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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'

cDef,icau[to nw $atfrn

SYED MTJMTAZ HASAN

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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et | ;' | 6, ot- u' L /tft ?,LlLtf/, Lt,et/t Lv ur- J v1t! dh - + tu u,I2- L La h.t r ( e y o ErJ&tAL + J cfJ t'4,!2- /L L,1. qt f/"* cs 2'/o - " ot I t i ! - -c;z Lt t'* i.; b Ju-t 4 I Jfu F| +, l. /i+'t.,t

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INTRODUCTION

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

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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.

stol4 R. M., (1999). Inh.rioMl Ponfolio FlNs .nd scuity Marl6 lnFeldsi.- M - IrtetuioNl Copital Frd& N.rional Budu of laomnic Rffihmd Unirerity ofchieso Pren pp. 25?.291.

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

CHAPTER # 1

RISK AND RETURN

FRAMEWORK

29

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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,:]

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8l

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a2

CHAPTER# 2

COMPONENTS OF

FINANCIAL

ENVIRONMENT

8l

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

Not.! rnd RefeRres

I Bay Janen, (2000), "Mo,4 Aa,king artl linarciol Morket: ln Eunonn r1ptarch ,

A.l.T.a.S PEE pp.l24 126.

2 Robcn Dubil. (1999). ,4n *bi1ruse A'Ae b Fiwiol Mubls", J Willey & Sont:

I Bhol. L .M (2005). 'Fi@ia! IBritdiu .|nd Llarkeb: Sndw Gm*th ud,rrokkrJ". Mcca*Bill: Nd D.lhi. p.126.

4 lobld R. Clenn, Q0O5), 'Mok, Fiwial Systen ntl E o@n ^, C.ltmbirUnirebitt Prcs: ColDnbia p. 214

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6 Todarc. Micnael P. dd Smirh Sr.ph.n C, (200t), Eunmn Derelapne.l. pp

|l2ll4.I Crcon$lod. J. od Smi.h, B.D. (1997), Financial Mdkeb in Developncfi ed thc

Dcvelopmen( of Finmciol MarkeB , Jaunul ol Ecoionie Dybict od Conb.l, (21),

3 B.ncivqe, & smirhi (l99lt "Fiuncial lnt.ftedidio' Md Endqpnous (no*$Revi.* of Eonomic Srudics, 53(2), pp. 20l- 204.

9 Jennib asftt! Kfldh W. D.m(2002) B..kinAon Softw Solurids-,l?vtrei

l0 Ssriftq (2002), "Fkxiblc CommnGd d Inflrrion T.rBding aor $e US?ILdial Reere Adt .:lS@ F'i@b.o: N.\ \ otk.htlp //s*s phil.delphi,fed.orAlfi l64r^rql03as pdf

ll Rob.n Lu6 (1933), {)n rh. Mech.nisms of Econonic Delelopnenr" Jov,ul QlMuetat, E.onann' el) ElsrierB.V.: Th. Ndh.tlands, pp. 163-170.

12 R, tevi'F.N t aya, T B€* (2000), "Financi.l Inlem€diarion .nd Cov'lh: Cousalilya Caret , Jofrnul of Monaary t rrori.r, Elevie. B v : Tne NelherlaMs '

13 F.var4 C. (2003), An Empirical R6s.ffi.n1of rh. RelationshiD B.rwn Fin.ncctndG@h IMF workinA Paper No. ot/123 ES - StucrMh unhe^itv.

14 Shs, ,a od A M*is (2m2), "Dcr Fimid Dcv.lopneDt 'led E eomicAtu$n1'.Intetuio,ol R.ritu oJ,rppli.a E m'i6, 16(2). Roud.dBe: Nc* Yo .NY l0ol6,USA pp. | 5l- 156.

15 Boyd, J H ad Snirh, B.D. { 199?), tiipit.l Mdlet InFrfrtios, lnrsmtauil CEdnM.rl.c. Non Conv.AeM . J,rel oJ EcMnic Iheoa, 1112), Elseui.r B \ ': lhcNerhsluds pp. 116 313.

16 Siri. ER.lnd Tufmo. P. (1995) 'Econotulca ol Poolkq:'. Eerrd Busine$ SchoolPEsrc8hbridge, MA,p. 127

l16

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18 Boyd, Jonn H. and PE$ot! Ed*$d C. (1986), "Findcial Inr.m.di.r,-colnions"Jomol ol E Mnic n@tf, vol.l3, n.2. El*vier B.V.: The N.rherl$ds pp. 212-2 l4

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24

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Douslas Cdl€, Mdin H.llwig ( l98t) _lrcenriv.{ompdiblc O.h Conk6: I he Oi.-Period Poblm . Irr rrvia oJr6.Dom &&r'pi Vol. 52, No. 4. Thc Rdid ofEmnomic studi.s Lrd: usA. pp. 654-6J6,

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l4l

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t42

122 chokmbony, Mdhum{i (2006), " M.rh Eincienct lor lhe Pakisen srek Ma&ef'Sodh,4sia lianohic Jot al,Sse. Publicdions: N.w Dtlhi p 25l

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l4l

CHAPTER # 3

COMPONENTS AND

SOURCES OF RISK

CONCERNS IN

EMERGING

ECONOMIES

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

Usrrrdon - 3.t

Crurrry Rirk Alr.rrcrt

Rirt

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.

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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.

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I37

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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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CHAPTER # 4

INVESTMENT AND

FINANCIAL

ENVIRONMENT IN

PAKISTAN

t9l

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

CHAPTER 5

RISK MANAGEMENTIN PAKISTAN

249

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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l9 Bolldsl.v T, (1936), GeDenli4d AuroESrc$iv. Conditio'al Hdercskedaiticity',JoumalorEconometica,(31)Ehevi.rB.V, Th. N€rh€rleds pp. I l0 I I2.

40 Boudoukh, J.. M. Rich&dson rnd R. whitel!* (1993), The Best of Bo$ worlds,

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

CHAPTER # 6

DATA

PRESENTATION AND

ANALYSIS

J02

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

lllv6lfle errirom lh colldmire

lha0me

55ft[0rro

4$$

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

hrF,6 n

lHrlo[ il$t ti[frfl

h,si Sr,tli

lll

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,

Heolhmdhlfld{Nfnfifin

mffi4mt Mfffi{06

314

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

lv*Ili0olSXHlnrrneilfte

ild ldlilhl[$ lnihflo, 3110,6

Jt7

$li$d rih tr0ft b klch0 hr turmm

H !flflrr ffilti

3tE

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

$0dd itt hmliffi Filihd to holtrn

n$rusi $ftast

321

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

$tffirihm[htrllrunrrl

rd&Iffi5s hMrt6sa

324

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

hidUtodellDlicilfliu

[!lr $ $

327

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

trciHq d lnldil! rl fidft hfilflb i hlhtNl

tt&Ht

130

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

$FfllalirulftheardPilmmilIdstiminthelrhl

rftgaltl0n0896

lJl

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

Conclusion andRecommendations

l15

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

APPENDIX

1.1.1

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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386

GLOSSARY

381

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.

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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

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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'

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