to languaae ed cultural
baniers, unreliabl€ infomtion, and a lack of acquaintance with the market-
As a result, an em€rging €conomy that opens up 10 foreign inveshent llalso ha\e ro rdce increased srocl marker insrabil;r).
In fact, this is pr€€isely the sc€nario Sliglitz wams of with capilal ma.kel
liberalization in most of the €mergins economies hishlishrins ihe crucial
issue thal when emerAina economies open their capital makets to foreign
invcstmenl, they in fact expos themselves 1') a large bloc of invesroB facing
considerable information jassedness. Insufficienl and poor informarion tums
for€ign iDvestors unable to re&h a consensus on rhe cquilibrium price ofdassel. and the situation would ulrimaEly lead ro for€ign inveslors beina
view€d d .esponsible fo. significant slock m,rker instability.
However, these fears and inlibitions can be md shall be overcome by the
govemments in the eme.ging economies, as rh€se econohis desperately
need assisldce tom the inv€stors, especially rhe toreiAn inveson bccause
lhey suppolt indigenous resource Seneralion. Emefging economies should
try all meds to remove infomtion asymmetries and prcvide investors with
an environment conducive enough and to ponny rhe image ofthe economy
as open and progressive wift hiSh flarc for growrh dd development'. Allihe banieN in the way ofattracring foreign invesrors Uke luguage, cultural
or market awareness musl be miligaled 6 quickly as possible since every
economy of the world strives hard in the intemational mdket to prcse
ilself d more f.iendlier thd th€ orhers, in orde. 10 atract morc invesrmenl
195
achieve higher lev€l of groMh and achiev€ a better standard of living for its
Pakistan has always struggled 10 transform its image ftom an unattmct've
economy into d open progrEssive and transparenl one for the solc purpose
of encouraging capital inflows in tie eonomy and, in doing so, numercus
inlem.tional finscial ag€ncies, institutions and consortiums have been
assisting the govemmen!. By doing so, they have b€en able to succestully
bring brcad srrucrural and economic reforms to the econom)6. This rcformed
eonom;c envhonment is to b€ na;ntained and progrcssed systematically by
the curent elected Aovemmenl as well as lhe tuture Sovemmenls, as it hd
proven elTective in achieving the obj€ctive of op€ning-up the econony for
The efforis to facililat€ th€ economic op€nness, prcdominantly to lhe
intemational investor, have b€en onsoing since $e beginning of the l.st
decade- As a result of seveml facilitatirs iddarives in ftis direction, the
eonomy hd shned to anEd a healthy incrcase in foreign inlesment. The
firsl iniliative lowards op€ning-up the economy for int€mational invstoF
was takcn in 1992. The focus of this initiativc was privatizalion,
d€r€gulation ofdiferent economic secto[s and liberalizina the economy d a
whole in order to promote investmenrT. This included allowing foreign
investo.s, €ither coQorate or private, to invest mainly in inftaslructurc
projsls such as ports developmenl, roads and connunicatioG
inliastrudur€, €ner$/ sector and oil and gas €xploration projects. Wirh the
kind of severity h th€ competition to atracr the foreign investors.
performance of individual economy in the area ofdegree ofopenness could
196
only b. svrbdcd b', brving . codp|rdiv. ro.lyiil A nallrc of tba
Pati*Ei .comBic Fft.n@ !! coqatd to ltd of nigh'b(.i.g
coreti.! ce bc a good benchinsting tool ftr the forciStt inv€dn irm.ldng a Ftddt inwteenr d.cirbn h 6b rcSiod- TItc fo[owiog
ihJltdion Sows s cqralivc |lrdFb of lhr DligbboriDg .cdmi€3 in
brief,
t9
Illrstritiotr 4.r'
Itrvql[.nl Cliprr. lndicraors ir FourCoutrtrie.
23.t0
Mr.lcn rir D-fii wrr
u.ornd.r PrF.ft (% srrr)
D.YrTock rcer(hrort)
D!r! ro Cl.r Crior (ErD.rt) (.3'
sr.n wfib (hadnn a.d||it
(e.4Nor.: No of.bMio. ir pc n*s.
rDolla'. D€vid VlrJ H.llqdrd-Drirnan 'nd
To)c M.ngrnr. ftc \rortd Bmr,200t
198
4.2. !qe$!cedsgd!sir-&&!g!
In lhe last decade major political. social, infra structural and economic
chmges have been introduced in Pakistd. However, despile a$inst all the
odds, from the image of a closed €conomy, Pakistd has managed to ponray
a inore open and wel@ming glund for foreign investment in tle elobal
markels. This change in economic approach from the govemmenl and
findcial institutions in Pakistd has led 1o significnl inprovemed in the
local economy and market structur€. Since $e coming to rnwer ofa manial
law regime dd despite doubts about its benefits for the counry, il hdprcven to b€ a stabilizing agent for the counrry in economic p€rspecrive. tleaovemmenttaking over fiom the marlial law regime. conrinueslo follow the
same linc of approach wh;ch resulled in reflecting an imaSe of a counry
nore suble in polhical as well as ecrnomic tems. There are lew inhibitions
aboul the eonomic targets and claims ofthe govemenl in the minds ofrhe
porential investors but they have not crcated a major hindrace in the foreign
capital inflows and we have se€n significam capibl inflows despire few
claims that the governnenr has no credit in lhe snuation'.
I1 is also necessary to note that the success of foreign invesrmeDr policies can
be jud8€d by the size of rhe infloss of capiral. pakisran has been making
effons to attmct FDI and such efforts have been inlensified wirh the advent
of deregulation, privarizalion, and libeFliation potjcies inirialed ar rle end
of the 1980s- Khan dd Kim (1999)ro point our that the mounr offorciglinvestme rcse from a tiny $10.7
"iUion in I97611977 to $1296 million in
1995/1996, thus grcwing ar rhe annual compood grou,th mte of 25.7
percent. How€ver, it declined to $950 million in 1996/1997. Wirh the
199
beginning of ihe overall liberalization program (1991/1992 onwards), rhe
innow of foreip investm€nt g.ew ai $e compound growlh rate of 15.2
p€rcent. lnv€stment inflows in 1995/1996 rose by 93.1% mainly due lo the
inflow of inveshent in rhe energy seclor.
Pakistan has made srious eflons. in recent times, not 10 la8 behjnd rhe
economies of thc r€gion, bu. to take steps foruard consistenl with trends
obseNed in growing Asia. The strucnual chuges in findcial mdkets
introduced by the recent govements have been remdkable and significmr.
At Pakistd's finacial sector's sope and scale. the srudy finds thal ove. the
past five year endins by calendar year 2005, financial assets have grown by
70% reaching Rs. 5.1 trillion. equivalent to 80% of GDP. Ob$rving the
performance of the banking sclor, the snrdy finds thal this s{tor grcw ai a
fasl€r pace relative to non-bdling sectors ,nd cunently accounts for 7 I % ofthe findcial industry assers. As far as markct capitalizarion of rhe sr@k
exchanges is concemed ii has grown sEadily, and recenlly louched new
psychological heishts relalive to 10.3 percenrofcDP inJune FY00.
Since the yed 2000 till pres€d, rhe intemational marker hd obseNed a
sleady and strong growlh in the Pakistani economy. The €conomy has seen a
significant incrcase in the FDI dd rhe foreign remixances. people mainly
dgue lhal the latter hd morc vilal impact thd the former for the increase in
the foreign funds in the economy. However ir should no1 be forgot rhat, no
doubl, the world evots taHng plac€ in the begiming yeare of twenty first
c€nlury have provided the foudalions for $e gro$,rh in lhe forei8t
exchange flinds ih rhe economy, bul the econony has taken the righl steps at
.he right tine despite the facr thar fterc is e enhancement in the DerceDrion
200
aboul the volarilhy of the econony. In tbat area, rh€ present govemment
deserves appr€ciation for taking keen interes( in formulating slrategi€s 4d
policies to cr€ate an ambience for investment targeting d€r€gulation md
privatization and thus representing an imag€ of progressive economy to fte
world. Due to this ponmyal of a erowing dd emerging market, the local
economy has managed to atnact the interesl of invesloB, either corpoEte or
individual and for€ign or domesti€. The economy has improved, on account
of influx ofthe for€ig! investor, €sp€cially in the area oftelecommunication
and energy, and the fact is obs€rved from $e forecasted gBph below. The
lrend is declining only between 2001 and 2002 whichjustifies itselffrcm the
events unfold after 9/l L Other than that, dE graph is moving upward telling
the success story ofthe economy in atrEcting investmeni.
201
Illustr.tior 4lrl
5 Y€ar Movins Averase GDP Crowih Rat€
GDP qrowth
200t 0t 0l fi
96
_9
_7
-5
-3_l
05 06wtolE(|!t
P isb Bl@u of Sdsds !006.
!year modng
202
Moreover, the €conomic d€velopments in the Pakistani market have ako
encomg€d the ov€N8 P.kisianis !o invest in their home counry at a
larger scale l.han experienced befo.e in the country's history. How€ver,
speculation on its own is not sutrcien( enough for a prudent forei$ inv€stor
lo be ;nlercsted ;n the Pakisiani marke| Analysis of th€ local sc€nario by
various finucial institutiom around the woid including the World Bank and
the Asian Development Bank €tc. continues as always, to provid€ a bird eyes
view ofthe progress ofthe econony. As p€r the ualysis ofthe World Bank
at the beginning of rhis decade, Pakistmi economy had major challeng€s to
overcome in od€r to attracr rhe interest of for€ign investos depicted in rhe
20.1
Illustritiotr4.3 'Too l0 Corsirrina! to Fi.m lN6tmert tu Pakilhn f20021
IO l0 C{| l ro fl|| hvrmfi h tdrh!|r C00?)
t olfinEid{ lint pobhr {'hd!r' rovel! 0l3rd.
roure h4p 7\str sorldbrnt ols
204
This sEph shows all the major op€mtional concems consid€rcd esp€cially
by foreign investment proposals. lt shos the concems which inveslos
nomally have while €valualinA inv.stn€nt decision in em€rginA economy
like Pakistrn. As depictcd in rhe above srEph, in some arcas the €conomy
has shown above average p€rfornance. In other a€as, th€ economy shows
below avcnge perfonnance hidlighting lhe fact that the ov€rall
performancc is about avcDge. This position nay hmper the opeEtions 8nd
performance of foreign corporate inv€stors in lhe Pakistani economy as
compar€d to other ec4nodes of the r€gim. At this poirt lhe snrdy believes
that the decision eslysis b€coines significant 13 the economy is sho$/ing a
gro$th rate amongst fte top notch in the world mark€t but has not attEcted
investnent in the snne bracket and thus holds an int€mational perception ofhighly volatile economy. Following dis.ussion refl€crs the areas of conc€m
for inv€ston in Pakist n elpecially tle foreign invesaors.
205
4.3 l4.pel!$vs-I!3!!4!-el-tets!!!s.!-E!9!.9!J
In the context of overcoming the inhibitions of the investos, the present
govemment of Pakislan, like all otier govemments of thc rec€nl past. has
made adjustments and carried out policy making so 6 to encouFge 8rcwth
in foreign investments in the country. Every govemmenl had its own target
arcas to work on to make the econony more invesunen!ftiendly. and
overcoming $ese obstacl€s has panly reduced the overall risk quotient for
theeconomy. However, a lor is still ddired 10 be done.
The study is of the view that there have been nunerous policy adjustments
p€rformed in a SEdual and syslenatic manrcr by the rcgulatory authoritis
10 counter the €ffecls of unftiendly and discouraginS events and procedures
fof investm€nts- Some have net success while oth€rs have not been thal
succcssful. som€ lack the popular suppon while otheF lack in policy design.
Each has received varying degree of response fiom the market and rhe
panies concemed. Th€se m€asurEs span a horircn thar includes the broad
policy ofopeninS-up the economy fo. interolional investors.
In lhe followinA sdion, the study anenpls ro undenake a derailed analysis
of rhe economic, social, cuhural, policy-makins and infra-strucrural
developments in o.der to elabonte tle mjor changes that have ccured inthe counlry. Such chmSes may bc aignificdt to foreign invesrors and have
impacled the level ofinveshe s.
,1.3.1 M,rke. Frrnework
Pakistan has rargeted to libeElire ils economy as wcll as its financial
ddkels sigdficantly ovef the past two decade or so. At present. il is one of
$e morc op€n trade md investnent regimes in South Asia, ev€n though the
region iBelf remains relalively prorectionist by inlemational standards. On
trading grounds. Pakistan h4 unilalerally reduced inporl lariffs so that its
applied rates arc often below the bound mtes ro which ir is commirted by
World Trade Ofganization (WTO) nemb€rship as per the Asian
Developmed Bank rcpon (2004).rr
Prkistan h6 st ned on a s€rious nole to libemlize its economy in the wlyI990s. Tle second phase of marker libeElialion staned in 197, which
includes lhe €xpansion of the ongoins economic liberalization policy. The
regulatory authorities took filrther steps by liftirg resrricrions on forcign
inveslor's p.ofit repatriation in certain setors ofrhe economy. These i.clude
lhe agricultur€ and infi-cstructure developnenr sedors. Furthermore, full
oMership allowance, alrcady permirted in rhe manulacturin8 secror. was
exrended to cover infialtructure and agri€ullu.e sectoB d well.
Despjl€ these beins major refoms, no norable srowrh we.e observed in
forei8n iove$ment inflows as expecred by the financial institurions, perhaps
considerinS the structure ofPakisran's economy as inconsistenl. One ofth€main re.sons for this undeQerfomance wrs the policy-making er.o6 retated
lo the findcial mekets in Pakishn soon an€r the aromic explosjon. The
cessation of the foreign curency accounts by the Aovernment of rhat time
16 by fd the major blundo b€cause by rakina rhe abovc decision
207
govemrnent seriously dcnted the investor's conlidence. ft show€d poor
irosinarion as well as rcflected lack of consistency in the policy-making
sinc€ rhe step ralen by the aovemrnent was detrim€ntal for rhe market
confid€nc€ by all standards. How€ver, this could not b€ consid€red as the
ody resson for th€ und€rperformance as rhe blarne fo. the b€low par
p€rformance was also due !o rhe security risks prevailing in Pakistan for rhe
forcign inlerests. The social setup ud th€ cultual differences with the
westem world hes shap€d a kind of aninosity towdds rhe developed world
and has also created doubts in the minds of investors thus made them
.eluctant about taking inv€stnor positioG in Pakistan. The study coNiders
mark€t setup as a very important €lement in fi€ decision making-p@ess,
and for that reasor, discusses it tunher in the comins lines.
208
4.3.1.1. The Priv.tizstiotr Drive
Thc p.ivatizadon ed lib€ralization initiadve fof the s€cond phase ofthe
economic reforms is still undesay up. However, due to fie slow progress jn
p.ivatizrion of state{Med insriruions, this initialiv€ ha contributed lo the
low growlh in fofeign inveshent as compared to the potential dufing this
stag€ of economic developnent. Th€ experiences of foreign investors
previously involved in the economy were not very encouraging. esp€cially
for those who had been €ngaged in legal disputs wilh the govemmenl
keeping ir mind the political in$ability here. Moreover, the Fansparency in
enforcement of regulations dd arbitralion ftom these laws is also a point ofissue when conside.ing any invesrment in the Pakisiani marker
The Asi4 Developft€nt Banl r€pon (2004)'' did acknowledge thar under
rhc inve$m€nt policy introduced in 1997, polici€s bwards i.ward fore;gn
direct inveshenl 1o Pakislan were liberal by redonal standdds. Foreign
investoB were gua.ut€ed nadonal trcatrnenr, faced low impon duties on
plant ad equipmenr of b€rwe€n 5 per cenr and l0 percent and a fi6t year
profils td allowance of between 50 and 90 percent of lhe cosl of ptant and
The present govement has continued the good policies of the previora
Sovemment and continues b move along the p.ivatizarion path.
Privatizalion of stateowned enterpriss continues ro rarget by the cunenr
Sovemment as well, and .he exanples ofPTCL, KESC, and Habib Bek etc.
are the illustrations of the approach even though some secrions have
queslioned the tFnspffency of fte deals. Furthemore, ro feitirate rhe
209
process of privatization of several state-owned entities and aho to provide a
fair bidding environrnent fo. forcign investors, the govement set up a
privarizton comnission in 2001. lhe main purpose of this commission is
lo overs€e the trarspdency of tmns.ctions up to a one year period md
ensure the enibrcement ofregulalions md agreements lherein.
The libehlization ed dercSuladon drive of the findcial s€cior has
facilitaEd in tmsforming the ba.king sector's ftajority owne$hip in io tbe
privatc sector. Moreover, this has le.t hod to rcoriem the secror, which is
relentlessly changing and restrucluring ;(self in the bsck-drop of imp.oved
domesdc and extemal conperition. The reason is that Pakisld's economy is
tapidly integniing ilself with global and regional markets (o meer the
challenges of globalialion. It has de been observed rhat therc has been
admiEble srowih in the profitability as well as efiici€ncy ol lhe financiat
seclo|s indusry. This, in addition ro orhers. ha irduced a wide @ge ofinstitulional diversification evident from the growlh oi equity markets. and
considering lhe possibility ofhi8her the normal rerumq they have anacted
consid€rable foreign ponfolio flows. Besides, the situation has also resuhed
in propagation ofa wide arny of non-bank finacial jnsrirurions prcviding a
rans€ of finucial services such as leasing, investmeht bankins dd fund
nmagcment, and offer range oflslamic financial inslru,nenls.
:t0
4..].1.2. InflowofForeistrlovestmetrt
The economic refbms made during the lasl ten yeds may no1 have tumed
out 10 be d effeclive as tley could haee been, but have ccnainly prolcn that
fte e€onony is now moving in .he right direclion. A positive and
cncourasins feedback from the indicators is good enough proof thal the
policies are in-f&t working in rhe sarne direction md exp$ted to bring
about the desired outcome. There is no denial ro rhe fact rhar the slow
p.oAress is due to the oveEll socio-political scen&io, however, the foreian
investoB are receiving positive siSnals f.om the €conomy which experienced
a 19% increase in fore;gn direct investhent in the fiscal year 2004. Th;s
indicals &al progr€$ is underuay.
In rccent times, th€ inflow of foreign investmenr is a clcar indicatof oflhepr;vatiation eflons of govemmenrs whether welcomed by the investors or
not'. The researcher is of the opinjon that despite the focus on rhe
inlemalional investoE. on€ caimor forAet the fact that rhe local investors do
also gel encouragement ftom the libemliztion policies and have gown in
confidence 3nd are contributing in the progress more posirively. This is why
tbe acts of the present and previous aovemenB can have justificalion for
focusing foreiSh investors.
The following table shows the progress in terms of forcig. investmenl
durins a period offive years:
:II
Ilhstnlion44''N€l ltrIlow of For.id Privrte hvestnent
TotallnvestmenB Millionus$
u.t(
souae www.sbo..rq.k/€{tar.Aetinflo* pdf
212
Asid Developmenr Bank report (2004)17 expr€sses that thc ;nvestmenl
climate and the uncertain national and reSional pol;dcrl siturion have kepr
FDI inllows into Pakistan relatively low in the past. Nevenhcless wc caD
obsewe in the above table thar since 2001, there has bee. a consunr and
subsuntial grouh in the inflow of lorei8n invesrmenls. Belween rhe fiscal
yed ending Febniary 2005 ed FebnEry 2006 il is observed tiar there is a
loluminous 34.4% increase in foreign inv€s(ment. By any shdards. this h a
major indicalion that thc investor confidence is building-up and capital
inflows are pouring into fte economy.
There have been litrle improvemenrs in the polirical and securiry issues rhat
have remained a ma.jor @rcem fb| inveslors in Pakiste. I lowever. the
forcign investor has beSan lo r€aliz rhat Pakistan is an emerging md fasr
growing economy and the govemmert is rrying to inniale md implemen!
significant measurcs consistenlly to imprcve rhe invesrment envircment for
the benefil oflhe foreian as well as local ;nvesror. Nolwirhstanding. Khan
and Kim (1999)13 express thar despire significmr dcrcsularion and variou
concessions given b foreign investoB, Pakistan still taces serious problems
as far as implemenration of foreign invesdnenr policies are concemed. There
s a strong perception amonS for€ign investos thal the pro-business
inducement. applied to attracl prcspective n€w invesroB, is somehow weak
dd would give in when they acrually begin ro ser up and op€rale rheir
ztl
4.3.1.3. hvestoBPrrticipationinPriv.tizstion
There has been substantial forcign investor interest in rhe privatizlion ofthe
state-owned tele@m, energy and financial services sector €nlities. ForeiSn
investos are p€mitted to bid for any of the state oMed industries on sme
terms as those of local or Pakislani investors. The (elecommunications
sector, now privalizd, has.ttracted numerous foreign bids and is onc oflhe
faltest srowina indust.ies in the Pakislani economy since 2004. Beforc fiese
economic rcfoms were inlroduc€d ed the economy beinA opened up,
mergen of all sons were r€stricted whether they were b€Feen
multinalionals or with local entities. Howevef, 6 pcr new reforms, thes
aclivili€s de now allowed in all sectors and industries except for defense
manufactunng and some listed ;ndustries. Such bnds of reforms not only Nbuilding lhe confidence ofthe
'nvestor but also allowins them to grow by all
mcans dd boost the s€lf belief ofrhe marker as well.
Il is noled that Asim Development ourl@k 2006 very righdy points oul ihat
privatietion of public e e.pnses, as well as allowing rhe p.ivate secror 1()
€stablish new operations in areas previously r€seNed for rhe srate, has had a
positive effect on the economy, panicuhly in banking, rel€com, md oit and
gas. These three sectors hav€ expanded very rapidly and atrmcted subsrmtal
foreign investment ;n the rec€nr years. Laraely because of grearer
competition, the quliry of bad<ing and lelecom seryices has improved
significantly.
Private osneBhip dd €stablishmenr of businesses by forci8n inv€stors is
permitred in all s€ctors of the economy except for explosives. arms and
2t4
radioactive substance indurlries. Trading of privately-owned prcpenies, rcal
eshre, equipment dd plat by forcian entries is not a regulabd or
govemmenl monitor€d acdviry. Consequenily, they arc athcting foreig.
inv€shent ever since lh€ refo.ms werc inlroduced. Furth€rmore, lhe legal
sctup Suaratees th€ continuadon in govemm€m policies and provides
proteclion 1o foreign direcl investmenls against polici€s aimed al
expropnanon o. nationalization. Th€ gov€mment is now following a
privadation policy. which is i. favor of fte new investoN md, as m
assurance! the investors sre obsefting the privatization of state-owned
entitie. This also is an €ncoura€in8 dpecl of the new econonic reforms
being put into force inrecentyears.
Khan nd Kim (1999t' identil' rhat Special lndusrrial Zones (SIZt hav€
been set up ro altract forcign investment in expon orienred industrics. Apart
hom foreign investoE, Pakistanis working abroad re also eligible ro invest
in SlZs. ln this regard, the Sovemment is taking every step ro make sure thar
th€ ne@ssary inftastructurc dd utiliry services arc being made available in
these SIZS. Inv€stments in SlZsarc exempted fiom exisring labor lawsofthe
country md hefty fiscal incentives are given 10 foreign invcstors in the StZs
lhat include income tax holiday for a period ofrip to l0 years.
l. r€cenl years, Pakisran h6 been enAaAed in inlensive activities in
developing a n€w flon city beside Karach renned as the Gawadar Pon City.
This city is included in the special industrial zones mentioned above and the
pon handl;ng had already ben handed ro a S;naaporcan finn. Invesrment
hefe, especially roreign investment, is husely encouraged. dd China has
been flowins funds inwards fo. secuins lhe gotden opporruily in rhis
215
highly lucrarive irade zone. The main objecrive of the govemnent is lo
provide aD altemativ€ hub for the buliness dd trade &tivities taking plac€
thrcugh tie Anbie Sea chmels. Mormver, similar indust ial zones have
be€n planned in other areas of Pakislan in order to promole the
indstrializtion driv€ by the Sovemmed.
As il ha! been discussed in the preceding chapler, the IMF, during 1990's
ed late l9E0's, convinced many emerging economies to move towards
increased private panicipation iD the economic aclivities by opening up lheir
economies. However! in order to summarize the position of Pakistari
economy since 1980, as compe€d !o that of conpetinA economi€s in th€
region, the following illustration by lhe Intemalional Monet ry Fund should
suflic€ arfte conclusion ofthispaft ofthe researchl
216
lllustration4.S'o
Pakistrr: Crowth rtrd Developrnent ltrdicttors. 1980-2003
I i;i
il1
!.1.1
m t!11
Sou... ldrsnrrional Monebry Fund, Inrern ionar Finan.iat S$nnrcs
2t7
43.1.4 Mirk . PerforDrmc
Prior 1o the liscal year 2004, all forcig! corpomte invcstors in the sesiccs
s€tor wer€ r€quired to maiotrin aa l€rst 400lo of locsl equity wiftin five
yees of investrnent. As a be{sur€ lowsrds facilitating and encouaging the
foreign investn.nt in the {.nomy, this r€sFaint was found to b€ a liniting
aaent. This restriction was abolish€d in June 2004, and the inv€sto{s ar€
now p€rmined ro maintain 100% equity for the lifc of the project. As an
out@me of this change in policy, we can obsqve the Pcrformanc€ of lhe
Kamchi Stock Exchange rhrouSh the followins illustration rEfl€cted ftom lhe
frct that Pakbtff's ecommy is anong the fastest growinS econoniB and
th€ mdkct is consthtly touching ncw psychological heights:
218
Ilultrrtior 4,Y'
KSf,.rd Globil Mi.k tg
l(sEti Globrl ll|rl.it
-World...-
E.c A5i. & F.r E.5i GPatira160
140
t20
t008
I
80
60
40
20
YJ:i:Ya=a=a=
s{urc.: stlre Bdk of Pakisbn, Fi6ci.l Metds Rdi.}, ll,w stnso}:,t
219
In addition. the SECP reg'stered 295 companies durins March 2005, dagainst 207 @npdies rcgistered during th€ coresPonding month of the
preeious yeff, showing an increis€ of l7 FErcent. Of lle totat 295
compani€s, 284 werc compdies limited by shees including lwo public
unlisled compmies, 272 private compdies dd ten sinSle member
compmis- ln addition lo lhis, six forci8n companies md five noGfoFp.ofit
aseciadons wer€ also registered. The highest number of45 compmies was
resistercd in s€Nices sctor whereas 32 companies were registered in
rrading seclor md 28 in real estate d€velopment s€ctor as per fte inibmation
disseminated by SECP".
The refoms regarding lhe renoval of equity restrictions on $Rices $ctor
foreign cornpanies h.ve result€d in d increase in the number of li$ed
companies fiom this sctor of the €conomy. Fudhemor€, the ovemll
perfomdce ofthe stGk markd ce also b€ obs€ned in the following table
f.om the K@chi Stock Exchange, showing the volminous leael ofaclivity
considering the past p€rformance und€r lh€ inefficient eonomic sruclur€:
220
lllu.rrlio! 4.6!
IDdic.tod of lturlchi S.ock Etchrnge
at)
l2l.!0
r23,31
ssc w!l!!.sa.d4i!Draa!!gg!5A!!-r!!!&.!dj
221
During the lenure of th€ present Sovemment, the study suggesls that
Pakistant findcial mark€ts have witnessed sisnificant changes in FY04.
Her€, the inrerest rares touched a historic low, th€ Rupe rerched a 3% year
high and tbe capilal market, 1oo, witnessed a new all-.ime peak; all markets
also saw improvements in depth a.d liquidity. These developm€nts pfobably
havc facilitated th€ e.onomic r€covery by catering the rising demand for
financial sewices by the fast recovering ecommy.
In the fis.al yea. 1998-1999 i.e. beforc the start ofpresnt .egim€'s control
ofthe country, the mdkd capitalisation was at Rs.289.2 billion. lt was the
time that economic refonns were being put into force. Within a pefiod ofsix
years, the market capitalisarion has increased to Rs.2,036.6s billion which is
almost 700% increase. Consid€ring the pdt performance and th€ policy
changes brought into efTecl, lhis incres€ is subsbntial. The study would
poinr oul here lhat we co obseNe ftat $e major erowth period is belween
fiscal years 2003 lo 2005, the time period corBpondine to fte removal of
equity maintenmce r€striclions on foreign investoB. As compared io olher
intemational mekets' cap;blisadon, Pakistm's performance cat be
benchmeked throueh lhe following illuslration:
222
Illultrition 4.7r
Crpirrliztion ao GDP Rrtio ofs.lccled Countrierzc{243
21.3
lt.t
SouK. hrp //llw.lorldblnt olg
223
4J.2. The Politi.G Ecoromic Eovirorm.trt
Anolher feature disus*d edli€r is the political iNlability scielal
imbalances. Pol;tical risk is importanl, especially to intematioml investors,
because political evenls often have s dramatic €ffect on srock market
performance. Sometimes these political fluxes can lead to Problems with faF
reachins consequences of differ€ni shapes and magnitude. In $me cases,
political instability has rcflected in the s€rious currcncy crises with
consequences for as long as twenty-five years. The cun€ncy ad d€bt cnsis
disins out of political setup can cause depressed stock markels and
economic hardship in lhe affected economies. Clark. M6ood dd Tunaru
(2002):5 point out that during the Mexican peso dsis of 1994, the Mexicm
stock mdket ind€x dropp€d by 38.7% from December 1994 to February
1995. Frcm.luly l. 1997 io February 16, 1998 dunng the Asid crisis, Thai
slocks fell by 48.4%. lndonesians by 81.7%, Malaysians ty s8.4%, adPhilippines by 49.2% dd Kor€ans by 63.1%. The Russid crisis of 198
caused a slock Imket decline of 41.3% in the month of Augun alone.
Argentina is still recovenng ftom its m€lldown in 2001. For lhe economy as
a whole, on average. a severe cuEency crisis causes m 8% cumulative loss
of real ourpul in emerging €conomies as eslimaled by the InFmational
Monetary Fund (IMF) (1998)16.
724
43,2.1 Politicrl Cullur€ in Prkblrn
Pakistan is conceivably the rnost tamish€d pol;dcal mystery in th€ second
half of the 20th cdrury. Il was conceived 6 a nation-slale for a ninority
commun;ry of 100 million Muslims ofBrnish lndia and €mbarked upon lhe
task of nation building when it wa est blished in 194?. At thal tim€ i!
compris€d of two component! divided by | 000 ftiles of lndian Tenirory.
h was an overpowering task to build a nalion-state whose peoples had only
one unhing factors-their abiding faith in Islam. Othe. than that. $ere w8s
norhing to keep them to8elher as a nation. Subsequent political
developnents in Pakistan cl€ady show€d that even the "abiding faith in
Islam wa! merely a inirage,' not a solid factor of polilical inl€gmtion.
R€sultantly, wilhin 25 yea6 of the narion's found;ng, Pakisl.an's
Seosraphically-divid€d paris became two s€pamte nations afler a brutal wd
prompted and proscriH over by India. Since l97l's painful experience,
r€mlining Pakistan has not politically s€nl€d doM and $e counry still
ne€ds ro d€fine ilself and devise a proc€ss ofgovemtnce. Pakistan's political
culture of almost four decades is nolhing but aisishnce for total national
disintesEtion, despne its suctess in dcveloping nuclear weaPons and missile
Around 1950, Paki$an instigated so many fundamenlal Proglams, both
nadonal and intemational, that it app€ar€d to have fte capabililies of
becoming a second Japan. That year, it sbned economic developmental
programs for the Etion's vast human dd natuml resours. In 1949,
Pakislan also $aned a non-alignment movcm€nt by orSrnizing the firs|
225
I emational Islamic Economic Conf€rcnce, wbile dispeEing the suggestion
of a Third Bloc in a bipolar world. Why and how all these consruclive
initiatives failed to develop Pakistan a! a modem slat€ de quesrions that
have neve. b€en scrutinizd despite the fact thar it hd become a cruc;al
center of world politics since Seplemb€r I I, 2001 .
As a rc$th of the above, lhe forcign investor, although snsing an
opponunity in the lcal IEk€t, is rcluctant in investing in the Pakistani
narket. May be Pakistant polilical culture is not so dystunctional atler all.
as the study feeis that political culture cannot bejudged on fte elusileness of
electoral democracy alone. lt rath€r needs to be.judged on the bash of
facrors tar more important than elcdjons; tuctors that are the lbubdation ol a
robust dem@raric cuhur€. A nation wift a democratic cDlture is not
necessarily the one that has achievd economic democracy - no country in
fie world has. Simildy, a democmtic culture d@s not neces$rily m€an that
exrremisi rhoughr dd rclion are €liminaled. But slill, at this $!ge. thc cost
benefit analysis is intent towards a higl-risk quotied as compared lo fte
e\pecred benefit frcm in!esrmenr.
2t6
4.32.2. So.io-f,coropic S.tupr ahc lofl.lior Isu€
The history ofPakistan's economy has been maftd with th€ inflatio. issue.
The failurc to control price rises renains the main pol;cy risk in Pakisun.
Th€ study has found that looking al the GDP and inflalion rate relationship,
in the history for Pakistd's economy: it is not diilicult to find, ftere exists
an inverse .elatioNhip betwe€n thes€ variables. While go;ng firough the
visual examination of lhe two variable ove. a fairly long P€r;od of time in
history for th€ prcsent reaime, d€nonshted in the following illustralion, it
can b€ found that grorth rales remained below 5 percent until late 1970s.
During this rime inflation raies remajned mostly double d;gil, depicling a
strcng case for lhe above mention€d assunplion aboul the relationshiP
betw€en inflation md Srowth. Another double-digii episode of infladon w6
in 1990s, durins which the src{rh perfonnance again rcmained dismal. For
rhe sake of a bene. under$anding, the illustralion below demonstrates the
trend in inflation and GDP groMh rares ofPakistm prior to the 2l "' century.
277
IllNtrrtion 4,8'7
Infllfiotr ard Real GDP Growth Rsles
1973 - 2{nO
30.0
21.0
21.0
2r.0
18.0
r5.0
12.0
9.0
6.0
3.0
0.0
r')rrf*oFordlroFooNol-NFF666666(D1!OOoooat6ndtan('0iDdl('('
GDP Gront
228
ln the re.ent y€s, Pakistan hes €xperienced a fluctuating trend in the
innation tate 6 in the €ady y€ars ofthe cunent deqde, rate of inflltion was
declining due to numeroui €conomic factots. Thes€ factoE includ€d
investned innows Foln abroad, policy adjustnents, declinins interest ratcs
and mnonic refoms iEplencntcd by the rcglrlatory tulhoriti€s. However,
as this trer of€.ononic Erowlh is signalling a slowdo*n, rhe inflation mle
takes on a rising trend th€reby comp.lling lh€ SBP to lake count€r measur€s.
The forc6ls by different institutions for lhe y€ar 2007 are not as exciting or
attractive fo. th€ investoB a! experienced in recent y€ars obsened firoueh
the followins illustration I
229
urrrrior {9ll5 Y..r Movilg Av.ng.Inn riotr
60ffi
sd@: Pidm r.dqd BlFu of Sl.lidct *w*,r.&.l ld A 2006
9l
_a
_6
_1
t
5t{ilffriil
2t0
Anothcr imporlant as?ect is to obscrve thc rclationsbip b€ts€.n inflation and
lhe broad money gmw ! dQicted in ihe following illustration reflccting that
inflation follows boad money gro*4h and privat€ sstor credit gowlh
closely with a la8 of about t2 months. With mon€tary growth picking up,
innation fouowed ed increased sharply in late 2003, pealong at I I perc€nt
year-on-ycsr in April 2005. Average snnual inflation appc€$ 0o hav€
strbilized Nund 8 to 9 percfft by Scptembq 2005
231
Inultrrrion 4.rd'Pakisrsn: IDfl.tior .d Momtrry Growrh 1999:l - 200516
(AvGr.gG ArDrd growth tu Pcr..rl)
l0
-ctrilbotril... clrrot0ald l2d,*a)- -ledryFi10!d u !d.du)
Lrs Jrro h{l b!2 lDol ,a& ,D05
s4cNrid-dr(d!0ddir
l0
l5
LO
212
ln Pakistan, incr€ases in the wheat support price have been blarned fof
inflation. Khafl and Qasim (1996)10 and Sherani, (2005)'' have worked on
the r€lationship between wheat suppon price and rate of irflation. Howevef,
lhe issue is r€open€d wilh two instances ofacc€leration ofinflation and the
incrcaies in whe6t suppon pric$ in Sept€mbcr 2003 and in S€ptember 2004
As such, the qu€stion "money or wh€at" is nol mer€ly &adenic, bul ha,
profound implications for emnomic policy lf inflation is a mon€bry
ph€nomenon, it is th€ r€sponsibility of the c€ntml bank and the fiscal
, horities to lchieve pric€ $abihy. If innation iscaused primarily by wheal
suppon price increas€s, il would appear thal the Ministry of Food &
ASricuhu€ should play a key role in containing inflalion while whear
accounG for only % p€rc€ni of thc Consumer Pdce lndex (CPI) baske!
wh€at and *heat-related products (flour) account for 5 l p€@nl ofthe CPI
I|lu!fi.tlon 4.llP*isrr[. lrfrdotr rrd WL.l Srppo.t Prlc. 1999:l - 2005:5
-c il'('€ddrrFq ird
..' $rrqdFa0libtrcrF{kl*&l
I&9' IcO Jb{l ibo lcIBs{G Ntulrtr d$rrddoL6,
234
After a caretul evaluation ofth€ economic silualion ;n Pakistan. it has been
idenlifled that monetary factors are ihe main &ivers of inflation in Pakistan,
while the wheat support price affects inflalion in th€ short run. Evaluation
includes analysis of slrndard moneory variables (money supply, credit to
the privat€ sector), lhe €xchanS€ rrre and thc whest support price as a
supply-side factor cover;ng lhe p€riod b€tween January 1 998 dd Jun€ 2005
The results point towards the fact that monelary factors hav€ played
overiding role in rec€nt inflation, affecting inflation wnh a hg ofaboul one
year. Increas€s in th€ wheat suppon price influence inflation in lhe shon run.
Furthemore. the study is oflhe view that hiSh and p€Bistent inflation is a
reSressive lax and adve6ely impacls th€ poor and economic prosp€cts 6tbe6e have little optioff to pmtect thcmselves a8linst inflation holding few
.eal ass€ts or equity- Besides, their s.vings are typically in th€ form of cash
or low-inter€st b€aring deposils. Thus, it can be argued tlnt lhis grouP is
most vulnemble to inflation as it €rodes its savinSs. Moreover. high ed
volatile inflation has be€n found !o bc detrim€nlal to growth and financial
sector developmenl and hence inhibiB oplimal reource allocation.
2Jt
4..1.2.3. lnfmstructuF St trs
The developmenl slage of infraslructure is also d atlribute responsibl€ of
low lbfeign direcr inve$menl durinS most of the period of Pakistan's
history. Pakistm h a third wodd econotny poised ro mainkin on its high-
Srowth traj€clory an4 now, can clain to have ioined the league of emcrging
econom;cs. How€ver, rhe economic rumaround owes its foundation lo
peBisre political dd macr@conomic stability which h4 helped rcstorc
investor confidence and anracled domesiic dd foreign capital There are
numerous developmenl ptojects underway such 6 dams and biShwav
conslructions, but lhe progress is slow and, as a result, this adds up to the
risk factors consider€d by a prudenl ioreiSD investor.
'the significance of lnfi'astruclurc, as an impo.tant detenninam for caPital
innows volume ud eror^,lh, has nev€r been in doubts. As conpared lo other
cconomies of the region thal .re in fte development Process, Pakistan has
been ke€ping ilselfat par with others in progress. However, it can be argucd
that developmenl in transpon and communicalions cane in late and
probably nor up to the mark when compared lo ,imild econonies. A ibreign
investor considers p.ovision of ;nfraltruclural developnent as a fundamental
rcquiremenr to enaaSe in the investm€nt pr@€ss for fte simple and straighl
forwafd rcdon that it has a dired bearing on $e cost of operations a.d
invesmed. Similety, th€ study is of the view that eonomy la8s far b€h;nd
in terms of power gmerations and there is greal potential10 attract forcign
investment but the foreign investor is very r€lucttnt 10 h€lp in this regard
This is beause lhere is perception that the economy lacks system, inslitution
and inl'raslructural framework which only adds to their risk quotienl. As a
236
rcsuh cv.o ttc nod poted ecdmy crtr los€ ib c.hltm f6 fo.€ig
invcstnent whcn weighing thc cosl and bsrcfts otinv6tiDg in lhe coultry,
In Pakistan's oa!6, thcre is an imm.diarc need to cff€ctivcly and effioi.ntly
iqrovc th. sioDtkro of ilnafi||ctr. aod irurinrtion dcvclopo€nl
237
4.33. B!sus!94-4gugegr4
The research is of the opinion that the fealurcs of Paki$d's economy.
especially in rccent times. should also be viewed in tems ofthe regulatory
siruarions wilh-in the financial markets ofth€ economy lt has been obsened
tha! ;nteresl in the Pakistani stock market has been on the rise in the global
arena, as a .esull of which, foreign corporate invcstors are becoming more
involved in the Karachi Stock Exchange aclivili€s. However, imProvement
in th€ overall economic and polilical environment may be claimed to hav€
led ro a significanl change in the perception ofthe Pakistani economy But, il
cmor b€ igno.ed that strengthef,ing of rc8ulatory f.amework is equally
importanr to poiray Pakislan as a more open and investment- friendly
country. The Securiti€s md Exchanse Commission of Pakistan (SECP) hA
issued a delailed code of conduct for credit mtins companies (CRCS) in
order to help rc eliminate a.y conflicl of inleresl in the Eting process. The
code h6 ben developed in light of intmational besr pnctices and ethical
The resedch suggesls thal Pakistan should try to improve its image to have
major chunk in the foreign funds movement. The .ole of The Securities ddExchange Commission of Pakislar should also be acknowledsed as il is
slriving to implement new inl€mational standards to the statement of
regulations for the Pakislani slock markets in order to facililale dd secure
the investors interests in the market. The firet and foremost infomation, an
investor looks for before investing in a listed company, is the credit rating of
the compmy. This requircs uhost prudence and transparency on lhe pan of
credit Fting agencies. A rcliable set of rules tor the cfedil rating companies
218
in the locat market meds that the investor is able to bett€r analyze $e
narket conditions. The study finds lhal the SECP has laken fo|ml steps in
rhis regard, ensuring that the credit radne system is gradually t@sformed in
accordmce with intemational slandards as ir hd been admited by the
commissior that these efIo.ts accumulate towards buildinA inlestor
confide'ce md reduce the .isk quotient for dE foreign investon.
The study agrees to the claim that boost in KSE-100 Index was dfiven
primarily due !o improvements in econonic fundamentals although few
b€lieve that the swelling is artificial, which ()atror bc ruled out ahogether.
The low interesl Etes that continu€d for mo$ pan of$e last seven y€es
help ro dr;ve non-bank corpomre €aminSs both directly by r€ducinS
financing costs as well 6 indirectly by spurins demand in rhe brcader
€conomy, md thus corpomte profitability. Similarly, low inlerest ral€s have
also added subslrntially to the profilability of banks, thrcugh increas€d
crcdit ofi-take as well as capital gains on th€ir long-lerm bond holdings.
2J9
4J3.1. Resuliliols. Licer!.s rod Pe.pi.s
The recent reforms in th€ rcgulatory frmework aim at promotins foreign
pnicipation in the investrnenl pro€ess must be appreciated by all odds and
ends. In the past, considering the economic structure of Pakistan. invesi,ors
werc subjected to lenglhy md painstakif,g d4 most of the time, coslly
proc€ss€s before finally b€;ng able to make the actual ;nvestment in the
economy. Ii was a prerequisil,e lhat fte investor would 8et rcSistered with a
foreign investn€nt authority firsl3r. Th€ recent reforms have done away
with this requirement. Hovever, the investoB still have to registe. with the
SecBities Exchange Comission of Pakise and State Bank of Pakistan.
Moreover, the govement h6 also relded the mandabry requirenent of
the scre€ning of new investon unless they opt for price guaranrees ftom the
Sovemne and also Ihe provincial apprcval is no long€r necessary to g€t
hold ofwhen decidine for lhe localion purpos6.
The study also reveals that the recent regimes have always given foreign
inlestors, th€ status ofa valued commodiry ad have not corsidered them of
a low prionry in the invesbnent process. All lhe foreign investmenb are now
subjected to thc same level oftaxation as that ofa local or Pakistani citizen.
Despite thes€ rcgulations having be€n put ih force by the recenl €conomic
refoms, there is a possibiliq of running into problems for lhe purpose ofconaacr 4forcement du€ to u in-efficient court system and comption.
In tems ofregulating rhe foreign banks, the Srate Bank of Pakistan as the
regulating authorhy fo. for€ign banks, has imposed no addilional r€strictions
on foreisn banks by v;nue of b€ing based oulsid€ f Patistan. In every 6pcct
240
of investn€nt, the regulating hy allows for same $eatrnent 6 that of local
banks. Even op€ning of new brsnchcs h!! to go thtough lhc sue proc€ss for
local and foreign banks without any discretion due to owteBhip or €4ui9
holdings. Howev€r, one important change brcught by the finmcial sector
refoms is rh€ requir€ment by th€ State Bd* of Pakistan fioln comm€rcial
bmks to be evalus&d on a ye{rly basis by prudcnt crcdit raring agenci€s in
order !o facilitlte rhe d€cisior for incnarional investors.
241
4.3J.2. &!is]-!E!kssr&$9!
Il is a knom fact thal local €conomy and €specially the finmcial market
have been operating under a fairly r$tricted setup. Within such a state of
affairs, there were bound to be numerous policy implemenlers, holding key
positions that were resistant to the newly formula(ed cconomic retbrms in
their vested ;nBrests. The stqdy observes that this situation always calls for a
caretul evaluation as there isevery possibility that thesc implemeners would
do ever),thing possible to step up the friclion ;d the market setup. The study
can daue that this ;ssue accumulated in several scddals od policy
enforcement discr€pancies have sprung up, on pad of the Aovemme ,
further damaging the already tmished md ucenain ima8e ofthe Pakhtan;
inveshenr environment in the ;ntemational arena.
h cluot be denied that th€ €nforcem€nt of tbe newly .efom€d economic
policies is a key facbr in ensuring that confid€nce builds among the forci8,
investoB about lhe atretiveness of rhe Pakistdi market- However, lbis
could only be done when the concemed sections of lhe system participate
with sin@rity dd look beyond their self-interests. Besides, the govemment
should take every possible slep to provide consislency to the sysrcm by
siicking lo policy of reforming the market along the lines of best
inlematioral p.actic€s and needs to stress that avoidable friction be remoled
rcgarding the refoms to establish investor's confidence.
242
4JJ.J.
Ir is a historical fact ftal foreign investors in Pakistan, before the maior
economic refoms, were subjecied to a ser;es of ambiguous laxanon
regularions ud as a r€sult ofexccssive discrelionary freedom, adminislradve
offices, were a source of inefficiency and presented a window of
opportuniry for exploitation. In order to resolve the problem. lhe regulatory
authorities md the Cenhl Board of Revenue (CBR) have implemented
simplifying policies .nd structure for taxation issues. In addilion, wirh the
assistance of the World Bank, the aurhorities arc trying to iniliate a self-
assessmenr progmm for corpoEre investoF lo minimiz the administralive
costs and exploitation for the inv€slors.
The r€search finds that when inlesting in a fore'gn emergins market.
taxation is one of rhe major issues an investor has to analyse. In the case of
Palistani economy, the 8ov€mment has wo.ked effectively to provide
several reldanons in that mnlext, realising thc fact thal taxalion ;s ihe
seond most critical issue for lhe foreign investors as p€r World Bank's
evaluation of top ten hudles to investiog in Pakistan. As per rhe Asim
Development repon 2004 rhere is a grodng awareness of regulatory
poblems, in p.nicular of the ned to strcdline ld administ.ation.
Measurcs have been intlduc€d to rcforin the Central Burcau of Revenue
thereby introducing a system of universal self-assessmenC'.
Sh.h (2003)15 dgues thal b auract forcigD ;nveo6, ue $tccesrv€
govemments in Pakistan, offered various investment incentives in the fomof tax concessions (ax expend'rure) and direct expenditure on inf.a-
243
structural provisions. The tdation policy of the hosl counFy has Sreal
relevece for lrans-mtioml corporations' involv€menl in production
acdvities. It is p€rceived to be a significant influedial factor in detemining
rhe inflo$ of foreign investment thrcugh the cosi of capital and the .esllling
The refoms ar€ aimed al prcvidiDa incentives !o if,vestoF in housina,
chem;cal. engineering, pr€cision manufactfing, chip manufacturina,
soRwre dev€lopm€nt and garmenls manufacturing industries in the form of
iax duty relaxations as compaied !o the past practices. ln the pasr, these
industries were subjected to rax dury h the ruge of zerc to 25% on all
imports ofplmt, machinery and equipment. The rclaxation provided to these
industriesnow requires paying nominalta{ dulies. In addition to the tax duty
rclaxation, thes€ industnes hav€ b€en provided wirh a g@rer degree ofallowdce of depreciation on plat and €quipment and, in comparien to rhe
intemational sta.dards, this is a fairly lenienr approach tos€rds forc;Bn
investment in thes€ sectors. which reouires to be maintained.
244
4,3.3,4. Elg[!.-&!!g!c!jss
when investine in a foreign market. tie sole purpose ofiaking th€ risk and
opectional responsibilities is rc draw prcfits fion the inv€stment. Profil
repatrialion is the key issue in foreign investments either private or
corpomte. The company law in rhe loreign land has a strong bearing on the
level of repatriarion of profits lo be allowed. In the cas€ of Pakistan, there is
no rcstriction on lhe amounl of profits an inv€slor can repatriale from the
Khan and Kim (1999)i6 claim thar foreisn investn€f,t on repatriate basis is
now allowed in agi€ulturc, seRices, infrastrucrure, and scial s€ctors as
well, subject to following conditions:
(i) the basis isjoint ventm (60r40)i
(ii) tore;sn equiry willb€ ar Ieast $l million;
(iii) foreisn @mpmies registered in Pakisran will be allowed to invest;tud
(iv) for s@ial sector and infrastru€lure projeds. joint venture is w.ived
( I 00% lbreign equiry may be allow€d).
Pakistan has made s€rious effons !o trmsfom the economy ;nto a liberal
on€ dd is open on foreisn qchange issues with minimal restricrions on
holding and/or rcpatriating profils frcm for€ign invesments. The rcgulatory
bodies and institutions enforce no restrictions on remittance ol' profils,
capilal, divid€nds and royahi€s or orher re6ons for fo.eign exchanse
tEnsfer uoud the wo.ldr7. Prcviously investon werc reqd.ed to rcSisrer
with $e central bank after entering into a legal conrmct for forcign d;ect
)45
investment. However, as per the recent economic refoms, the above
restriclion h6 been r€moved from bank remifting forci8n exchange for
repariation of proflls, paying royalties or paying any o(h€r ovels€a
obl;gation. This has reduced the tim€ it lakes for a foreign rcmittance 10 gel
ihrough from s€veral we€ks lo less than a week on a normal tansaction. As
psn of the new rcgulatiotr and 4ononic reforms, the State Bank of
Pakistan now requires infomal noneychangeB to regisler 6 fomal for€isn
exchange companies and the govemmenrappointed auditoF would audit
these new companies. Trading with corporations and individuals is allowed
in all inslaces ad can sry€ .s intermeditui€s fo. forciSn inv6tors to remit
'lo sum up it can be said that with respect 10 ovefconing the inhibirions of
the investoF, the presenl govemm€nt of Pakistd, lik€ all other govemm€nls
oflhe recenr past, has made adjuslD€nts dd cdicd out policy- making so
as to en€ouage gio*th in foreign investnents in th€ coulry. Ev€ry
govemment has its own target areas 1o work on for making the economy
more investmenlfriendly. Ove.coming &ese obslacles has .educed the
oveEll comtry risk quotient for the cconomy but a lot is still to bc done.
246
Not s rnd RefeRtrces
I liichengrccn, BoFy (2001). ch. l0: c0pihlcontoh: cryit.Lldea orcapihlFolly?"rnd Ch. rr: r'amin3 Capibl Flows Capital Fl@t ad (-rrcq MNachusdslF ue of T*hnololy: MIT Pl6s, pp. 237-233
2 $iglie Jo*ph E (2002), "c.piral M.*d Lib6didirn.nd fx.hdge Pxre R.aifts:Ri,f wirhd R€*rd.' ,re"rr o/
'h. ANi@ acoaenr af Pottnat md socidt
Ll.rc., (579.0) th. Am.ricd Acrded' of Pouticaldd SeialSciace usA. pp 231.2!4
I Eich.nsrun, Asry (2003tr O/' Ct . pp.274-275.
4 Srillie JoeDh E. (2002). Q. Cnr, pp. 226 223.
5 s**.vqDnliredgknicl.s4003kunne/trsuf-p.lttu-pohicllanigna/6 Akhtlt, snmsh.d (2006) Pa*istu - Eoromic outlst ed Prcspet" spceh by
Dr Slcmshad Aknff, Covcnor of thc Srire Bek ol Palisbn. ar e Adan Smithln{nut, Thun, S}ilailnd, BIS R.vi.w 71, B{k oa lnlemdion,l $neleD.N:
7 www inro4/excb.tpubs/n/wp400e*p0660.tdf
3 Dolhr, David. Hall*md-Orideier, Maq dd Mdgine. l.yc. (2005), _lnvcnnenr
Clim eand Fim perfomon& in D.v.loping Econonies. fhe Univ.uityolchicalo
9 w.fiid'ricl6.6nvp/rnickdoa moJQP/h 2002 S.prli 91751559
l0 Khrn, ashfaque, H. Kin, Yun-H!0n. (1999), FNiCD DiEr Invcsnenr li P.lisb:Policy lsues And Op.ntioal lmpli.arioDJ', Asio Dcrelopmcnr Banl EDRC R.ponSoi*No. 56 w*.adb.ordDocumenitEoRc/ReponvER066 df
I I P.khhn AllHu Of Srarislics 2006.*ss.shrpdl.gov.plrd.fl ntsdinictetionol scounrrnarional ac.ounts.
l2 Th. Wtrld Ba't Top T.n Cofrinis.o fim Inv6he.r in P.ti*n (2002).
ll Asiln Dcvelopm.nt Bdk lnnitut iosiobd 20{4), "lndust ,l Comp€tiriv.ness ACh.llenge for Plkistan , ,,lDr.Irrrute-Paki:t Rxtlent Mtlti,n S.nino
14 sian Der€lopment Blnk lnnnur (Ocrobi 2004), "lndulrial comperirivenc$ AChrllerye for Palist!tr . ADB In$nuie.PrlisLn Resdrnr Mksion Seminnr.
r5 www.sbp.sov.pkpublididr/fMR/ch.prd_l.df G005)
16 Ansi. lsh'qre Ann.d. (2006) "l{.r Inflow ofFo6i8n Priv.r. Inyesbenr Srac 6!ntOf P.kisbn-Sraristi.s D.ponmenlPalhran.www.sbp.ore.pk/.cod.rd^ednnow.pdf
|7 Asirn DevelopDe aek Insri6@ @. Crt.
l3 Kh,n. Ashhquq || Kin, Yun-Huf. (1999). (} Ct.
20 Int.mdrional Monery Fund, Inlem..iolrl Finincial Suri3rics M.imaorg 2004
241
2l sule Bank Of Pa[ishn. Fi6ciol Mdkcts R.vi.w. tw.sbp eov pk
22 Seurilics Erch.ngF Commission of PrlEbn, Nexl*t ' Ne* R.Sishtids in
K@hi Sl@k Er.hDs. Vol-5 No.lo Nov.nbq 2005. 'wv sp.aov pr
2l A}nbi Abdul tt nid. 'lndil:'@ oa K.fuhi S@k f,xhrnC., Kmhi sckExchoru. P.kisrD,- corFcb Dirision. sdislics f,krlim.n! 2005*}*.shp.ory.pUd.p.nn.nt9eE4s wdlly.pdf
24 The wolld Bank capirrliation b cDP R.tio of s€ldred coDnties 2004htlpU**r *orldbmk.org
25 ti. Clirk, O Mdrood and R. Tuneu (2002). Pdkiol Evenls AiTecti',8 dre PakktanSbck Excho4p: An Aml}sis of tne Pai lnd ForecoslinE the Futurc". Cr* Busine$Schdl, Cir, Uni!.6ity: lnndon, p.6.
26 lDbariorl Mon.crr Flnd (lMF) 1998. Wqld tionomic Ourl@k. wdhingion:Imdarimrl Mdebry Fu.d
27 ffi.sbC.orB{klpublidrionstuplF Jwpo8.pdf
23 Pa(kh Fcdrdl Bueu of Sbrhrics. *w.sdpat.aov p* 2006
29 Ndioml alrhodti.s and IMF s6fi crlcularions. 'rw.imt:org
l0 Khan, Ashlique H, trd Qsim M. A. (1996), lnfldion in P0kklu Revklted,'msPohktn Dewlopmnt ls}t,. Vdl. 35, No. 4, Part ll, Ptkhd Indluc ofDcvelopmcnt E onomics: Pa*. pD. 747-759
I I sn.d| S*ib, (M!y 10. 2005). 'Thc D$l Si& ofrhe Fofu. /a :,lMio ,.d,'tc
12 sss.sh.orB.p|Jpubli6rions/wplp.drp0l.pdf
33 Se.uiti.s Exch.nge Comission of Palin.n. hnp://*nw.sp.[ov.pk 2005.
la w.adb.oqldocumenB,trok9(1o2005/updidpat.sp
l5 Shah, Z.hir (2003J, 'Fi$al lncenriv.s, rh. Cosr ol Capilal and Forcign Direcllnvestmcnt in Pckistan A N*Clasicd Apprcoch', Annual CorfercNe, Pakirhlnsntoc of D.veloDm.nr Economics (PIDE).
16 Kho. Asharqle H. Kan, Yu-Hum ( I eer). (} c,rl? uw*.sbpila.p*/publididrs/*T.F.t*'03.pdf
248
The persistence of political instability, coupled with economic inslabilily,
crops numefous risk related issues for d investor in Pakistn. Th€ risk
associated wiih inveshenl in such e economy iends to be on the higher
side, which r€quires a Ftional approach lo risk meagement to deduce
desirable rcsulB out of th€ inv.stment decision. Pakisla, however, 's
acdvely se€king to inprove its narket structure by introducinS veious
refons mostly aimed at regulatory framework. This improvement aims at
enhecing its image in the intemational scendio to altract more foreign
investneni to elevate its e@nomic growth md boost the overall efficiency of
the ma*et, as the.e is deanh of indigmous resource aeneration.
Furthermofe, in Pakistan, after the 9/ll incident, bel;ef has groM rhat
mdkels here need improvements in theh legal dd inslilutional envircment
to attrao the investors looking to gain from the alobal adjuslmenls afrer the
incident. Claeser €t al., (2001)r ud La Po.ta et al.,(2C103)':have found rlat
the govemaxce of equity mdkel inlmedidi€s drough the appropriale
design and enforcement of law and regulalion, panicularly in emerging
markets. has received increased emphasis recenlly. The study b€lieves thal
sellie8ularions b) brolers. lo hardle risk (oncems in emersins economres
like Pakistan with costly law enforcement. are unlikely 1o be successtul. The
study also consideE that despite such concems, litle is known about the
co$s of risk measwment and forecasting issues. I! feels ;mpondt ro
discuss ib this chapter the issue of risk managem€nt and forccasting with
250
Arother alpect common.o emerging markets is the limit€d role they play in
Eising capital. In the KSE, therc w@ orly two new lisrinas mising S33
SECURITY PRICING IN PAXISTAN
s.ll. !E-Eses!!s@!-E:s!eisg
The Karachi Stock Exchange (KSE), despit€ b€ing the main exchange in
Pakistan, has more features faifly different from what one could €xpect in
mature markels md are compsraliv€ly tlpical of emerging markets
Bhatlacharya ed D&uk, (2002)r claim thal lbe KSE established ;n 1947, is
dound the medid aae fo. excheges around the world dd somewhat older
thd the lypical stck market in emerging economiesr. In the fiscal yeaJ
1998-99 i.e. beforc the stan oI present regime's control ofthe counq, the
market capitalisation was at Rs.289.2 billion and it ;s at thal dme the
econo'nic relbms were beins pur into force. ln 2002, il had 758 stocks lisled
wilh a total market capitalization of about $10 billion or 16% of GDP.
Howev€r, wi$in in a p€nod of six yea.s, Ihe market capitalisadon has
increased lo Rs.2,036.65 billion which is almost seven limes ofwhat it had
during 198- 99. The KSE caplurcs three foulh of the oveGll tradina
volume in Pakislan with the other two smaller stock exchanges covering the
remaininS one founh. Despite the small size ofthe marke! it experiences a
sugrisingly high tumover (88%). ln conlrast, a mature markel such as the
NYSE is much bigger (a market cap to CDP mfio of92%) and h6 not dhigh a tumover (65%). Both fte shallowness ofthe marker and the high level
of lumover in eme.Sirg markel! are of particular inler€st as the former
makes it more memble to, and the latter more ind;cative ofrhe prcblems
dising from poor infomation, insider trading, liquidity. and manipulalion.
million and l8 delistins in the markel in 2001. Out of49 emerginS mdkets
in lhe year 2001, 2E markeB had two or fewer new li$in8s in the yeat, with
15 ofthese ma*els nising les thd a million dolles. In contrasl, ofthe 50
markers classified b) lhe world Federalion of l-\change5 a5 non_emer8inS.
only scvcn had two or fewer new listings in 2001 md only eighr rabed less
$an a million dollars in new capital.
In addition 1o the high tumovef, the KSE h6 high p.ice volatilily. Over the
fiv€-year pdod fiom 2001 to 2006, th€ stock mdket experienced large
overall busts and booms as w€ll a! significant fluctualions over shoner dlne
inlervah. The standard d€viation of monlhly stock retums for fte KSE 100
;ndex duing this period was 15 (as compred with 5.1 fof ihe Dow Jones
index). Ihese moveme s N all the nore surpnsing, given lhc low lev€l of
real investmenl aclivity in lhe stock market. In brief, small and shallow
equny muket with hiSh tmover, Iittle real invsftrent activity, high pri@
volatility, and skewed siz distdbution @ all fstures of KSE thar de
rypical of em€rging stock marke$ around the world.
252
s.r.2.@Regulalory bodies in Pakistm have enjoyed nixed fonunes with limii,ed
suc@ss, ed most of them are widely vilifi€d for the;r inefficiency,
comption, contused agend4 and a Seneral inability ro regulale dything
beyond th€ir own vested inl€rest!. Howev€r the exception is lhe Securities
and Exchange Commission of Pakhtan (SECP) which h working senrly
towards the success of lhe corporale sector and has respecr at dintemarional level for esrablishing a repuhtion for doine rhc job what it was
setup for. The SECP was ffearcd to succeed the Corporate Law Aulhority,
m anached department of Minklry of Finance. The course of restructuring
the Aulhority was iniliared in 1997 under the Capital Marker Developmenr
p1m of tbe Asian Developmenl Bank. In puBudce of Securities and
Exchange Commission of Pakistan Act (1997), rhe SECP, having
autonomous status, became opeEtional on li Jeuary 1999 and rhus making
il one of the younAest of the indig€nous .egularory bodies wnh its scope
widened ex(ensively since iis inceprion, covering rh€ entire non-barling
financial sector. lnitially, it was responsible only for the rcgularion of the
corporate ed the capital market. However, subsequendy its errands were
expanded to include the supervision and regLnation of insumnce conpdies,
non-banking finance companies and p.ivate pensions. lt hs al$ be€n
entrusred lo watch out vdious seNice provideN io the corpoEte ddfinancial sectors, which add to the ranse of responsibilities and powers ofthe SECP.
253
In an era of globalization and commercialization wherc ev€ry organizition
needs to have a clear visualization as to where they are heading, and which
they tend to express with a grmdiose pomposity and a degree ofobfuscation,
it is mandatory for bodies like the Secunties and Exchange Commission of
Pakistan to exprcss the vision and miss;on umbiguously. The SECP has
set for its€lfa vision, mission md stateAy 10 pin down as to who has to do
wha1, where, and when, which is firsl of its kind for a resulalory body in
SECP has sel its focus to develop a fair, emcienr and a rransparenl
regulatory frame-work based on intematioMl legal standards and besr
practices, in ord€r to protecl investors and to mitigate syslematic risk aimed
at foslerina aro$nh of a robust cory'orate se.tor and broad bded capiral
markeB in Pakiste. The SECP has expres*d and pursued irs mission ro
develop modem and efficient coryomte sector and capital mdket based on
sound re8ulatory principles thal prolide impetus for a high economic groMh
and developing social harmony in the comtry. l. ord€r to work iie sfategy
oul 1o develop an elicie and dynamic regulabry body thar encourages
principles of good govem&ce in th€ corpomte s€cror. it ensurcs proper risk
managenent procedures in the capitrl mdket. In addition, pro@cting
investod thmugh proactive policy mesms and effecrive enforceD€nl
practices, the SECP h6 to @ntinu€ what ;r has been working on.
5.r.2.t. visiotr lnd Missiotr ofSECP
The SECP is operating in a rapidly expddins and intens;ryins corporate
enviroment, and in a wider ontexr. within an economy thal is showing
signs of developing strength in depth and $dth. In Septembq 2006. rherc
254
were 48,895 companies incorporated in Palistan plus 755 finance and
bankins companies. Despile nuherous gloomy predicrions in $e I90s.
ftere are at las! indications that Pakistan has finally dug h€6elf out ofthe
linancial hole it had fallen into prior ro the 1999 coup. Conlinuiiy ofthe
reforms provid€d by the pres€m govemment hd brought professionalism to
the sector not previously experi€nced in Palistan. Reliable sources arcund
the world have consislendy b€€n reponing that the Pakislani govemm€nt has
made substrntial economic rcforms since 2000 to promote investment,
especially by attracting the foreign investoF. In rcceflt y€a6, govehment
revenues hav€ gr€atly improved as a rcsuh of economic grc\th, tax r€foms
- wilh a broadening ofthe td based, and more emcienr rd colledon rs a
rcsuh of self assessment schemes and complion conlrols in the Cenrral
Board of Revenue (CBR) - and the privati?alion of public utiliries and
lelecommunicalions. Thes€ reforms ar€ tunher backcd by the steps aimed al
agarcsively cutting tariffs dd assisring expons by imprcving porrs, roads,
electdcity suppli€s, irigation projeds md lasr, but hot the least, the
education seclor. The developm€nt spending has doubled f.om aboul 2% of
GDP in the 1990's to about 570 in 2005, a necessary step towdds reversing
the broad uderd€velopment of Pakistian's social sectots which still lags
behind in terms ofcore finding in the budget dominar€d by the needs ofthe
Growing $abilily in the na.ion's monitory policics has co ribured ro
considemble expansion in the quanlity ofcredir some might sy loo much,
md the.e are concems abour th€ ability of bonowerc ro service all this new
found dedit-debq chuging rhe nationk consumprions and investm€nt
patl€rns during most pad the presenr govemeni. I lowever, due ro rhe
255
mounting inflarionary Fessure, the monetary policies have been aightened to
cul doM th€ c.€dn l€vel as th€ govcmnent is trying to s€arch ihe fne
tuing between the credit availability, investments and the inflation ral€ In
the year 2005, rhe World Bank report€d that Pakislan wG the top reformer
in the rcgion and at numb€r ten in crms of economic refonner globally -naking il easier to set up a business, dropping the cost to r€gister proPerty,
increasing penalties for violating cooperate govemance rules, and replacins
a r€quir€ment to licens€ cve.y shipment wilh two yeaN dmlions licens€ for
traders. ln shor! Pakiltan has op€ncd herself for buin€ss and in mmv
respects doing very w€ll and, no doubt, naintaining corporat€ probity in
such d environment is a challmse.
256
s.13.@
Allen and Cal€ (1992)" classiry, price mdipulation into rhrce categones
$anding on infomation, action md tmd€-based. The firsl relies on sPreading
false infomation, the second, on non- lrade actions that could affect slock
pdce, nd the tNrd, on traden directly manipulaling pr;es $rough iheir
tradinS b€havior. Moreover, given the several theoretical models of trad€-
bas€d m&ipulation, lhe sbrdy is ofthe view lhat Zhou ed Mei's, (2003)6
nodel is closest if, characleristics to what h happening in Karachi Stock
Exchange.
Apparcndy it is not hard to idenliry brokeN in the stock markets ofemergna
economies: in geneml, mmipulatina prices io their own advantage ar the
expense of the outside inveslors and KSE is no exception. Tbese brokers
gene.ally enploy fiequ€nt and $range trading pattems reflective of fte
mecdolally proverbial "pump and dump" maniPulation designs Such
schemes very regularly r€sult in subslantial gains, at times, even much
higher p€rcentzse poinb or higher amual retums than the bpical ouiside
investor. Such ldae rctum explicate the absenteeism of many potendal
ralional investoF ftom the capital market in Pakislan. Moreovcr, frcm a
political econony perspective this also helps to provide an understanding as
to why entrenched playeB s oft€n actively sbnd finn againsl efforts to
inrroducing reforms r€sulting in all sorts of scandalous aclivilies The
exploitalion activity of such kind can also be idenlilied to be ubiquilous
amof,g many ofthe em€rgin8 markets around lhe world Khaina and Sunder
(1999)', ;n a cas€ study ofthe Indian stock market, point out that "brokeF
*ere also often accused of collaborating with company oMers to rig share
251
pr;ces in punFand-dump schemes". Zhou ad Mei (2003)3 arsue that
manipulaiion is extens;vely widespread in many emerging markels wherc
r€gulalions are weak, dd rcveal thal China\ wo6t slock market crim€ in
2002 was a plot by seven peopl€ accused of usin8 brckerage accounts to
manipulate company share prices'y. The study afier takin8 ;nto account the
hisbrical data of mature financial mark€ls, suaa€sls that such manipulation
is a familid impediment thal young markeis have lo overcome. Cordon,
(2tl00)r0 shows a wide concem for lhe preval€nce of price manipulation in
these markets as subjective elidence indicates that meket intermediaries in
the fom of brokeE m mdipulative schemes, by differentiatinS between
trades done by a broker for his own sake md those done on behalfofthe
The srudy, having found compeuing evidence, rcveals lhal, on days when
the $ock price is relatively low, p.incipal brokeB i.e. b.oked who acl as
principal trade.s in the stock, mostly lrade amongst thems€lv€s. Conversely,
on high price days, most trade is done by outside trade.s and the principal
brok€rs st y out of the trading activities. Also the trading pattems of
principal brokers have sbons predictive power for tuture rerurns, which
'neans that p€riod when principal broke$ buy md sell stocks only lo each
othcr. olte. lead to positive retums. Furthemore, evidence also rcflects
manipulation 6 back-and-fonh principal broker's tradins appeaN lo
adificially i uce the pn@ b move up and onc€ $e p;nc;pal brokeB exi!
the market. pric€s collapse i.e. the abs€nce ofprincipal brckeB in fte market
predicts negative returns.
258
Despite the forcetul evidences for the presence of pric€ manipulation, it may
be argued thal rhe prcfitability disparity could also arise for reasons other
than price manipulation. P.incipal's uading profitability could be jBtifi€d
by two altemative €xpldations: matk€t timing dd liquidity prcvision
Principal brok€r could erm geater profils b€cause they are b€tler al market
timing for a multiplicity of reasons. For instance, they could have superior
ability to predicl fuiule stock performsnce or they could have better o. inside
information on a stock that they can us€ lo lime the mark€t Bhatlacharya et
al., (2000)" in a study of6e Mexican stock mdkd indic{te thal there is no
public r€action to corpomte news, and €xplain insid€r tEding b€for€ lhe
news as the reason. Either the ability or infornalion story imPlies that
brokers will buy a srock when its price is low dd sell when high as "buying
low dd selling high" by definition leads lo hiSher prcfitability.
However these explMtions cannot b€ comidercd suflicient fo. the
profirability r€sult d previous studies have sho*n lhal inforution
asymmelries or inclusion ofbroker attributes or even liquidity mersures fails
to ecount for th€ profitabiliiy differential. Natural reasons do exist to expecl
that brokeE have a comp.rativ€ advantage in engaging in manipulation
aclivities. They have lower transaclion costs in conducling the ftequent
hdes that could be nsessary to genemre mom€ntun in a stock. They have
better r€al-time information about the movemed in prices, volumes, and
taders' expectations, and they poss€ss a natuml advanlage in spread;ng
rumors or false infomation in the market. All these ftctoB are crucial 1o the
success of a manipulation strateSy.
259
s.r.4. !!![!.89gg!4e!&!s!
It is inteBlinsly useful 10 examine how capital narkets in Pakislrn deal in
retm of its regulatory laws pen ining to the stock markel both in absolute
terms and r€lative to oth€r countries. By drawin8 on a detailed
categorization of securities. laws conducted by La Porta el al. (2001)'r,
construcled two broad measures to caplure privare and public enforcemenl
implied by the secu.jties laws. The fomer measure captures the extent to
which securilies laws reduce the cos$ of privare conlracting by
standardizing securities contracts (by mandating disclosure rcquirem€nrs)
and clariryins liability rules for inaccurate or incompl€te disclosu.e.rr The
laner me6ur€, public enforc€ment. capur€s the extent to which a public
enforcer, the SECP in P.kistan, regulates the markel as detemin€d by the
basic atributes md investigative powers of the regulator and the ability to
impos non criminal dd criminal sanctions for violations of security laws.
In view of this study, what p€rhaps is the most damaging featre, although
tbe SECP is inovi:E in the righr direction, is fte weak prclection to invesror
in Pakistan- ln public €nforcement. while the country ranls very hish in
1€rms of the supeNisor's a(riburcs (indep€ndence erc.) and investi8ative
power, it does very poorly in tems of both non crininal and criminal
sanctions thal the supe sory agency can inpos€ for violations of se€urities
laws. Thus it ;s not surpris;na that to date there has hardly been any case in
which a broker $as prosecuted for improper acrivir.
260
5.15. ErsEEcls]lglc
Ahhough lhc KSE docs rccciv. sone dir€ction from thc S€curiti€s and
Exchange Commission ofPakistan, but it is predominanlly broker-mansged,
i.€., majority ofttte exchsnge's Borld ofDir€ctoB ate broke6. Funh€rmor€,
tlding on thc aock cxchangc is poGsible only through one of licensed
brokers, and inerEss into th€ brokenge system is r€slricted as a new broker
can enr€r only duough the salc ofan cxisting brokerage licens€. However, in
practie, such sales arc r.rc b€crus€ of the hid pdce of brokcrage s€ats for
instance in the ye€r 2000 lhc licensc of a defaulting broke. was sold for
US$.5 million in a mlrket wher€ per ctpirs CDP is only arcund $450 and
also b€cause th€se sal€s nornally lake place in thin matk€ti with access
limit€d to insiders.'' Thes€ features ate impoGnt from. Sovemanc€
peFp€ctive as th€y are kept ituentionally wcak !o support brok€rs, who ar€
cming stcady rE s fton sust'cclcd manipulation activities, aSainsl lhe
ma*et br€akdowns. All such ftslures and atnple anecdot€s allud€ !o a
significrnt amount ofbrok€r conrrol ofthe ma*et and the study highlights
this asp€ct b€caus€, in focusing on pot€ntial ma €t mmipularion, most
eviddce advocatcs for a closcr cxanination of bmker trading pattlms.
Exclusive interviews ofm.rk€t pgiicipants in KSE .nd LSE insinurte that a
subslantial numbcr of brokeF sct a! principals instead of inErmediarics and
such brokeE contribut€ !o potentially und€sir.ble activities in the m$keL
SECP itsclf b€licvcs lhat b.okc6, who Egularly act a! principals and not a!
intcrmcditics, usudly lead to ext€mely high tumover, widespread
spcculation 6nd very little g€nuine invesh€nt activity, with hardly any ris€
in capilal. To r€slor€ inv€sloas confid€ncc th. study f€els that slock
exchange nanagehcnt should be liberdcd ftoln brck€r innu€ne, and rh€
261
gov€mment nusr suppon and v;sibly seen to b€ backing the sBcP's reform
aSenda.
Brokers are 8€nerally s€en acting !s principals and not as int€rnediades end
eam significandy high€r reiums at $e €xp€nsc of outsid€ inveslo6 rradins
through inGrm€diary brok€rs. Although th€ r€tum diff€r€ntial is hiSh
enough to b€ of concem as deterrarc€ to the average investor ftom enlerif,S
&e malket, at limcs th€rc scclr|s no reason to believe thal this differential is
surp€cted. P.incipal b.oke.s could simply have greater ability or be in a
bener position to time the mffk€t. This is not surprising, given that the
outlide investor in an €merging markel is unlikely 1o b€ as exp€rienced or
traio€d. Some of the rccent reforms, by the govemnent regulalo.y authority,
the SECP, like appointing independent non-broker memb€rs to the bodd of
dir€clors, have b€en tsrgeted at wskening boker power, ahhough rh€se
rcforms have bad limit€d succ€ss. Tl|e isrue ofbroke. conuol in the pasl has
plagud markets during rheir e{rly stages. Ir now app€a6 lo b€ pr€senl in
emerging markcts today and se€ms co inuing to exisl in near tuture as w€ll.
262
sJ.6. I44sipd!$9!-!49$r!.is!
The study realizes the importanc€ of explaining why the principal tradins
result could stem from manipulation, especially in emerging ma.kets
Conceptually, one may exp€ct fo. lwo reasons that those who inlend to
reson ro narkel manipulalion, panicularly trade-bascd manipulalion, would
more probably be rhe principal brokers. FiBr nanipulation ofPrices is likely
to involve frequent buying and selling of lare€ numbers of shares in the
process ofsenerating artificial volune and price chanses- Anyone interested
in such an activity would wanl to minimize the trmsaction cosl of such
trades, md the natural step to tal(e for such m individual would be to buy a
brckemae licerse on th€ stock markel. Second, rcal-time infomation .bout
the movenent in prices, volum€s, and tEd€rs' expeclalions aie all trcto6
crucial to the success ofa manipulation slrate$/. Having a bmkera8e license
thal pemits one to be in close p.oximiry to other market playeF and keeping
an eye on information in real tim€ is a huge comparative advantage- This is
panicularly uue in an em€rgin8 market wherc the ;nformation technology
markets are nol well developed.
The mechanisn prevalenr in KSE suggested by the anecdotes and tading
pattems is a pump and dump nechanism ihal entails brokeB creating
artificial excitement by trading back and fonh in a slek, in the hope of
attracting trcnd €hasers and then exiting the market prcfilably beforc the
bubble buB1s. However, the above mechanism is exoemely slylized and it
relieson the existence ofmomenlum tfaders assuming that Broups ofbrckeB
get logether to manipulate prices as opposed lo individual trader doin8 so.'5
261
Agg'rud md wu (2003)'" describe the strategic maniPulation me€hanisms,
ihe fiBt such mechanism as againstto the previously discussed specific Price
manipularion mechan;sm in which two or mor€ brokers trade amongst them
ro generate artificial momentum. Such mechanisms rely oh asynmet y in
information to allow ev€n a lingle principal broker can artificially move
prices and mak€ money off investoB with less infonation instead of
requiring principal brok€rs to collude. Howevef. the application is rtre
despite theor€lically b€in8 possible. Anolher related mechdism, closesl in
spiril to the pump and dump mechanism, Presencd by Zhou md M€i
(2003)rr which is purcly trade-bas€d and assumes that a sinsle investor is
lar8e enoueh to manipulate prices withou! relying on infomational
The above price manipulation mechanism relies on positive fedback
invBtment stEtegy assumed on lhe pan of outside investoF. TNs study
finds that extspolative exp€ctations on the pan of the naive trader often
underlie such positive f€€dback b€havior. De Long er al., (1990b)rt edShleifer (2000)r' have hypolhesized such investment stra@gies lo explah
st@k market anomalies such as momentum and bubbles. However, whal is
nol cl€ar from the* tesb is whether these outs;dc ;nvestoa de naive in the
sense thal they are consistendy losing money of that momentum trading is,
on the whole. a profitlble strale$/. This is Possible if the extenr ddftequscy of mdipulaton is low atd lhere is sufficient momentum in the
mtuket so, in equilibrium, it isprofitableto be a momentum irader.
2U
As investmenls globalize and iinancial mdkets expand a.ound the world,
inveslors aE increasingly faced with questions aboul risk asGiated with
this globaliztion. When foreisn investors invest in cm€rgiDs economies like
Pakistan, they nay be r€warded with higher rclums. flowevcr, they are
cleady exposed to the political and economic turmoil that oflen characterizes
market like this and mos. of which has been discussed al l€ngth in the
previous sectio.s of this study. The investors have 1o make delailed
cohsideration as to how they would be dealing with the key issue that they
have lo face when €valuating investment decisions in emerging markeis due
to the existence of exlra degree of risk a comparcd to inve$ment in
developed mtrker. More importandy they have to calculate how mucb
additional risk premium should b€ charged when investina in these markets,
md for that, the investors have two distinct apprcehcs that can be used to
estimaie risk premjum. The first approach is based on hisl,orical risk
premiums whereas in ihe second apprcach the equity risk premium is
estimated by looking at the market pric€s of stocks and the expected cash
5J. Rist Premium Eltinrtiotr b Plki$ar
265
s.21. g!$9d!rlErgE!c!q-4ppl94!
In this approeh, by looking at hktoric data, we estimate what lhe investoB
have eamed by investing in equilies as oppos€d to invstins in risk free
;nleslments'zo. we will also co.sider why tbis apprcach is not suitable for
emerging markets. The reasn for using historical risk premium is simple lf;nvestors, on d average, have emed 5olo more by investinA in siocks thd
covemment bonds, ths this is a reesonable estimatc of whal they would
conlinue to nake in th€ tuture. Although, this eslinale comes with a
stmdard enor; d€veloped nuk€ls like lhe US would have a sl4dard er.or;n
the mnge of 2-l%. But with emerSing markets, i1 bccomes very dimcu[ to
get access to as much historic data as we do for lhe developed markets. Also,
the volarility in emerging mdkels is so high thal ihe conclusion drawn from
the historic equity pr€miums may b€ of little usc because of ihe large
standard error in the €stimates. While hisbnc risk prcmiums ourside mature
markeb cannot be €stimated wilh precision, we slill need an estimate of risk
premium. Thercfore, we starr with a base which can be as:
Equity risk prcmium = Bae premium for mature equity mdkets + country
By taking this into account, th€ country prenium would rcflect the exlra risk
in th€ specified m.rk€t, which would not b€ comidered in a malurc market.
The easiesl method used to measur€ country r'sk is by compdng lhe yields
on bonds issued by a developing comtr in dolld
d€nomination. This would help @mpare it with a d€fault-free bond yield in
the US or West€m Europe. Evo ifa country does nor have a dollar or euc
266
denominated bond. as in rhe case oflndia. we can compare lhe bond yield of
a country which has a dolla. denominaled bond and has the same counlry
mting a lndia. For exanple, if India and B@il both have the sme country
radns and the dollar denoininated bond in Bl"zil is p.iced to yield 10.5%
ften by comparing il wirh fte US Treasury bond rale of5% would genemte
a defaull spread of5.5%. This default spread ofBrazilian bond ovef the US
bond cd ale be used as the Indian bond default ratc. while it cm be argued
that the defauh spread on a bond is a reaonable measure of the defaull risk
for a counlry. it is also tru€ that bonds are relatively safer invesment lhrn
equiti€s. Therefore, if inve$ors demand a s.5% default spread on bonds,
they would l@k no. a higher spread for investina in equiries. Therefore, to
addrcss lhis issue w€ look ar lhe volatility oflhe equity mdkel in the country
rclative to lhe volatility ofthe bond market used 1o eslimale the spread. This
yields the following estimale for the country equily .isk premium:
Country risk premium = Country defauh spread ' (slanddd deviation of
equily/stddard deviarion of bond)':1
261
s.2.2. !Ed!!Cisg!!lI!!!l!4-4Dplses!
There is an alternalive apprcach of €stimatina .isk premiums which d@s nol
require hislorical data. In lhis approach it h assum€d that the cunenl markct
p.ice would be equal to the presenr value ofexpected dividend flows from
the mdket'::. To apply this method one rceds to first projecl th€ €xpected
dividend flows from lhe markel. The di$ount rale which fien equales thc
strcm of dividends to the crment market value is then considered as the
"impli€d equily risk premium" (IERP).
The advantage ofimplied equity risk premium approeh is thal it is markel-
driven md takes into coBideration the cwent events. h is not ba*d on
hisrorical data- ft is however compulationally inlensive dd depends o. thc
availabilily and reliabilhy of the data required for the model. While the level
oftle index md the divid€nd yield may be eisily available, eamings srcs'th
estimats are more difficult to cone by in mdy ofthe developing mrkels
The implied equity risk premium for a market can bc vcry diiferenr from the
€arlier approach, used by looking at Pdt dab. Pan of the reason is thal
implied equn) rist pemium is an esrimare in perperuir)
s.3. Q-c.!.!l!Le!J3&!!&!&-.14-t-!.3ss-4r-4
Qudtitative slock selection is delined as a struclured equily investmefi
having the aptitude to mix the markel level risk wilh the opponunily to allow
lor above market r€tums. The nucleus of quantitative slock s€lecdon is to
d€velop ponfolio or structured equity str_ategy thal 6 outperform the
ndket wh;ch requires coale$ed approach based on proper lrackins of enor
and risk embedded in any stGk selection strategy or ponfolio This speaks
for the strate&/ to b€ chaEctqized by risk conrol and a disiplined,
theorelically sound approach to stock seledion.
For mdy inveslois, the us of quantitative tehniques in buildin8 eme.Sing
markets portfolio is sub.iect to debate for a number of reasons Tlese r€asons
includ€ lhe markets are constantly changing, €merging mark€ls companjes
are difficult lo value, and $e dala is often incomplete ud inaccunte Many
of th€ previous researches in rnis area have focused on quatitative models
for the counlry dd s€ctof allocation rather than for slock selection because
this approach resls on the dsumption that rclalively large groups of
emergin8 mark€ts stocks are highly conelated and thus move to8ether'
leading 10 dominanc€ of country selectionrr. other r€search sugaests,
howev€r, that the dis.ipline of quandtative techniques can also be applied lo
srock selection. In these studies, three key concepts underlie modeling for
en€rging markets stock s€lection:
')iD
iii)
The mdkers are at difere stages ofdevelopment.
Each may have ils own unique cheacteristics, md;
Each mdket may have exposure to dilTerenl economic situations-
269
Mor€over. in many of lhese ma.rket$, therE are ft€quent political, economic,
and financial upheavals. These assumptions would indicaF thal the same
quandtadve faciors will no! work across all markers dd rhat each markel
needs a cuslomized model.
For emerSing markets, only few sludies investiSat€ the individual stock
selection, which has rendercd conflicting results. For example. Claessens er
al. (1998):1 lind evidenc€ for a premium fof large fims and gro$tb srocks.
Another sroup of Miters which include Fma and French (l998tr, Patel
(1998)'6 md Rouwenhorsr (1999)'7 repon a premium for smau fims and
value stocks. Claessens et al. (1998)'3 also documenr apremium for bela and
rumover, bur in contrast to this rcsull, RouwenhoFr (1999)r' finds no
evidence for either of thos. Althou8h the above mentioned siudics
considered a number of strategies, Achou et al (1998)10 cxamine a much
broader range of trading stntegies based on fim chamcterhtics, but their
sample includ€s only srocks ftom emerging markeB of Malavsia, Mexico
Ila (1995)rr urilized more extensive set of slrategies and larSer samplc of
stock !o examine the performance ofslock selection sralegies for emerginS
markets. Th€ir wo.k is.esdded complime ary 10 ttaney (1995)r'1, who
using counlry - wide indices, documenls thal emerging equitv markets
appear to be pr€dictable in lhe time-series dime.sions
210
5.3.1. O.P.M: i Crs. for Pakistar
Pakistan, being one of the emeraina markets, offers many opponunilies for
investmenr. but iacks the capaciiy to Provide structured appfoad ro
investment. Quantitative stock selection can & an av€nue ior new
rechniqu€s fior both structured dd active managemenl st.ategy to attEct
invesrmcnt. Mor€over, the capital mafkets in Pakislan being fairly illiquid,
qwtitarive slock sl4tion would add objectivity to ihe proc€s of ponfolio
management md hence would add lowards thc efliciencv of the capital
market in Pakisan. Quantitative stock selection. easilv aPPlicable to Kdachi
Srock Exchange, will also allow for comprehendin8 fie process of Ponfolio
managem€nt ed det€rmine lhe implications thal are denoted bv th€
vdiables used lo emble the proc€ss ofQuantilslive Slock Selection
The study also explores th€ performance of stck selection stmlegv for
Pakistan\ market. pffticularly in relevance to Karachi Stock Exchange ll
has l.ake. into consideration the rcsponse variables to detecl the pertomnce
of selected $ocks floating in Kmchi Slock Exchrnge l he oodel is sirnple
but the canon ofsimplicily will allow us to understdd embedded systeMlic
risk and slock reseruen r;sk lhat may cause implicalions on anv stock
Over the yeds Pakisrd s nnancial perfornance hd improved due to cedain
level of stabiliry in political and econonic $enano.'lhe capilal mdk€t of
Pakistan has matured durine the last few yeafs Betler regulalory svstems
have been put in place dd small investors' intere$ is now morc pot&red
thm ever. Besides, electronic syslems hav€ fu.ther made stock market
711
dealings easier and tresparcnt. ln addition, the relum on slock markel
investment has improved and the mutual tunds markct is also rapidlv
expandinS, which is sood for small investors. EmPirical studies of $e
Kdachi Stock Exchage have shown high volatility of stock price- Sludies
have shom that lhere arc few long-tem investoB Markd has become
incessanrly dominated by speculalors who invesl only in order Io make large
shon-rern gains. A ttr8e najoriry of inve$ors ente6 the market when it is
strong. and abddoned it when it falls. Tbe.e is smng positive correlatioa
between the volume oftrading and expected rales of rehrn The contr;bulion
ofthe stock markel lo financing long-len inleshent is therefore limned-
There ee good reasns to believe the infomadonal inadeqlracies in
Pakistan's capital markets dd that $€re @ banieBlo the dissemination of
informalion, and companies appear to divulge less informalion with a Sreater
time tag thm is the norm in dev€lop€d markeb. Morcove.' if the cost of
capiral to lhe speculator is higb, which is likely 10 be in an incomPetenllv
rcgulated finmcial system, dd tlEn the volume of tEding (md paniculdlv
the volum€ of arbitrage) will be lower than is necessary for eflcienl pricins'
On the other hand, neSarive s€rial coEelations are more l;kely 10 occur in
thin, speculative mdkets; the stock matket wimessed €xtreme bull;sh and
bearish sentiments during lhe period Jnuary-March 2005 The bull-run in
th€ stock mdkel was lriagercd during January dd it lasted for t*o months
dd a halt How€ver, a sharp d€cline commenced on 16 Marcb 2005
r€suhing in the KSE-100 index d€cliningby 25 p€rc€nt lo as low as 7,708 as
on 28 Mdch 2005. This was lhe founh set back for the mdket over the pdt
five years; previous setbacks €xp€ri€nced h May 2000, Sep. 2001 and Mav
2002.
212
Despite the extrem€ and abnormal volatiliF/ in March 2005, financial
stability was €nsured as aresullofthe r;sk managemenl measures introduced
by the Comissiofli the absence of th€se recenl reforms inroduced by the
Commission would have resulted in a cnsis silualion and the market being
closed. All trades ere settl€d and marked to rnarket losses w€re collected in
accordance with the reSularions. The sanclily ofthe contrad nd integriiy of
the system were prcserv€d. While a crisis vd avoided, the Commission
constituted a Task Force to conduct an independent and impanial inquiry
inlo the root cause of the situalion. The @ommendalions of the Task Force
included lhe €lih;nation of Cary-over Transactions (COT), which wd
already being pursued by lhe Cotunission. Afte. extensive consullalions, the
deadlines were relaxed to facilitale the maikel. D€spite vdious obstacles
faced during lhe process, COT was completely eliminated subsequent to the
close of the year and a Codinuous Financing Syslem (CFS) has been
inlroduced 6 d interim n€asw to repl@ CoT/badla fimcing in order to
enhance fie level of liquidity in lhe narkel while altemative modes of
leveraSe finacins are being developed which include maigin financing and
21J
s.4 l4!!s-4-B!*-Appre!s!le-Bi$-A$s!!s.s!l
A major concem for .esulators ed investors cspecially in emerging
economies is th€ catastophic mark€t risk and the adequacy of capital to
meet such risk. It requires a primary tool for ii.ancial risk assssment, and
wherc value ar Risk (VaR) methodology has become the slan.lard measurc,
financial analysts use to qumtiry marke! risk. It is dcfined as e mount lost
on a ponfolio with a siven small probability over a fixcd nmber of days-
VaR cm also be d€fined as fte maximum potential loss in value of a
ponfolio du€ to adverse mdket movements, for a given probability. The
grea! populariry thar $is in$rune ha achieved is essenrially due to 'ls
conc€ptual simplicity: VaR reduces the (market) risk dsociated with any
ponfolio Il)justone number, the loss associated toa given probabilily.
By its very natu.e, VaR estimation is hiShly dependcnt on Sood Predictions
of uncommon events, or catalrcphic risk, a common fealure of emerging
economies like PakisrmI. This is fof th€ reason lhat the VaR is calculated
from th€ lowest ponfolio retms. Th€ major challenge in implemenlinS vaR
analysis is the specification ofthe probability disribution of extreme rctums
used in rhe calculation of the VaR estimate. Duffie and Pan (1997)"
identified thal oul of my slalhdcal melhods lhat can be used for VaR
estimation, it 8ot to have fie prediction of tail events as ns primary goal
;mplies that therc is no room for rule ofthumbs to be applied.
Allhough vaR is a very sbaighlfoMard and intuitive concePr, its
measurement is a very exigent stalistical dilemma. The maturity of
techniques lo evaluate and foe4t the risk ofuncommon evdts hd moved
al a mpid rate in recent tim€s. and specialired methods for VaR prediction
are now available b be used in the investment decisions. Existine models for
calcula.ing VaR employ differcnt methodologi€s rcgardless of the fact that
lhey all follow a common brcad-spechm structurc, summarized in tbree
poinls viz: mark-to-ma.ker the ponfolio, estimalion of the distribution of
podfolio retms, and computation ofthe VaR of the portfolio. However, |he
main ditrercDces among VaR methods lie i. fte way they addrcss the
problem of how to estimate the potential chdges in the value of the
The numb€r and typ€s of approaches to VaR csrimation is srowing
€xponentially and it is both inpossible and b€yond the scope ofthis study lo
take all ofthen into account. These methods fall into three main caleSories:
Parametric predicrion of condnional volatilities, lik€ J. P. Morgan Risk
Metrics dd GARCH methods, Non Pdmetric prediciior ofunconditional
volatilities such as techniques based on historical simuladon and, Semi-
Param€ftic method, propos by Danielssn md de vri€s (199?a)rr and
Danielsen od d€ Vnes (1997b)s, for VaR esrimarion usins laih of
{ina.cial rctums, which has b€en buih upon rec€nt research in extreme value
theory, enabling inv€stos to accurately estimate the tails of a distribution
while combininS non-pammetric hislorical simulation wilh paramelric
esrimation ofthe tails oflhe r€tum distribution.
The results, which can be yield oul of each of these methods, can bc very
differe ftom each other, Beder (199s)r7. Hence, in o.der to decide which
melhodolo8y to choos€, it is necesary to unde6tand the underlying
215
assumptions, the mathematical models and quantitative rechniques ued.
Only after this preliminar/ srep, uf,derslandably one cm ch@se the model
thal can be considered close. to objectives.
216
Pmetric Models such 6 GARCH and Risk Metrics offer an explicit ddunambiguous paramete.ization for the behavior of prices. The simplest
CARCH model has two essential eleme s: the m€dculous sp€cificalion of
the vaimce equation and the assumption related 10 the slandardized
.€siduals. An additional necessary step to implement any GARCH algofithm
is the speification of the distribulion and, by and large, sledard nonnal is
$e mosl used distributior.
5.4.1. Alteruliv€ V.R Methods
5.4.r.1, Prrrtnerric Methods
Under the Rjsk Metrics approach proposed by J.P. Morgan (1996)'",
vdimce is computed usins an Exponentially weighted Moving Average
eslimtor, which matches up to an Inlegnted GARCH model, accenrualing
morc on current obseRations. This approach assigns diverse weights to the
pasl observadon enclosed in the observation period. As weishls declin€
expon€ntially, lhe most recent obsenados obtain a high€r weighl fian
prcvious obsewations. The "decay facro." d€termines rhe rale at which the
weidts on lh€ palt obsenalions decay, a-s they b€come far-away. The
aspiration to capture the twe of movements appreciably influences fiechoice of obseNation p€riod. While th€ Exponentially Weighled Moving
Aver€€ Model incarcerat€s volatility clusterine, GARCH Models proposed
by Bolldlev (1986)r'prcvid€ a derailed desc.iplion of volarility clusrerins.
The$ models permit for boft autoregressive md moving avemge behavior
in varimces and co-varimces.
211
The gen€ral €stimalion is that th€ above appro&h€s (both nonnal GARCH
and Risk M€trict tend to und€rvalue the Value at Rislq because tfre
normality aslumption of the 96nd.rdized residrals s€€ms not !o be s|eady
wfth the bchvior of fimncial retunls. However, the fo.rl advant ge ofdt€se
methods is that they allow a complcte charactGrization ofthe distribution ofr€tums, l€aving space for inproving iheir p.rformance by avoiding the
nomality assumption. On the cont".ry, both GARCH and Risk M€trics arc
subjec. to du€e difierent @us€s of missp€cificarion: tl|e sFcific{tion oflhe
vdiance equation, the distribution chosen to build the lo8-likclihood nay be
wmn& and lh! standardiz€d rEsiduals. Whethe. or .ot lh.s€ missp€cific{tion
issues are rclevant for VaR estimation purposs, is largcly an empirical
218
3.4.t.2. Notr-orrsmeiricMethods
Historical Simulation is considered as one of the mosi common nethods for
VaR eslimation which significetly simplifies the prcedurc for computinS
rhe Value al Risk, since il doesn'i crafi any distibutional assumption about
ponfolio retums. Histori€al Simulation is based on iie concept of rolling
windowsi however the choice of the "window lenFh" is vital to lhe success
of this e$imator- Small€r window measure is pfone to mpid and hasty
swings, while lhe longer whdow stable over lonSer
periods of time bul fall shon to hav€ the required uliUty. Historical
Simulation Approach is simild lo the equally weighted moving average
approach as, likewis€, it rclies o. sp€cific quantiry of p€sr hi$orical
obsenalion period. Howev€r, instead of using these obseNations to
calculate standard deviation, it uses the actual p€rcenliles of rhe obseration
Pe.iod as vaR meisurc.
Even tholgh this approach males no unambigLious assumptions on rhe
distribudon of podfolio retmq an implicit assumption is veiled behind irs
procedure: the distribution of ponfolio returns doesnlt vary within rhe
window. Because ofthis implicit ssump.ion seveml prcblems derive, like
the empnical quantile esdmator is consi$em ooly ifthe window siz 8o€s ro
infinily. ln addition. VaR esrimales based on the hisrorical simularion
methodology will be inclined downwards (conespondinsly upwards). when
the mark€t is poiAnant Aom a p€riod of comparatively low volaritiry to a
period of relatively high volatilhy md vice versa. Furthermore, vaR
est'mates relying od histo.ical sinula$on nay rcflect prediclablejuDps due
to the dkcreten€ss of extem€ rerums. lt is easy 10 predicr that rhe VaR
279
estimate will jump upward (downward) when conputing lhe VaR of a
portfolio using a rolling window and that one of the d!y's renm is a large
negative nunber. The sane eff€cl (rev€6ed) will r€app€e once the larS€
obseration drops out of the window. This is a very undesirable and
unatractive characteristic ad it is in all probability enough to cast off th€
historical sinulstion nefiod as a r€liable one. However d inlerssting
variation of the historical sirnulatioir melhod is the hybrid approach
proposd by Boudoukh, Richardson and Whitelaw (1998)"". The hybrid
approach combincs fusk M€trics and historical simulation methodologics,
by appllins exponcntially d€cLhing weights to pasr r€nrms ofde portfolio.
2E0
5.4.1.3. S€Di Parrnetric Models
The infieased volarility of finrncial maikets during thc la$ decade or so has
prcvoked rsedchers and pmclition€rs to come up with morc rcfin€d
approaches to dsess VaR. A number of methods have becn prcposed
recenlly 10 estimare Value al Risk, for instance. the applications of Extreme
value Theory Deielsson, and devries (1998)'r or courieroux and Jasak
(198f: ed applicalions of rcgression quantilc rechnique such as in
Chemozhukov and Umantsev (2000)ar and Ensle and Mmsmelli (1999f.
Funher app.oaches, fiat can said to fall in semi paramelric models catesory,
are those baed on BolleFl€v ed w@lridse (1992/i quasi,maximum
l;kel;hood GARCH, as suggested by Diebold, Schuennmn and Srroughair
(1999)'", and autonomously and independenrly implemented by McNeil and
F.ey (2000)47 sd Engle and Mesanelli (1999/3. A sinilaf idea ce b€
found ;n Hull and White (t998)r', although rheir model is not as srour and
robust as those mentioned above, since the variance is no1 estimated using
QML CARCH. Anyway, the study feels it enough to discuss only extreme
valuc lheory ar this and focus on other imponanr issues.
Extrcme Value Theory is a convenrional issue in probabiliry rheory. EVT
can be opportuely imprcssion as ar auxiliary 10 lhe Cental Limil Theory
wherc the CLT deals wirh fluctuarions of cmularive sums while the EVT
deals with fluctuarions of smple maxima. Ther€ are rwo differcnt ways 10
apply EVT where the first one is generally buili around the Hill eslimator
(Embrechts, Kluppelb€rg & Mikosch (1997f0 and Danietsson & de Vries
(197)'') md the second one is based on the concepr or exceptions ofhishth.esholds. Studies on th€ issue conside. rhe second approach 6 more por€nt
281
than the Hill estimator beause the Hill esdmator is designed only for dala
coming ,iom hervy railed distributions. Moreover. estimates based on this
second apprcach tend to be more stable dlan the Hill eslimator with .esp€ct
rc the choice of the threshold, as shown by McNeil and Frey (2000)r?. EVT
seems lo be a very general approach to tail eslination as its main strength is
thal the use of a Genemlized Extreme Value dislribution 1o parameterize the
lail doesn\ seeD to b€ a very resrmining and reslrictive assumplion, and it
cove6 mosl ofthe fr€quenrly used distriburions.
Ilowevq, there ae seleral prcblems that n€ed !o be addressed and rhe firsl
one to mention ;s th€ assmplion related ro obs€rvations that *eh ro be at
odds with the charact€risdcs of financial dara. Even though generalizations
10 depcndent observations have been suggesled by vadous slud;es
(Leadbetler, LindSren, and R@tz€n (1983)5r or Embrechts, Kluppelber adMikosch (1997)'{), yet they also esrimate the marsinal uncondirional
distribulion or innict condidons that rule our rhe volatiliry clusrering
behaviorarchetypal of financial data.
In addition, EVT is considered appropriate only for very stMpy levels ofprobabiliF/. To add to the issue it is exlremely difficuh to express before
hand as to what level probabili.y is deemed as low. llowever, Monte Carlo
sludy perhaps provid€s $me kind of dsislace in idenrirying rhe rare al
which the efiiciency atrd p€rformance of the EV't csrimalor declines while
moving away ftom the tail. Addirional problem that could b€ encountered is
lhe seleclion ofthe s€paration or cur-offpoint thar provides the number ofo.der slalistics 1o b€ applied i! the esrimation roure. tlle prcfercnce of the
ftreshold pose simila. prcblems a! cd be encounGred in choosing th€
numb€r of upp€r ordcr stliistics thrr nay cnt r ihe Hill *timstor, Th€r!
would be frr too few €)|c.ptiors n ddng in ! high vadee c$inaor if tulhrt3t|old k cho6.n !t a higll.r lcvcl. Cd.ry to this, if rhc chG€n lMoldi! loo lo% lh.d it would prcduce s bi.s€d €ltimator, b€s.d oo the ftct rhat
tt alyryaolic ry.i',dollim night b.comc v.ry poor. With lt!adv.nccn€nt in dl€ ffeld it i! d.finitlly not dirtrnt awEy whcn th6l! could be
spcciffc atrtidicd nd|o& otrd bob avaihblc to cloodc all optiEal
6r!!hold ed @ rould mt hrvc to rcly ol simulatiolts md grqbicd
2E3
s.4,14. es!!s!i!s!Jllu944s
Comparison ofthe VaR nodels is bofi a very tedious and meticulous ldkbecause ofthe scope dd significance ofthe risk dsssment issue in todays
globalize village. The Risk Melrics'M model is bNd on a restricrion on the
GARCH mod€l which has been rejected for numercus finmcial rime{eries.
The GARCH model is known for difficulties of aggreSaljon and peNistence.
However. the histori@l simulation is p.eny usetul, bur only when the dalaser
is not very lege md, in this case, not enough inforution available about the
profit dd loss distribulion. It ;s usually very time-consuming, bur enlails a
very si8nificant advantage based on rhe facr rhar it catches all recenr marker
crashes, m importdt fac€l ftom risk qwtification point of view. Since
Value at Risk is a very srriking featurc of risk
financial world. it cm be considered as th€ definirive object of atlenrion and
cunosity. Ary bad infercnce or drimarion ofir miglr hav€ very relevar( cosl
on the profitability of a findcial ma*et as a whole and therefore rhe study
believes ftis topic desewes tunher exploErion.
284
s.4.2. l4Bl!!lcs!!gleA!qtr&lg!
Earth .otates on ils axis in twenty four hours but the financial world takes
mmy rcialions wilhin ftal same timc period dd every rotation meds
smething got lo cheae. With changes raking plee so quickly, th€re @uld
b€ every kind of consquences mnging from the gro*lh oflrading activiry in
fihancial ma*ets to finucial turmoil, and hishly publicized losses suffefed
by vdious financial institutions around the world and have imp&t in the
wa) we now p€rceive risk- Risk alsessment has become nost souAht after
issue and the mosr widely advocated measure of risk is Value at Risk (vaR).
VaR measures th€ worst exFcted loss, under nomal market conditions over
a specifictime period with agivenconfidence level.
Equity Ma*ets in Pakistd have observed a very vibtui and significanr
expdsion during the l6t half of the decade well esconed by momenrous
reforms in lhe rcgulatory framewo.k. A new g€neralion of tresfomations.
largeed bwards rcdefining lhe methodolo$/ used rc wofk out margins paid
by members ofclearing houses across the stock exchanges in Pakisrd. The
much di$ussed cheAes to the .isk management a! the exchanges fiom rh€
Securides and Exchange Comission of P.kisrd (SECP) sussesr usine the
highesl estimate of VaR produced from thr€e diffe.ent models nmely,
Variance Covariance, Historical Simulalion, and Risk Merics.
The $udy b€lievs that a very serious concem is beittg addrcssed in arimely
mam€r and, therefore, these effons would result graduarion ofou. market to
a more superior state dd would enhece rhe confidence of local md
inremalional investoB. llaving said thar i1 is appropriare !o shre thal only
285
hdi. y VaR in th. n dy Ead.6t l.gd.nf rhougb rhe1! alr VaR b.€.drynnr! ur ulo d dl. .xchsrges aaroas r[c world ( Ifl. lrl.r8ifitrS sylra irhdi. is bcsd oo 99./a Cooftcncc Lev.t (using a z_vatuc of3.5) and lanbdrvaluc of 0.9t. L
Altemative VaR m€asures are widely known ro produce fairly dilTered VaR
estimaies mising concems about the optimal method for Senerating VaR
estimates in Pakisrd, based on empirical evidence aplly capluring the
volatility 10 produce VaR estimtes. lt requires a compreh€ns;ve evalurion
risk percepdon by panicipants of capiul markeis in Pakistan resultins out of
the growing concem in equity volatility dd the suggested changes in the
.isk management framewo.k ar the thrce slock exchanges in Pakislan-
Analyzing lhe altemative VaR methods using market index KSEIO0 and
selected stocks, for the period July | 997 through June 2006, a p€riod marked
with groqth, volatility, inarke! micrcFucture chmges, and political
instability. Ir is, therefore. a long enouSh period 10 lalidale rhe use ofa VaR
Model and it wd obsened that KSEIoo Index retum disrribution had
neaative skewness and display fat rail.
The tests for the veiance of retums for rhe Index ard Single Srock in
Pali$an hvor using Risk Metics in addirion to having orher Erionates thar
mak€ Risk Met.ics altraclive for p.actical realization. Risk Merrics is very
closely .elated to moving average and, for thal reason, it is very easy ro be
mdeEtood and expressed. Furthemore, in order b esrimare VaR for
ponfol;os, it is fai.ly ea3y to put into opeErion Rkk Melrics as opposed to
iis counte.parls and ftere is no requirement to esrimale parameFr for long
run volatilily as in $e case ofcARCH Models. In addition, rhe risk metrics
al$ coveF the concems for regularoB ed cledina houses in Pakisran when
mdkel .isk measuremenr is based on it.
s.4.2.1. .g!e@-Bi$-I4e4L&LEeEs!e!
241
Since orly Risk Metrics is considered to hav€ the ability to qpbrre lh€ time
varying volatility of the KSEI0O in Pfistan, it r€quircs turth€r tuturE
cxploBtion and not limitina lhe efrorB lo the varisnts of Risk MeLics. The
preference to risk metdcs Fovided on lhe b6is of a general impression of
the models is commonly used in $timation of end of day volatility.
Ho*€vq, a filnh$ rts€arch is rcquirEd !o lest lhe ext€me value volatility
estimates, which fiay rEsult in b€tr€r undcrsrandinS and .vduation ofmarket
behavior in Pakislan.
288
5.5 !tds!!s-!e-B!4-!4igs3$s4lee!
The benefits of hedeing caluro. b€ denien by ey mes, especially witlt
reference to lhe r€ward they provide to ein€rging ma*et economies which
include risk trasfer, price discovery, and morc public information.
However, the introduction and development of hedging instrument should
not b€ considercd 6 a substinrte for financial, capital and commodity market
reforms. lt can b€ argud rhat the success ofhedSing inshments d€pends on
lhe strudure adopled56. The empirical evidenc€s suppod ihe proposition fiatthe core fiDctions of h€dging, while rcmining sme acros the markeB, can
be tulfilled with different insrirurional anEngemenls.
The study is ofthe view that the most importanr m€ans ofprcviding hedging
facility is to introduce and d€velop the denvadves markets as arguably thes
mark€b are beli€vd to be conplementing developmenb in rhe stckma*els in many countries at l€ast to some extent if not on . larger s.ale.
Abken (1994)r', Beckefli (193)13, and Srout (1996)5'qa.gue rhat rhese
d€rivatives ndkets have jusrified th€ atlenrion giv€n to them by growing on
enormous levels of global tmdiq for both exchange-rmded producrs ddoverthe-counEr products. Remoloia (1992)s has found lhat lhe explosive
SroMh in derivativ€s betwe€n 1982 ad 1992 bfought trading at levels
exceeding $20 trillion. lt w6 also found that by th€ etrd of 2006, stock
markets of ern€rging markeb have groM in nurnber of domesdc compdies
lhred in them in addition to their capitaliurion beins increased many a fold
over the past fewdecsdesor.
289
The study suggests that derivativ€s markets facilitate the ransfer of risk
amons economic asents by ofI€ring mechdisms for liquidity and price
discovery". However, this function can b€ performed efliciently only wirh
p.oper iBtitutional arrangements and a suitable excbange microsrructure.
Merton dd Bodie ( I 995)" dsu€d that resdches have be€n done 1o suppon
the prcposition that lhe core tunctions in lhe financial system are the same
scrcss time ad place, bur fte institutional anangemenls, ltuough which
these tunctions a.€ perfomed, are not. Core flnctions in the financialsystem
include clearing and senling paymenb, pooling resources md providing
shres to facilitarc diversification, tmnsferring resources across time and
space, managing unce.lainty and conlrolling risk, providinA information for
pricing inshuments dd contracb. and d€aling with alymmeric informafion
and aSency problems. However the functional approach suppods thal fte
inslilutional fom follows fimcdon.
29n
s.sJ. !e!e-sl-Drdve.!r.!!-Ers!4!r!!
Th€ study assumes tha. there is no denial to the claim lbat derivatives
exchages have contributed to the d€velopme of the findcial
infrarructure of many emsging market economies by facilitatina the l;nks
among cash markets, hedg€rs, dd speculators. In addition, with the global
deregulation of findcial Mkels; derjvatives exchang€s hav€ captivaled lhe
inlerest ofacademic literature. However, the siudy claims thal lhere is still a
lot to be €xplored aboul the internal organiztion md funclion'ng of these
€xchanges despite muy resdcbes havinS ben conducted ove. the yem.
Bensaid, Lens€, Pages, and Scheinkman (1992)s and Bick (19s2)6' have
t.ied ro explo.e in detail the ;ssues of valuation and pricing of derivative
producls. Funhermore, Damodaran and Subrahmanyam ( I 992)'" and Scon
(1992) have focused th€ir attenlion towdds the issues relaled 1o the
infomtion content of prices in derivalive cont@ls ln addition, Hodges er
al. (192)6r, Hull dd whir. (1993)63 and Lee (1994)6e evaluate fte issues
rclated to the pricing ofcomplex instruments under differenr sp€cificarions
of uderlying assets pammeterq and the issues relaled 1o efficienci€s of
derivarives ma.keb was t€rgeted by Crai8, Dravid, ed Richardson (195)'0.
The study finds tha. benefirs ofderivativ€s exchanges arc not limited to risk
reallocation and price discov€ry within a country, but the additional b€nefiij
encompassi more infomation b€ing publicly available. improved diftirsion
of price arld oth€r mdkelrelated information, supenor dedit sysrens, nore
@eptrve capilal markets, highef standardizafiofl in r€paymenl rules ddm&ket surveillance, rcduction in tmnsaction costs, precise forrard p.ices
and, therefo.e, more €fncient allocation of re$urces. Bhansali md Wise
291
(2001t' also observed in fte study ihat in several emerging markel
economies, the developm€nr of derivatives exchanges, alo.g with stock
darkels, sends a message to intermrional investors ftar capitalism is nol that
bad after all. However, the study would like to make this clear rhat the
desirab;lily and effectiveness of a derivatives exchange dep€nds primarily on
fte status of the counlry under focus but also on the design of thal exchange,
dd then on the character of local comodity dd tnflcial markets. After
all. an illiquid derivatives exchange very expectedly would not inspire
confidence 10 neither a for€iF invelror nor even a domesric agent. Il would
also be obseryed thal in quite a few siruaiions. rarher tha sening up thei.
own derivatives exchanges. mrny emerging econonies could do better by
lislins their products in olher r-vell e$ablished exchanges. For exampte,
derivadve instMents on Larin Am€.ictu srocks are tFded in Chicago ddnot in domeslic markets wh;ch, if looked from the opposjre u8te, rcfleci
thal the regional exchanges can aho b€nefit form a number of sma er
emerging markets within the region.
297
5.5.2. D€rivrtivs Mrrket ir PaktulrD
It has been found by the rcs€dch thal the d€rivatives markeb have played a
major role in developing the capital markets in many emerging economies.
The markers have contributed also in rhe context ofmore balanced allocadon
of resources, transfer of rhk mong agents in a counrry, and even conraining
risk across countries. Although the.e are concems abut the explosive
grcwth ofderivatives and the risks $at they may create. srill ;r appeN thal
rhesc mrkets arc increasins $eir business as the global dereguladon offinancial markels md ma*et liberaliation have crcared new ineestnenl
opponunilies and risks that require the developmenr of new instrun€nls.
Agents in r€cendy lib€ralized market eonomies de exposed 1() more risks
such as commodity pric€ and intercn de volatiliry, and require appropriaF
hedging products to counler fiese risks.
The study is ofthe opinion that even rhough in Pakistan, de.ivarives have
been comparalively a new-fdSled concept until r4ently, yel rheir volume
has increased manifold amidst rhe eecdoral market md .egulabry
environmenl. In response to rhe evolving market dynamics and in order to
develop m efficient derivatives markei, SBP iss@d linmcial Derivarives
Business Regulations in 2004 to look after Overthe Counter(OTC) financiat
derivatives ma*el wherea! rhe SECP worked on estabtishing derivatives
exchange. Prior to th€ issuece of FDBR, bmks wer€ atlowed to undena,l€
the busin€ss of linocial d€rivatives affer getring spccific approvats from
SBP. How€ver, now, with rhe issuarce ofth€se guidetines, rhe banks/ DFIS,
besides meeting the eligibilily crirer;a specifi€d rherein, also obtajn
Authorized Derivatives Deal€r (ADD) o. Non Mdket Maker lnsdrution
293
(NMI) status from SBPi are allowed ro undertakc dcnvatives business
although, al prcsnt, the regulations allow three types of transactions viz.
Intercsl Rate Swaps (IRS), Forward Rrte Agr€enents (FRAS) dd FX
The study finds that as per the statistics revealed by the SBP the, derivative
trmsactions have grown substandally owing lo the growing interest of the
markel players since issuing rhe direclives. Resulrantly, lhe ddvatives
phye6 in OTC derivatives market alone have reponed a substanrial growlh
in oustanding derivatives contrads wirh a notional value of Rs. I | 5_5 billjon
as ofMarch FY06. compared to Rsl4.5 billion in March FY05 despile most
of these transactions being then under rhe IRS caregory by md large being
undenaken by the foreign bmks. h has come under obseNalion that bdkshave been quite energetic in carrying our derivarive trnsactions as the majof
ponion of th.se transacdons ties with rhem dd whitsr fte bmks can
undenake derivative transacdons for hedeing md market-making borr, the
most ofsuch ransactions were assum€d for hedgi.g reasons. However! now
witb greater market sophistication, rhe transacfions for rhe latrer are expecred
10 Srow more in tuture.
294
After a detailed discussion, th€ study concludesthat Pakislan's Slock market
has been the b€s. performing ma*el in the region. This shows from the facl
thar lhe Karachi Stock Exchmae (KSE) shate index ftat stood at 1,507
points at the end of the year 2000. has now reached rccofd levels in th€
viciniFJr of 12.000 po; s with meket €pitaliation being close to $57
billion, or equival€nt lo 44% of cDP at rh€ end of fiIs( quane. of 2006.
Howevcr, the study believes that the presence ofhigh degree ofvolatil;ry is
a mmif€station ofslructural wealness in the sto€k exchange. overleveraging
of the ftarkd, dd maryin calk, which have triggercd heavy s€lling,
neryousness with the introduclion and settlemenr ofthe conrinuous funding
system (CFS) to do away fully |jtrh CO'l (ha.lla). ti8htening of some
rcgulations, introduction of univers3l idenrificarion number for brokeN, in
addilion to those discuss€d above. SECP in an effon to boost invesror's
corfidence and curb the manipulation powers ofthe brokers. did launch a
prcbe inlo shon and blek selling. Il ale proposed measur€s ro riahlening
the .isk manaaement practices ai ih€ srock exchanges, addfessing issues ofnettina of open meket positions across these markersj marking mdker
]b re$ore investor's confidence! the regulalor is encoura8ing synemadcatly
the slrengthening of govenme of exchanges by resrructuring of Boaids and
appointment of independenl management, encourag;ng the dendualization
of exchanges, while strenathening risk manaAemenl systems that have
involved the introduclion value al risk approach and circuil brcaker limils,
proper capital adequacy fo. brokers elc.Investoas confidence willb€ turther
enhanced as afier incorporation of the Code of Corpomie coverndce into
the lislina reguladons of stock exchaaes, rhere is enhdced vigilance to
295
check undisclosed trading and front ruming, and eifecrive enforcement
mecheisms are implemeot€d.
EfTofl! are und€rway 1o achieve market development through the
intoduction of stock futws. oveFtle-counter m&ket and online access for
Inlemel trading and over the period phasing oul of badla wiih CFS and
eventually margin financing to provide tundirg ro l€veraged investors ln
parall€]. the SECP has felt the need for introducing more sophisticated
me.ns of risk midgation by introducing derivatives insllMenl and has
work€d for senhg up derivatives excharg€s to facilitale inveslors with better
meds of risk manaS€ment. Apan ftoft this, rhe study is of the opinion lhat
the setting up of rhe fint tully autornated Natio.al Commodity Exchange.
which plans to introduce tEding in derivatives, mainly featu.es conrracb in
commodities slarting with gold conlracts. I1 will lale. expdd to agro'
commodily contracts such as cotton, rice, and wheal would hmher exp6nd
fte markel here. R;d;ng on dle strength of the stock market boom and in
rcsponse to the reforms made to maj€ an investment friendly envircnmcnt.
fte investment avenu$ for investors in Pakisun have more lhan tripl€d in
rhe la$ few years and the study visualia itcontinuinS in the long run-
296
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4l D.ni.l$on, J md C. de Vrics (1998), "B.tond lh. Smple: Exteme Quannk udPmbahilit Enindion , Lrdd tdrel o! Ec@oni.t, l)isclssim Pt{f,j 293
42 G.uridu! C. ed I .l!$l (1998), "Trrcd Mdimum Likeliho.d. Go.dnes ofFirTs ed Tail Analysis . Ihp,klbhzd Mdwipl
.13 chflodukov, v rd L. Udm6.v (2000), "Condnioul val'HlRisk: Atpct ofMod.lilg rnd FiiDttid ', Sbdfo'd U.iv.Fily, pEpnnt
14 EnAl., LF. od S Md!'alli (1999), CAVi.R: Conditiml Vde d Risk by
Qudil. Resresion ', ,vrtX, Woi*in8 P!p.r 731 | CmbridSe. MA 02133, USA p 2
45 Bollml*, T. dd J.M. w@llidS! (1992), "QoaiMdimuD Likelihd.d Ejimtaotlnd Infmce in Dmdic Mod.l! whh Tim. V.rying Co vorimes", &,M.r.r.Rev8r I l: pp.l43-145.
46 Diebotd. F., T. schuem.nn and J. St$sl*n ( 1999), "Pitfalls and Chponunni* in rhe
Lse of Exrreme ValE Thsry in Risl M.Mgrm. t .,4.leanc.s in ConpuationolF,'d.!, Klurer academic PDblirh.u: Aftcrd.m, p, 16.
4? McNeil, A.J. dd R. Frcy (2000), "E imatiot oa TdlRelded Risk Masures forHeens..do$ic Firdcill TiDe S.ios o Extcme valle APprotch'. Joumal ofEnpiial Finre, 7: p 274.
43 EnAle.R.F.dd S. Maneln.lli (1999), Op Cit p.4.
19 Hull. J. od A. wniki (1998), h@lpoltin8 VoLrility Upd.ling inb the Hhroridlsinuldid M.rhod for v!^_, ItE Joorol o/xi'l ( I ), Ituisive Media: t on,UK
50 Enbrehq P-C. Klupp.lhcg.ld T. Mil@h(1997),,{,.&t/r,g Eure,'d EE?Bj, |BWM a..t Fi@e".sctin3d: &rlin. p.66.
5l Doni.rs, r. rd C. d. Vri6 ( 191t7b), OP Cit. p.241
299
52 McN€il. AJ. ud R. Frcy {2000), (h. Cit pp.275-217.
t3 L€dbdd, M.R" G. LindgH nd H. R6@n (19a3),'ExtrM Mt Retdedlrcpef,tes oI Rddon Seq@rc.s @rl Pedrx.r". Ne, Yott: Sp.ina.rverla& p 24
54 Embrcchs,P,.C,(luppclb€rgandT.Mikosh(1997),OPCir.p 42
55 Matrgoellia.d Etrgle, (2001),'Valuc sr Risk Modek in Fii0ncc', E tuAm QnlrolBank lvo*irA ,aW Senes, \to*ing P.p.r ro. 75, Fhnkfun. C.many. p 3
56 Bhdsfi. v. (197). lriatA @d Mua|iry Boft atul E&A Ortra', McOm*'Hill: LodoD. pp.65 66
,7 At&.n. Pder A. ( I99a). "OwGrhdcount.r Finmcial D.riv.riv6: Risky Busins?,"FRB Atlmla lrNni. Rerie\\1 9(2). F.d.Bl R.srye Bank, NY pp.ts
53 Beketi, Sed (1993) Are Derivarives Ttu Rhky For Ba!ks?,' Emnomic Review.v73(3), FRB Kesos City. pp. 2910.
59 Sbu! Lynn A (1996)."Dqivdive Tnding In A wond OaRir[ Ard Uncetuinu_.A'oolin8s Rdid. , v l4{ I ). I1ie B@lin8r lnnibrio: Wahin4d tr. p. i9.
60 R.molona. Eli M. ( 1992). "Ihe R*nt GoMh Ol Fimcial Oqiv{ive Markds," FX,NN rtk Quoflerl, tuvia, u t7 (4), F.d.ral R.sre Bant. NY p, la.
6l DAd Univ.nh, Developnenr Re$arch CnW, The Wond B8trk. (l997l. ThoShdue of Deriv.tives Exchflges: Ler$nr lrcm Dclelop€d aM Em.rgine Ma*es .Colle8eof BusinsAdhinitbalion, Drcx.l Lhiv.Fig.pp I 2
62 &aal J.D., 1200a). 'voldiliry of InGmrional Fimncill M.rl.ts: Reslldion &Findci.l Suo.*ision . Fim /rr'ia Indirn Inniur of Fiuncc: Oelhi. D.l3
63 M.non- Rob.n, C. dd Zvi Bodie. \t995), rh. Globtl l:in@ial Ststen: Afutuiuol Pe^pectire . Hcd^td Busin.s Sch6l Pre$: USA. p. 24.
64 Bensid. Benrrd. Jecn-PhilipD€ L.sne, H.n Paaes md JGc Scheinlm. (1992),''D€rildivc As$r PricinA Wirh Ttue.lion Co(:' Mdletuic.tl Fia@ce. v2\2),
65 Aick Avi. (lg32tr'Comndts On Th. Vlloition Of Denvdilc Asds." ldml ofFin.ncialEconomi.r vl0(l) Simon S.h@lolBusim$, Univcuh' of R&he*: NY
66 lramodamn, Aswrrh aid MrniC Subnhm!trrdn. (1992), Thc tifaect OfDe variveSeurnies On Th. Makeb For Th. Undcrlyin8 A$els l. lhc Unncd SaB: AS!fr.!,^ FitNial Mukzt' latitutioB @d lnftrne,B. . \l\5), t.l2
67 Hodg.! Stw.d D., Michtrl J. P. S.lby. lrs J. Clwlo*, Chrh R. SbicklMd andXinzhms G. Xu. ( 1992), "R@d Dewlotm.nc In D€rivariv. Scu i.s: 20 Yffi OnFrcm Bfack Ard Schol.i" F m.kl Metds, I4tittins md Innntuh*, , rlts), pp.
63 Hull. John and Alrtr While. (1993), 'Otr.-Foctor InEres.R . Dcdvdive Securniei"rawnat oJ Fkoreat ahn Q@ituiE ,rmrrq !2E2), univecny or wahiDerotrSch@l or BusaGs Adminishtion: w6hin3tor. pp 239,2.11.
100
69 r.., B. ,. O9aI 'l{olt rdi. T- Of Dan i[ R-ti.rl@ R.hr. Toheduf Ma..it -o,'E drb let,,\*542tP'ltt
?it e.it Ar-i, ^iry
Di,n -d ildlte rillda (l99t) 'ltLi. Etr idtAnd ft. C|drr s@ sqp.rih! Blt !s U3i!! FddaDa.rd Dcnds"Jotut { Fhed &Mit,,v!9(2,),SI'Ms.i@lof hdh..* UohdivofR@lF.dd: l.IY !0, UGUI.
tl 0lr@|i'VnturB,Wb.,(!,OU"FdE iBldt6lbR|!|(ItNdurdd&{dMrr..a lDiCOr gC NaFi C- Dna Ndpa! CA 9660, P. t.
301
6.t Re3effch Findim.
In this chapter, the focus ha been on performing analysis of responses ftom
fie survey caried out ,nd intervi€ws conduct€d md th€fl the views and
€xplanations of each response has been discussed in detail. Th€ number of
respondenls and tlEir respons€s in ,erms of percentage of btal rcspondents
has b€€n summarised in lhe form ofpie cha.rs after each ofthe question. The
study ba taken ! sample of forty five respondents to express their opinion
against fte quest;onnaires, in addition to €xplaining lhe rcsponses ffom
twenty marker p.&tition€r beinS inreniewed. In lhis part of the chapte., a
combination ofquestionnaire responses by respondenls, and the obs€rvations
and @lys€s of interviewees ar€ combined. Funher explanarory illustrarioN
on respondenls are also prcsenBd.
6.1,l Irv$tmena Elvironmept CoIduciven€sg
Tle sludy has 6ked ro express in lh€ frsl place, rhe satisfaction of marker
participdts about the conduciveness of the Palistani investmenr climate.
Sroung p€rception exisr within th€ ecrnony rcneds a posilive picture and
th€ sm€ is r€flected in th€ r€spons€ as larg€ number ofrhe respondenB said
that in the recent yeals, rhe inve$ment environment has become mor€ and
conducive for new inveslrnenb but srill majority of them werc ofthe view
that therc is still a lot to be done.45% agre€d and 55% disagrE€d to rhe
qu€ry whether the inveshenr environhent was conduciv€ in pskisran.
l0-r
Those who supported the conduciveness of environment factof argued that
Pakistan has inlroduced a wide range of incentives dd reforms, congenial
for both local and foreign inveslors. The country provides a one-window
faciliry for setting up business. and foreisn inveslmenl is iully prolected
under law, including avoiddce of double taxatior- The reorientation in
policies design€d to attract more FDI, has ben acconpdied by lhe adoplion
of policies rclatinS 10 privatization and deregulation of economic aclivity
and grearer relidce on markel forces in the country. They claimed rhal
Pakislan is now one of thce countries in the re8ion whose r€foms and
economic achievements duing the last few yearc have sleered the counlry to
a business-friendly envircm€nt, creating a win-win siiuation for borh
'nvesto6 and consumers. Pakisla has emerged as a fdr growing economy
with sound mafioeconomic indicators, low production cost, effective
regularory frmework and investment-fri€ndly polici€s with an invesrnenr-
conducive envi.oment, and grcwing peace in the region. tley rciGrar€d
lhat Pakistan offe6 enormous opponunities for foreigh invesrors nenrioned
in the World Bank repon 'Doing Business in 2006r' !s amongsr the leadin8
economic refomeB ofthe world dd the top one in South Asia. Sp€cifically,
Pa,Listan is better placed in di$losure dd investor prctection index in
comprison tote averaSe ofthe oEcD md south-Asim region.
When funher 6ked io pinpoint rh€ reason fof believing cnvionment as
being conducive, 45% responded Economic, I0% rcsponded Social 25%
responded Legal and 200lo responded Poliri@I. Funhermore, they r€sarded
inflows of foreign investment as rhe key ro economic gro$th and
appreciated the role of govemenr is implenenting policies .nd .egularions
that de morc investment friendly sd en@uEAing for rhe invcsrors.
104
Those who disagreed with this view argued that the Pakistani environrnent
may b€ becoming more conducive with passae€ of lime bul the pMess is
loo slow as rhere are systematic problems. To them lhese problems afe the
main inhibitions to making the economy mo.e conducive to foreign
invesrments ranging ftom $e slow md eEatic panern of developmenl jn
different sectors ofthe economy !o the level of comption prcvailina in the
econony. To b€ more precise some of them pinpointed rhe polirical
instabilily as the main reason for non conduciveness narure of rhe economy.
Theyclaimed that many invesio$ have paid a hea\a price for overlooking or
ignoring political stability faclor in other pans ofthe world. The sme issue
is prcvalent and coNide.ed as th€ hallmdk ofPakistan's rconomy thercby
denting confidence ofthe foreisn invesror. Some ofrhem laid fte blame on
the Pakistdi leSal system which may be t@ slow and cumber$me and most
of the time it place investors uder complex leAal siruarion. Furthermore
sone have obseNed thal as economic fiDdamentals brve nor been moving in
the righl direction since 161 many years and have forc€d rhe foreign
Investod to adopt exba cauliou approach towalds invesrment in Pakisran.
The respondents also consider€d s@iat issues as an of elemenr non,
conducileness nature ofthe mdket. Sone poinied towards rhe feudal culrure
in the sociery as g€nerally mas*s feel esuanged fiom rhe govement and
irs policies. All kinds of sociat problem exist ranging hom so€iat injusrice.
to socisl inequality; to in€ome disparity ro tack of rule of law and so on.'lh€* $eate doubts amona the population as they feel ftat govemnent
policies are aenerally aimed ar privileeed ralher thu masses making
implenent.lion of the policies md r€gutarions dimculr dd compticared.
Any major chdSes in policies prompr the existing investos ro susped the
105
rr.!dl3 b.hfud lh. chsngF ed rt !! Gistins .grnt3 in i&plcodtion of
polioi$, r.nd€rirg t!. invcstd.nt .nvironm€nt non'conduciv€ Most ofthe
r!6pood.ots xfto di!.gr! d clrio€d thtt rmlcrs thsc politico .c@mic
problcmr are sdtt!$.d €freorivdy md sidly, Pskisl,d c|!dr be
cmducivc enough ro corrpete with olh.r .m€r3iDg .rommies oflhe rlgioD,
306
Q.2 Reason for s!8ring inv€stm€nt environmert as:cason rcr sl8ug hv€ss€n e
P"ril""r -T E*-;t"_ l.€"r -t (nh*
20 45 2a l0
,tT, l ro I15 I
llH$l]r lrr llol| rcirsrus
[siN lfflon l: lmi$ |l$|i
Itflidl ibilil|l tun rslatilii! l,{al
6.1'2.@tb€ Reqiop
When respondents were alked to express their views on lhe level ofrisk and
oncems investor has to face in compdisn to other economies of the
reg;on, the study foud rhat 70lo ofthe respondents were ofrhe opinion that
an investor has to face hieher degee of risk while making investnent
decision here. 25 percent consider investor ha! to facc lower risk whercd 5
percent thought thd rhere would be not much difference jn terms oflevel ofrisk while invesring in emereine economy.
Most of the respondents who consider€d the lev€l of risk being higher
blamed political instability a the main reason. They mainBined rhat the
political scenario in Pakistan has a hisrory ot vulne.abiliry dd a.gued thal
the instability in polirical situaton h6 lead to significdt drawbacks
rcsultins in economy suffering from huse snaes. Some of rhem expressed
fial even thouSh after being subjcred ro conrinuous se$ios of potitical
u.res! the economy is one again moving i. the right direction_ The gm\ftexpefienced in th€ first half ofthe recent d€cade is due to a retative calm snd
stable political environment $e investor is cautiously attracted ro fteeconomy but it'sjust the b€8iming.
Responden6 were also of th€ vi€w that the economy has lows degree ofslability owing to fie lack of consistency in rh€ poljcy matter dising oul ofpolitical shcks. Funhermore the inabitity of the elected govemmenb ro
effectively manase th€ law od order in th€ back drop ofsuicide bombine
and polidcal unrest in rhe neighboring counries atso atlribued to the
109
economic instability. Howev€r Inosr of rhem agreed that the steps t ken by
the prcsent regim€ towads bringing €onsislency in policies and establishing
control over the sfety nd security condilions in rhe industrial cnies bnngs
about a visible change in $e situalion ud as an inpact oflhis improvement,
there is a significant change in dE econonic fundamentals.
In terms of legal md regulatory stabil;ty. the response was divided but
majority ofthem were agrced that legal dd rcgularory incenrile provided in
the r€cent past must be maintained in the longer run if the €conomy were ro
atEact investn€nt on a rcgular basis. lt is a knoM facr dal investoB face a
nore painstaking p.oce$ her€ as compar€d ro rcgional economi€s. Ths acls
as a disadvanrage to th€ Pakistdi sonomy despire many reforms aim at
providinS relief to rhe invesro. as geneElly rhe imptemenrer resisls the
change for lheir or! vested interest. However 25 percent ofthe respond€nls
were of the view thar the refo.ns indoduced by rhe present regime have
made the economy as the most investment friendly economy oflhe region.
They consider that political consisrmcy coupled wilb economic uplift has
ehhan€ed the risk profile of rhe country in comparison ro orher economies of
ll0
6.13.@
In .esponse to the question about $e role of govehment in developing
infraslructure, 60% of the respondents repli€d in n€gative while 40%
responded lhat they ar€ satisfied with what $e Sovemment is doing.
Majorny ofthe responded f€h that the government is so far struggling 1o get
a stronS grasp over dte development process in mosr of the secbre of fte
economy They stressed the need for the govemmenl ro employ more
resourc€s lowards inftastructure d€lelopmet{ rathe. rhan spendinS mo.e on
defense ud relat€d sectors ofrhe economy. Some respondents suggested
that the 8ovemm€nt ne€ds !o focus mo.€ on industr;alization of the counlry
md privatiation of numerous slate own€d sectoB of rhe economy in a
transparent way! as they have reservations in rhis regard. Some respondenrs
poinred out th.l the govenrmerr polici€s were mainly focused on attEctins
foreign dircct investrnenis and were not encouraging for the local investors
and as a result, the Sovement is compromisin8 on locat investor's
Prcspects. Moreoverj the sl.ess on inflows in power genenrion and energy
s€cto6 in recenr yeds has rcsu1Gd in inv€stment in th€se sectors but srill the
development ofthese seclors is b€ing wetl under pd.
R€spondents thal werc sdisfted wirh the rcle of govemme in developinS
infrastrucrure for anracring investment agreed rhat there is no doubt need for
a much activ€ and sEoryer rol€ in rhis issue but lhey were oflh€ op;nio. tha(
fte authoriiies arc moving alons rh€ righr path dd their performance willsoon bea. fruils ifthey continue follow the cot€t approach. Thefe h6 been
significant dev€lopmert in mds media and relecommunications, €sp€c;alty
I2
rnd thc privrdz.tiG of thc stor. th.r€ b!! b.€u repid go1vft in 1iir &ea
ofthe ccomny rs DAjd cqitrl iDiow hav€ @urlEd afr.t ltc pdvalizaim
ofth€ std. ow[€d t€l€.ommunicati@r indufy. They werc optinistic that
thc goGMt i! cd€dry tb! irrr6 rfici.dly lbrough r! ldbl€ policy
iftplom.ntrtion to hav. lorgsr t rm advet ges of the cun nt growlh
occuntlg in 1116 rcomy,
6.r.4. E!Is!9s!-q.cq4!-Bs$ 9y
On the issu€ of availabiliiy of skilled human rcsource 70 percenl of ihe
responde s were ofthe view that availability ofetrcienl and skilled labor is
one big issue ;n Pakistd. 30 pefcent ofth€ r€spondents were ofihe view that
availability ofskilled labor is not as bisger a problem.
Majority of the responde'us beli€v€ that availability of human reeurce
locally is a key ingredienl in economic developmenl It allows the economy
lo become selfreliant h tuiure rather than dep€ndin8 on exremal eurces to
mdage lhis issue oflhe development process. They srrcssed rlur on th€ back
of the lower literacy .ate and lack of inreresl fiom the regulalory aurhorities,
rhe economy is still la8 far behind in nunurins dd keeping ski ed human
resource widrin the lnarket. Furthermore all th€.espondents were unanjmous
in their comments that emcient human resource allows the monomy ro
become proficient md enable ir ro find solutions to its own problems and
ln vi€w oflhe najonty ofthe r€spondenls, the mosr comrnon deficiency is
the lack oftBining and innovadv€ness mosr peopl€ find in human resource
workng in the market. They felr thar lhe deficiency in rhe core knowledge
about lhe product leads ro the facr that marker tags behind in producr
innovation dd efficiency. Some ofrhe respondents even felt rhar the lrainer
lhemselves lack comperency while othe. consideB cosl and materials oftrainins as a major problem. The issue of lack of ski ed hman reeurce also
highlighFd f.on the facr rhat organizarions ar€ finding probtem in relaining
their pcople due h bener opponunities in financial marker of other
3t5
economies reflecting th€ dean! ofskilled and tmined human resourc€ in the
In rcsponse to question about the effons of the regulalory authorities in
enhdcins the skills of the human resource, a8ain majorily of the
respondents were of the view thal the re8ula1ory aulhorities are .o1
perfoming al the level reguircd from them. They maintained thal elficient
human resource has a major role in markel developmenr md it cm only
happen when the human resources are exposed to lalesl skills dd training
and have opportunity to work on their skills in the market The respo.dents
srrongly agrees lhal human .erou.ce of financial markel in Pakistm ne€ds
modification in compeisn to human r€sourc€ in a dcvelop ma.ket desPite
some of dEm don\ consider this modification mmdalory. Some of the
respondents were also of lhe vie* lhat rcgulatory autho.nies de providing
some assistdce in upgEding human resource through conductine sninars
md slmposiums. However accordiflg lo majority of the respondents ihe rcle
of rcgulaiory authorities should be more proacdve and eflicient d they arc
doing little to what is requircd from th€m. 'th€y musi sp€nd more tunds to
nise the competency ofthe human resource oflhe mdkel.
ll6
6J percenr oflhe respondenrs were in support
'ncentives to invest in pakisran, whereas 3J%
tnal rnvestoB have sumcient
responded hetd fte opposite
The economic policies and rhe levet ofincendva direcr bealrnaon tre jever of invenmenr,;;i'j::j:j;#;:Pakisrani economy is al a shAe wher€ ir nee
i:::.'::':Y" * **J- ;"';":";l''::1,*'l; ::#rnveslmenr in all s€cto.s of rle &onomy wherher ponfolio or corporablnvestmcnl. HowNq some of rh€ respondenb werc ot the opinion lhalincedives tre on rheir own, are insufncienr I
Eovemme n€€ds ro provid€ concreb in""nrtr't "tn""t the invesbr' Tle
wirh an asurance resarding * -*rr_.,;;":;I ff,iffi:::^conomy.
the prcvious rrack rcco.d ofvarious sovemhe policis towardsrore,gn 'nvesrmenls aDd political instabitity is not very encouraging.
The. government needs !o revatuab its incenlive potici€s and ensureimplem€niadon of rutes and reAulatjons. FLirthermore rhey mu$ bemoniro.ed closely as rhere had been nomerous uevery now and then, bur rhe probren ,, -,,,*'j::IH;.,:::1'fi:policies. Ir has been a well k')oun fad that when ir comes to enforcem€nlofreSulations, rhere is a hiSh degree of va.iarions.
exploiration by the policy impt€merreB. ThG k
'nn'on'on ""'"",ur, .. *" ;;;;#';"il:::-#:"".,T:lt9
taution &d excise dulies structure in
contusing for new inv€stor's especially
inves(or being unsre of what ed how
hisher risk level.
Pahstan is fairly complicated and
fo.eign inveslors od due 10 this, the
of the tlMrion pro@ss, attribubs a
120
6.1.6. Bs.cE!9ry-Elrsgprl
On th€ question of whether dE SECP is tulfilling i15 regulalory duties
efficiently, 45% respond€d in affirmativ€ wher€as 55% responded in
Those who supported the role of SECP aigued that sin€e irs inceprion rhe
SECP has b€en workjrg on bringing the capital markels at par with rhe
intemational ben pmctices md has broughr major uplift in the overall
perfommce of the meket as compaEd ro dE period b€forc them.
Optimi$ic inveslors have sho*n rheir faith in the reforms inrmduce by the
regulatory authorities ref)ecting safe and conducive rnvesrmenr envrrormenr.
Some, on th€ other hand are nuch mor€ caurious and critical of every poticy
change dd development by the regutabry a$hondes. They werc of the
tiew ftal no doubt economy h4 shoM positive signs; bu1 what putls the
narket dom is simply the 'cl6h of interests' od Frhaps inflated egos.
I6iders' maipulating the bounes is a global phenomenon and there is
nothinS epochal about th€ rev€lation in this case but the dis.urbing factor,
however, is the imputation rhat top gov€mmental officiats arc somehow
patronisina this activiry. The economic advantases jn having a prime
minister who und€rstands lhe bBiness cornmunity,s concems arc no doubr
there, but the dowside to this relarionship is lhat it makes the ofiice ofthehead of sovernment wlnemble to charges of favouirism and improprieties.
R€spondenls also felt that inmuniry fiom scruliny and accounrabiliry c1nnol
be sen as one of the bonuss ofdoing buiness in pakisran md thercfore the
impr€ssion musr be removed. They suggesr€d rhar ro make an end of
l,
pmbl.Nq a start can b€ rnade by en5udng that ihe conclusioN rc€ched by ih€
va.iou! investiSations in|o th€ iffairs of the stock nsrler h€ implenented
without b€ing birsed onc way or anolher. TIE on-going blame game
b€tw€en lhe SECP and KSE managcmmr must sle cone to an cnd dd thc
SECP musl p€rform irs duty to guaftntee fsir play st the bourses ed to
p.ot€ct lhe irterGis of all invdors, inesp6ctive of the; clout. Fudhe.nor€
aa KSE, the capitsliztion ratio, which is low, and th€ tumover rstio, which
is on€ of lhe high€s in the worl4 pmbrbly r€flcrs lbe larae sp€culative
el€nent in the markets and .equires strong regularory uplift ar dl clmers ofthe market is mandrtory to aftsct sftdl inveslor to tsk€ risk snd invest in
321
61.7. 4llIsle!-elMeCd$s-EsEsllJolrdliq
95 p€rcent of th€ respoodmts were of tlte opinion that effectiv€ application
of th€ pricing model is low with only five percent of the r$pond€nls
expressed that models can be effectively applied while considering the
special circumstanc€s of our eonomy.
The respondents i. geDeral werc of the opinion rhat in Pakista low
application of financial nodel to forecast volatility stems fioln innumerable
factors ud which not only affet the lEket but also bring element ofmdipulalion in the m&k€1. It can easily b€ identified rhat brckers in lhe
st@k ma.ket manipulat€ prices to lheir ov.n advalage and at the expense oflh€ outside inveslor. Respondeds wer€ of lhe belief rhar model application
to fbrecast volatility of the financial narket cannot b€ done because srock
p.ices are based on 90 pe. cenl sentiment and l0 per cenr e.ononic
fundanentals pointing to a highly speculative narure of fte mdket.
Nevedheles The Board ofDreclors ofdE K@chi Srock Exchange (KSE)
has impleinented the VAR (value al risk) - rhe new risk managemenr syst€m
md lhe new netlinA reaime.
Furth€rmore they poinkd out that that the nnecial market in pakisran is
exremely voladle and also one can find grEar aDomaly in the omposition ofKSE index that shows the mdker galloping when it is jusr trodng. Major
burden ofthe market is b€ing lifted by one o. two specific sctor, making rhe
sovemment comfortable as th€ investoB rre being ture by .isin8 m€rcury ;n
the financial t'arometer. lt suirs th€ govemnenr.t authoriries & the KmchiStock ExchdSe (KSE) alike for ir rcinforces their claim of b€ing rhe..b€sr
325
FrfuEioS so.! Drt r h rhc rrslf. Howcvrr sig'liffcd ngr d6yms.rurcs ero n !d.d tom the SECP'S sidr to fll up tlc gsp b3twrlxr th.
dd & brl.dtt in tt! dod nrt t in..d.r to dop tu tte plry63 frwtaking tt advs{agp to oFlic n rkct on rFouldions.
326
6J.8. ggdsirylllqlE9!$iq&Egc!
on lhe query about the satisfaction over the issue of the perfomdce of the
hedginS instruments 40% people said thar they are satisfied wirh the
eftciency and availability ofthe hedging ioirume . They were ofrie vi€w
that S€curities & Exchang€ Commission of Pakistm (SECP) is playins eactive rcle in d effort to ue ditrerenl risk mi rnizing stralegies to
safeguard the ;nterest of invesro.s. Nev€nheless 60 % people say rhar there
are no definite hedging inslrments. wh;ch afe working in Pakisran, ddlhere are doubls about the efficiency of the instrumenr used fo. hedging
Those who are satislied are ofthe view that in the eyes of tocat compdies
seeking lo hedge interest rate and cunency risks, the recenr launch of aformal derivatives ma*e( in Pakistan comes at d opponune time.
Funhermo.€ the emergence ofa market in futures contracb would not only
provide investoB with balic hedging instruments dd invesrnent altematives
bul also depen the capital marker in Pakisran. Atrhough derjvatives have
long been traded in Pakisran. bur $ese de done ovcr the counter, needing
cenual bank's approval before rhey de allow€d for sate. However with a
formal ndket in place, ir is b€lieved thar instruments will be stddardized.
dd transaclions will be fasrer.
Those who afe not satisfied wer€ of the view lhal all over the world mdkelis beconing morc and more fiasile ed rhe requirements ofprcper hedging
instrumenl is ;ncre.siogly becoming recessity. They wefe ofrhe view rh.r
the Pakistani rnarket up till now fails ro come to rem with the inremarioml
128
'Eket as more dynanic and
The h€dging inltnnnents are
Dodern h€dgine instrument de oceded hcrE.
introduced but because of thc systematic
Ilt€ r.spoDdents were of dF vicw that there is stron8€r n€ed for cr€ating
awaf€ness anong the masses about the f€ahres and benefits of these
instruments as it is important that all dle playeF tully ude$rand the risk
that they de und€rtaking dd th. meds of hedging ar theh disposal.
Howevea wirh the kind of infi:asd ctllle and lhe levcl of educarion in the
economy it is very difrcuh to find the d6ncd bvel ofundeNlandins.
fiidion and opposirion their eflicicncy mighr not be as $ey would b€ to
addEss investo.'s.isk-related issues.
129
61.e. !4$-!!.e.!ip.cb!&ur4-Belr-slEre&E
According to respondenB, secuities pric€s do not truly reflect all known
infomalion about the company/narket. 80% p€ople responded lhal Stock
Market in PakisBn is driven by speculalive forces. Stock prices iluctuate on
rumors wilhout any coge reasons Bultandy drivinA oul the small
investors into sideline and ultimalely atTecting the shares prices in the Stock
The respondents were of the opinion thar sirce the ftarket is broker
moag€di fiese brokeB of srock ma.ke$ do nor Sive cr€dcnce ro fteeconomic findamentals- According b them srock prices in Pakista are
baed on 90 per cent senriment and 10 per cenr cconomic fundamenhts.
Highlighling the above-mentioned fact some of the rcspondenrs quoted the
perfomadce of the stck ma.ket in rhe past for imhnce the incrcas of I I z
per cent in stock prices in 2002 wa! on account of speculativc buying io I0to 15 stocks as lherc was no acrcss,lhe-board inc6e in rhe value ofshares.
Funhemore the KSE-100 index, afrer touching fte figure of2954.53 in the
dti.d week ofJnuary 2003, declined sharply and, wirhin five days (20th to
24th January 2003). it losr 345.08 points, closing ar 2609.45. t-he declining
rend ha not sropped ad on 7th Feb 2003. the index was less the 2500
comp€lling the KSE ro reson to codedive m€asurcs in d effon to check
free-fall of stock pric€s. Ir may be added here thal n has be€n mentioned
lime and again by the bokers wirh pride, rhar rhe KSE h.s rhe highesr
tumover rat€ in the world srock mdkets it but rhis does not reflect a bealrhy
sign as it poinrs to a hiShly sp€.ulative marker Ins;de trading, p;vare
information, manipuladons are the importaDl pan of security pricing ar the
lll
sto.k mekeas in Pakistan. 'nEy felt thar lack of strict reguladon led to
rationaliz.iion of price manipulalion ahnough recendy SECP has taken up
to hinder the way to pric€ mipulation by introducinS
t12
6.2. further Comments
Commenrs werc nade by 20l" of rhe cspondenri 80% respondents did nor
provid€ ey funher commenrs. The coments added by the respondenls
included suggestions on the inplementation and formulation of regulatory
policies. Some respondents suggested rhat the proposed reforms in rhe
tayalion depanments, if€nforc€d and controll€d prudendy by the authoriies,
would have a nanifold ;mpact on the level ofcapital inflows 6 compared ro
Further comments include fie need for developmenr of infmshcture,
especially the transportadon and commmication secro6. Furtlermore mosr
of the rcspondent, who werc dissatisfi€d wirh rhe overall s;tuation, werc ofthe view that insiability both at economic fronr as well as polilical front has
been the main t6on for not atrFcling the true amounr of investmenr
allhough we are providing arguably the nost favoured investmenr policy in
the region. This will facilitate the op€mtions ofexisting inv€srors and anEcr
new investments. Moreove., a conrrol over rhe invcstment ;nflot{ in rhe
enerSy sector was advis€d due 10 rhe @ent exp€rience of gov€rnment.s
iMbiliry lo manaa€ the inflow offor€ign investment in lbc en€rgy sector
Notes rnd Referetrces
I world a,nr R.pon f,\o'ng BuMes 2006
134
Cotrclusion
This liteBture mcovers and evaluates the change in eco.omic aPProach to
lib€ralization and d€regulation, by the Sovemment and regulalory
institutions in Pakislan which have lead to siSnificanl improvemenl in the
finmcial environment ed mdket structure. Forcign investmenl inflow is
one ofthe k€y facto6 in fosrerinS an envircnment of economic growh in
my economy and Pakislan has been workinS to transform ils previously
eshblhhed image of a fiagile economy inlo a stonger 4d open one tb. the
sole purpos€ of encouraginA investofs Panicipation in fte economv
However lhe economic tumafound claimed by the current govemmenl face
senous concem despite a relatively long lerm enjoyed by them
The principal r€ason for the lack of atir&rion and probably holding long
lem investment is the presence of political inslabil;ly. which leads to
inconsistency in 4onomic policies. Effons are i. place to ove. come the
problem ard numerous int€malional financial institutions have been
dsisling lo successftlly bring brosd structral md economic refoms to fte
maik€t. However, this r€s@ch believes that the rcfoned €conomic
environmenl is to be maintained and progressed systematically bv the
successive sovemment, to show to be effective in achieving lhe objecdve of
op€ning-up the economy for forci8n ;nvestors lt is slill 1o be *eing as
whe$er fie najor political patties, no matter who comes to power, have
enough innovative ideas and lhe hunan resources to tackle the coming
challenges posed by a record cunent account deficit, stagnant exports, an
incrcasins fi$al deficit, low social indicaton, ener$/ shoflages ed nsing
infladon are just few to mention.
t36
There have be€n some improvements in the securily issues but the study
again fels that much is still require lo be dof,e thal may be majo. concems
for invesmenr, as Pakist& is fightinS a3 a ftont line state in war against
tero;sm. The main focus should remain to made invesror realia that
Pakistd is d emerging and fast erowing economy md significmt measures
are being implemented consistendy to improve the investment enviroment
for rhe benefitofrhe foreign investor.
Last but detinitely nol th€ lealt is the regulaiory issues d there h6 been
impressions that nanipulalion activiiies do exist ;n the fom of unusual
rading patl€ms ed syslematic gofilability ditlercnces arising from rades
between brokers and ouilide investors in the market. Funhermore, the
prcsence of mMipulator ed naive lEds imposes large pdticipation costs
for ntional and sophisticated agenis trying to ei$er invesl or raise capital in
equiry markets and are rcspons;ble for excessive volatility in the market. The
s;tuadon ;mplies that in$ead of focusing only on a few brokers. regulation
must corer for the pr€sence and €xtent ofmanipulation in g€neral-
To conclude, becaus th€ risk factors and the refofts ihtroduce by the
economy discussed in this lit€raturc are reflecting a positive si8n for rhe
inveslor to pa cipate in the economic progress dd in rum be rcsponsible
for enhancing rhe depth and size ofthe markel. and help them leaving the
infancy raps in the presence of positive reforms. The concem is that
whether the political stlbility could be made available for the economy to
flourish as it is theirjob 1o facilitate realeconomic activhy.
JJ1
LiDiotiotrs to lhe R6€arch
The basic limitations to ev€ry research are stemmed ftom the possibility of
bias in responses ofthe smple during the sutrey. It depends mainly on the
vi€w of the respondent. By d€fault, this is one dea wh€re lhere is a
po$ibility of over dfiusiastic or even pessimisnc responses durins the
Th€ rcsearch is not sufficienl to cater for the ne€ds of inve$ors looking for
any leads towards mMgement ofrisks in the Pakistani economy. R€s€arch
in the area of infratructure developm€nts ongoing in ihe counfy is also
anolher dimension where dis resear€h lacks in providing a satisfactory
Another aspecl that is not covcred in detail here is the existing labour laws
and policy changes to iinprov€ the law and order situation in major industrial
hubs of the economy. Funhemorc, a detail€d r€semh is required to
elabomte the aff€cls of under investment in vdious seclors despite various
fetbrms jntroduce that may lead to distress for the rconomy.
l.l8
It has ofte. beine said lhat economics is more of an art thd science, and
fauhy twisrs ed tums could lead to anlhing except a mslerPiece. This
p€rhaps hd had happ€ned to Pakishn's economy. The groull rcflected in
rhe €arlier pan of the previous rcgim€ was ba*d on consumption led by
credit-card minGet nth€r than fundane al econonic p.inciples of 8ro$,lh
throlgh evin8. expdsion md production.
The economic policies and reforms implemented in Pakistan have so far
shown to b€ €ff€ctive in inducing growth in €very sector despite in the last
two years decisiom de led by ad hocism and political pressurc rather than
pure economics. Th€reforc lherc is utnost ne€d 1o ensure that these policies
e continued and followed with due visilance and if ir requires strong
decisions to be take4 gove.nment must take tho* deisioN wner than
Another point of focus should be the s€curity dd safety condirons in
Pakistan esp€cially in the designated tlade zones ;n order ro build investor
confidence. Pakistan is fightinS as a front line slate in wd against renorism
and musl male a clear statement to the investors that positive outcome
would show dd also made them realize thal memingtul meaures are beinS
imDlemented ro imDrove the investmenr environment.
Moreover, the situation penaining to fte enforcement of legal issues in
reg.rd of contracts and the time i! takes to resolve a dispure is very
discou€ging for the foreign investors and as a result offtis imp.ession; the
l.)9
investor tends 10 be rcluddt and for€ign inveslors prcfer less risky
econom;es lhan Pakistan. Policies and regulations are in place, but need ro
be enforced with full €ffecl. Without resolvine the problem associat€d with
free, fair and swift judiciary system, the economy will nor be able 1o atlract
long-tem invesrments Fom domeslic inv€stors leav€ aside th€ foreign
D€velopment of inftastructure, especially the human resource development
is a key ea tha( requir€s imediat€ focus lioln the govemment. Level of
educar;on and lcininS opponunhies must be improved in order to encourage
and keep inve$ors irterest€d on a long tem basis. Also, for the sake of
long-term sustenance of economic grc*rh, infrastructur€ projects hold the
Iirndamental value in any €conomy. By compeison, in this e4 Pakistd is
the ledl advanced economy in the rcgion. The d€vclopment stage in tems
ofinfiastructure is the basic concem for foreign investoE.
Funhermore in th€ r€cot past Pakistan could have anained srructural
sfengtb in th€ shape of exports since the country sided with major powe6.
However, exp€cbtions have not been mel dd risirg al three of four perc€nl,
Pakistd's export have tmiled fd behind iB impons ud definitely is one
area where work has lo be done. Moreover i1roy be viewed thar the rupe€ is
over valued especially if we want to mise the exporl base which has almosl
remained constant for the ldt €ieht years. China has rcsisted the westem
pressure against appreciation of its exchuAe Fte to help hs exports captur€
markets across the glot'e.
340
Another point of focus is the improvement in prot€ction of foreign interests
in the economy. In times of social unresl until recent years, tlis has been a
major problem for foreign investoF in Pakistd. The forcign intercsb ate
esp€cially largered and damaged durins civil unrests. This lrend times md
again, has damaged Paki$an's reputation throughout the corporate wodd.
The regularcry aulhorities and law enforcement aSencies ne€d 10 Sive
priority lo ensuring lhe non-occunenc€ of such ircidens if my gro*d in
capiial inflows is required in th€ economy.
The regulatory auhonties ned to advance the srructural ard rcgulatory
changes on a wider $al€ thd cunetuly undeMay. ln doing this, it musi be
kept in view that the stability ofthe economy is nor compromised by such
broad baed policy chang€s. Moreover, the rcgulatory aulhorities also need
to enhanc€ th€ skills of policy enforcement personnel throughout the whol€
regulalory system dd eNure that they fully undersland the imponance of
ftese r€foms. This would enable the policyinakers and impl€me eB to
dainiain an effe€tive outlook on these refoms in the long-run.
341
Ec!qe-89!9ssLD!4q$9E
There are cenain @as tha! can be forther researched in the Pakistlni
economy. Further in-depth .esearch is needed to identiry and elaboGte on
th€ policy shrcture of the e@nomy as compared to thal of the conpeling
Funher resedch cu be of us€ in terms of identiting specific t@ls for
mitigating risk to the investors ud how to imprcve the awareness l€lel
among local investors. A significam agenda for tutur€ research is to
undeEtand and show what additional mechan;sms used by regulatory bodies
which could lead to cut down excessive volatilily in the stock markeb of the
Another area of firnher rcs€arch is the levels of inFastructur€ development
esp€cially ;n lems of hmd resourc€s development to meer the challenges
ofmodem Slobaliz capital ma*er. Aho, research could be caried oul lo
idendry and undeNland what reforms are successtul in limiti.B lhe mis-
govemance of markets by intermediaries. Such refoms could includ€ a
grealer presence of independent members (non-brokers) in the exchange's
board of directo.s; facilitating entry and competition amongsl brokers,
including the setting up of new exchanSe!; bat€r sysrems of suNeillanc€;
tigh@r enforcement of existing rnd new regulation, such a stricter marSin
and capiul ad€quacyi and infomation disclosure requiremenls that protect
oulside invesroB dd prevent undesimble aclivilies in the market.
342
RESEARCII OUESTIONNAIRE
Q. I Do you think invesh€nt envnonrnent is conduciveness?
b) Di$eree
Q.2 What do you @nsidn is e main reason for )oul answer
a) Political
O Lesal
Q.3 Do you think risk concems in Pakistan are high€r than oiher
economies of the reSion?
a) Hishe. b) lrw€rc) ssme
ArE you srtisfied with ihe role of govenunent in
d€veloping the infiasiructure to encourage forEign investinent?
a) Satisfi€d b) Nor Satisfi€d
Q.5 Do you think w€ havc efficiot human resourc€ to dev.lop
a) Available b) Nor Available
Q.6 Are you satisfied with thc etrorG to €nhance skilh of rtum.an
Resource?
a) Satisfied b) Not S6tisfied
b) Economic
d) Oth€r
44.
Q?. Arc you sstisfied with the inc€ntivcs provided to investoB in
Pskisrgn?
a) Satisfied b) Not Salisfied
Q.8 Are you satisfi.d wilh the regulatory frarnework fior capital
markeis in Pakbtan?
a) Ycs b) No
Q.9 How would you ra& pricingmod€l applic.bility in Pakislan?
a) Hish b) Low
Q.l0 How would you IaG $. availability tnd efrici€ncy ofhedgiDg
insfutrrcnt! in Pal&tan?
a) Hish b) Low
145
INTERVIEW OUESTIONS
AE you sarisfied widt tlle legal, politic6l 8nd economic stabiliry of ftc
whar impad do you feel political inslability wonld have on €commic
stability?
Are you satisfied with the rec€nr reforms introduced in the narkel?
Why has Pakiern b€€n able to attDct les! for€ign investnent as comparcd to
olher €tmonies of the rcgion d€spile introducing most att active inv€slm€nt
ftiently r€fodns?
tue you satisfied wilh rhc ftgularory fimcwork? Ifnot, why?
What neasures would you suggert to conEol ibe level of volatility in
financial market h€re?
How effectively can we apply modeh to forecast volatility in financial
What aE the short comings in impl€menting the models?
tue you satisfied with the hdginS insrrument and its applications in
t46
Do you think, pdce roanipulation sxist rt rdious lcv6l in our ma.kef?
Do you thtut brokfr! brve Erjor lob ro plly in luch nanipul|tiottt?
Do you tiink broklrs .r! sg.iEr thc Etk t rc6rnt inEo.fu{c by SECF? If,
y€r, wty?
Do you !gr€. rh6t we s€ laE io idld$ing th. hcdSing itrsr|m.nt?
Ify€s *hat ar€ lhe rcoson?
t47
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GLOSSARY
ARCE Mo.t.t: d autoregressive condilional heEroskeddslicilt (ARCH. Engl€
{19E2)) nodcl co6ide6 the v.rimce ofthe cuft dor tem 10 be a tunclion ol'
the vuimces of the previous rime period! enor lerms dd relates the edo.
vatiar.e lo lbe square of a p.evio6 period's ercr.
Augnen ed Di.k ! Fu et (Arr): An Augnenred Dickey-Fuller is a rest for a
unil rmt in a time sdes samplc.
Aatoconelotion: Alto.nelation tulction (ACF) of a random proces explai.s
the corelation beMe.n the pr@eses at diff@nr poinrs in rine.
Ba.lta: Bodla nading i$olyed buying st@ks wirh boftowed noney wirh the stock
€xch@g. acting a an int€nedidy at an inrer€$ rare delemin.d by the deoddfo! the udeilyiDg sl@k od a maturiry nol grea1q th& 70 dayr. il is a fom ofl.vcBger however unlike futuFs. rhe brcker-not the buy€r o. *lts is
rcsponsible fo. the maintenance of the ndkerb-mdkel me8in. Bddla *s eindiSaou cantr-foN.rd system invenred rs a solurior ro rhe peAetuat lack ofliguidiry itr $e s@ondary ndlet.
Copital Ac.unttttion: C^pital accumutation ce refd vdiously ro eirher reat
i!!€stnent in rangible mds of prcducrion or fin@cial investment in paper assets
o. investment in lon-produdive physical assers such 6 rcside iat .eal dare rhar
appreciale ir value or enhecing educalion ed taining rherebt increasi.s the
sldlls oflh. hmd capital.
Capitol Asset hictns trlod.lr Tle CAPM is us€d to dertrminc ! 0jeoletcally
appbprial. requircd de of rcrlm of e dsel ad ihus the Drie it qrt€d cshflows c€! be estim.led.
Corlri4rc.j Covariece is lhe oesuc ofhos much 1so mdom vtuiables !.ry
333
D.nvotita Ma.*et: TIe derivatives ndkets N lhe linancial na|ke1s lor
dcnvafivd.'l-he nrtel cd be classified inlo two. thar for exchuge Faded
derivalives and ihal for oleFthe-counter derivatiles- 'lhe legal nature of thesc
lroducts is v.ry ditrercnt a well .s the way thcy de hded-
Di'.6ilied Po.folio: refqs ro a conbination of s@uities desigred by the ac1 of
spreading irvesrmos inro moy dinercnt types, including stocks, mutllal firds,
bonds, md cash- il can also be dildsified inlo dirdent nutual fudd investmenl
stmt€gies. includinS arosrh funds, baleced funds. index fu.ds, small cap, large
cap, and secloFspecilic tunds.
ElF.tnt Po.ltolio: An E.P. is one whse no added divetsification cm lo{e. th.ponlblios risk for a 8i!en relum expectalion of altmstelri. no addilional cxpecled
rctum cd bc Sained sithout ird€6i!8 the risk of lhe ponfolio.
Ed.ryine Econody: AA qonoay is considercd 6 "emerginS if ils per @pila
src$ narion.l prcduor (GNP) is below certain level thar, however changes rhrcugh
Et hange T.d.l.d Mo.ket: where 1be kansaction be$een rhe panies takes place
via orpo.ate-oeed facililies consruded fo! rhe purpo$ of tFdin& such dtu1ures exchanges or srock €xchanaes
Erp..1a.l R.ttn: Tte ex,arrc reIm expected by invesros ovd ene tuturc
Finuciol ldsaltulion: ^
frntcial institutid acrs 6 an agor rhal providcs vdielyoilin&cDl*^ices ro rb clienh or memb$ tor a pric.
ad,.r4si k a srddardized conract. traded on . tutures exchdSe, ro buy or sell.cenain udeilying 6sls ai. cenain fulus dlte &d at a prcspeified price.
GARCH Mod.t: Bolldslev (1986)) modet is a generalized auloregresivc
@rdiri@al hercckeddlicD GARCH md f(ELg if & auro.€aNive moyiog
avease modelrARMA modcu i\ assumed tor the enor raridnce.
189
AddAr',rAj engaeiDg in fiDancial operalions with the i ention ofreducinS risk.
Intetturional DiteBi.licatior: iNohes diveGification usinS a mixlue of
investnenls insrments amsse€ognphi@lboundries.
/d.rtra.a lte commitmenr of fun& to one or morc assers that will b. held over
sone tuture tim. pcriod- lDvcstnol is d aci elatcd io saving or defening
r!"or&: fte degre ro which a fi.equenq di$rbuhon is flal rlo* kunosisr or
pealed (high kunosis).
,rE dt i Ue erient to which rhe deision depends on tixed cosr.
Ljurs a6 Q-stoti'tics: Ine Ljung-Box (1978) lest is an iDp.ovenent over the
Box-Pime (1970) t.sl aimed ar solving the problem wirh rhe Box-Pierc€ shrisric
which wd perfomitrt badly for smallsamples. The Ljlng-Box stalistic is berer
Aaryi, Firaicins: a IMSin is collaier.l $at rhe hotder of a posinotr in
wuiti€s, options. or firtws conhcls has to deposil lo cover th€ crcdit risk othis
Mo et Coplalhotion: is the total value of d compdt deremined by muhiplying
lhe shre\ meket price by rhe number of snms oubranding.
Market lht grotih: Co-mo\emenl in muket veiabtes.
lrIa*et Pdttolio:'t-lt pontotio on rhe eftcicnt fronrier $.irh lhe highe$ Sharpe
R lio k known a the Ddker portfolio, or ihe supcFefficienr pontblio.
Ma*owitz Eficien. F.orti.r: The Mdkowitz Emci.rl Frontiq is the ser rhat
coniliN all ponlolios rhal witt give ihe hignesr expecrd etum for each gjven
190
Mod.tn Po.folio fteoryj MPT focuses on how dtjonal inveslo6 will usc
di!€lsindion to optimize then ponfolios. md also tdger d 10 ho$ d rhky 4sot
Optiod: Oprirc @ finucial ins|rument that cmies rhe riCh! bul no1 rhe
obligarim,lo mgage in a tum ransaciion on eme mdolyitrs ssels
OEr-thecouru MuId: O fC ftdin8 is N to rade finmcial iBtrmdls such
A !hds. bond\. Lomodirie\ orderir.rives direcrl) ber$en Mo panies
Pnc&aEottirg Ratio: 'tl'e P/E.alio oi a ssuity (also called d "euings
multiple", d "multiple") is a measure of lhe Price paid for a shde againsl the
profil em€d by the fi.m Pe. shde.
Rdt lon Wolk Theoryt'the tundod qau( hypolbesis is a finmcial theory $aling
lhat secu.ities prices evolle according to a rudom walk md thus catnol be
nh* AwN Ineestot: An iNeslor who will not .ssume a givd lael ohsk unle$
th.rc is exp€craton ofadequale comp€nsation for havins doing so.
X&r Pr.rtlr: the risk prcmium *ould be fte exPected.dte of retum above the
Aii*i Risk is the vdiation in posible outcomes of an evenl bdsd on chace
moasured as standdd deviation,
.tldrlz Xartoj is the quelity defined as cotdilional expected excess relum on a
broader st@k ndker index divided by i1s corditional sledard d€viadon
Stton @d Rlank Sellits: is the poctice of sclling linocial seurilid which the
scller d6 not owtr rlo- in the hopc 10 rcpurchde them later at a lower price.
Sldrdri Bidne$ ofthe rlala lo one side.
,tE na.r? Iir*i is rhe mar*d rkk or the risk thal cmo1b. div€sified away, doppos€d to "idiosyn .atic risk", which is sp€cific to individul stelG.
l9l
Th. Arbit a& hiclng LIo.t l: holds lhat the exp€cled retum of a fitrociol aiset
cm b. modeled as a linear fectim of vriou macro'eco.oDic facloB or
rhcodical narket indi6
Th. Etrtcient Ma*et Hrpothests: Elttl assens lhat findcial mark€ls @
infoiarioElly effici.nt, m@ing thd prie on traded asls r.0ccl all bominfomation and therefole are unbided in the seDse thal lh.y rcflect lhe coll@tiv€
b€li.h ofall invBtm about tuture procPc.ls
t/o.lance: ^
wsy to c ptse the scale or deeree of beinS sP.ead out The variance
of a rmdom variablc, prcbobility dislribution d sanple is one Inejse of
sbtisiical dispesion, avonging the squ.Gd disiece ofirs po$ibl€ v.lues ftotn the
,/rnart: is ! security $a1 allows lh€ hold€r to buv stock of th. companv thal
issued it al a speifie! prie. su.Nlly higher fian the securitv's p.ic. at the time of
I ftaa): , fsdor used to d€r€minc tbe apprcP.iai. hurdle rarc to w n
appropriaE rhky investndt prc.ist derives ftom Capital Asset Pricing Mod'l'
J92