derivatives market in gcc

Kuwait Financial Centre S.A.K. “Markaz” R E S E A R C H

Derivatives Market in GCC Cutting a (very) long market short

In spite of having an advanced trading infrastructure, most of the GCC capital markets (except Kuwait) haven’t yet started the process of introducing derivatives products. Our previous research (Managing GCC Volatility) has established the fact that GCC stock markets are the most volatile in the world. Given the growing size and volatility of GCC capital markets, the road ahead is clearly to have a complete market structure that will enable stakeholders cost-effectively raise capital and manage risk. A key missing link in this process is the derivatives segment. GCC stocks markets have remained a “long-only” market for a very long time. Across the globe derivatives, especially Options and Futures, has played a very crucial role in capital market development. Equity Derivatives market has now reached a size of $114.1 trillion (Appendix 1). The presence of strong equity culture along with limitations of GCC capital markets provides a compelling platform for introduction of derivatives market in the GCC region. Strategic investors can unlock their potential without diluting their stake. Institutional investors would welcome this as they are familiar with using such instruments for fixed income and other instruments. From a regulators point of view, there are questions such as:

To what extent derivatives destabilize the financial system, and how should these risks be addressed?

What is the impact of derivatives upon market efficiency and liquidity of the cash market?

Can we borrow the experience of developed markets to developing markets?

We propose to address some of these concerns in this paper through a discussion of the following:

A. Limitations of GCC capital markets B. Application Areas C. Current Status in GCC & D. Suggested Road Map

March 2007 Research Highlights: Examining the need for the introduction & growth of derivatives market in GCC.

M.R. Raghu CFA, FRM Head of Research +965 224 8280 [email protected] Hussein A. Zeineddine Manager- Equity Derivatives +965 2248013 [email protected] Kuwait Financial Centre S.A.K. “Markaz” P. O. Box 23444, Safat 13095, Kuwait Tel: +965 224 8000 Fax: +965 242 5828 www.markaz.com

R E S E A R C H March 2007

Kuwait Financial Centre S.A.K. “Markaz” 2

A. Limitations of GCC Capital Markets The case for derivatives basically stems from the various limitations that beset the GCC capital markets. Hence, it is worth recounting some of them. a. Incomplete Market Structure Complete market structure is brought about by the presence of equity market, debt market and derivatives market. While GCC markets have scored on equity markets, they are yet to score on the other two important segments. Islamic bond markets are gaining ground through the issuance of sukuks and other instruments. Lack of secondary market is hampering its pricing and growth. Due to under supply of such instruments, institutions tend to hold them to maturity thus providing no liquidity. Except for Kuwait, derivatives market is absent in other GCC countries.

b. Lack of Depth and Breadth Breadth is indicated by the number of companies listed in the stock market while depth is indicated by the active contribution of these companies. GCC stock markets do not score well on both counts.

Table 1: Market Breadth No of companies 2002 2005 2006 Saudi Arabia 67 77 81 UAE 47 89 93 Kuwait 88 160 165 Bahrain 42 46 42 Oman 96 128 131 Qatar 23 32 36 Total 363 532 548 Market Cap (USD b) 160.9 1157 778 Market cap per company (USD b) 0.44 2.17 1.42 Source: Markaz Analysis

GCC market structure is still incomplete with inadequate growth of debt market and absence of derivatives market. GCC markets lack both breadth and depth of the market.

Equity Market

Debt Market

GCCCapitalMarkets

Derivatives Market



In terms of number of companies, GCC region hosts about 550 companies as at the end of year 2006. When measured against the size of the market (market capitalization), it can be seen that the growth in the number of companies is muted relative to the growth in market size. While in 2002, the average market cap per company was USD 0.44 billion, the ratio shot up to 1.55 by 2006 as during this period markets grew by 5 times, while number of companies grew only by 1.5 times. (Table 1)

Table 2: Market Depth

2006 Market Cap

(USD b) No of

Companies Av Market cap (USD b) Saudi Arabia 326 81 4.03 UAE 168 93 1.81 Kuwait 147 165 0.89 Bahrain 64 42 1.52 Oman 13 131 0.10 Qatar 60 36 1.68 Egypt 208 290 0.72 Malaysia 236 1,025 0.23 Australia 1096 1,829 0.60 India 819 4,796 0.17 Korea 834 1,689 0.49 China 918 842 1.09 Source: World Federation of exchanges & Markaz Analysis

In terms of market depth, it can be seen that relative to the size of some of the GCC markets (Saudi Arabia and UAE, especially), the number of companies are relatively small. The average market cap ratio for Saudi Arabia 4.03 is significantly higher than say India’s 0.17 or Malaysia’s 0.23. c. Skewed Liquidity & High Speculation The GCC markets are classified as “long only markets” where trading strategies are limited to “buying when market is expected to go up and liquidating when it is expected to fall down”. In fact, the absence of the short-sale activities in such markets does not allow investors to enhance their returns during the down trend. Thus investors are left with no choice but to liquidate their positions which on one hand will exacerbate the effect of the downfall while on the other hand will adversely affect the liquidity of the market. The size of the decrease in the liquidity levels is driven to a great extent by the size of the corresponding downfall. Thus if the downfall is very sharp the liquidity could be completely drained- out. Kuwaiti market during the period 2005 to 2006 can be offered as a good example. Although the Kuwaiti market is characterized by the presence of a wide diversity of sectors with a major presence for the blue chip companies such as NBK, MTC, and PWC…etc, the market was not able to sustain liquidity during the correction movement in February 06. Investors as well as fund managers, in the lack of the hedging tools such as the put options, were desperately trying to liquidate their positions while the market was heading down and “draining out” the liquidity with it. This results in a Domino effect. (Figure 4)

Given the size of the GCC markets, the number of companies listed is very small. GCC markets are “long-only” markets limiting the possible trading strategies and hence growth.



Figure 4: Kuwaiti General Market Index

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Most of the GCC stock markets are speculative as well, though in varying degrees. While volumes are concentrated in few stocks, even these are among penny stocks. To present an example (Table 3), we can see in Saudi Arabia the most active shares constitute nearly 30% of total volume while they account only for 6% of market capitalization. The second highest traded stock in Saudi Arabia (Al Mawashi Al Mukarish) is a penny stock with 0.19% share in the market cap.

Table 3: Saudi Most Active Shares – 2006 2004 2005 2006 Share in volume traded Saudi Electricity 15% 11% 10% Al Mawashi Al Mukarish 13% 8% 8% National Shipping 7% 4% 2% Arriyadh Dev 4% 4% 3% Saudi Industrial Development 4% 3% 2% Gassim Agriculture 3% 5% 2% Saudi Public Transport co 3% 5% 3% Saudi Automotive Services 2% 1% 3% 52% 41% 32% Share in Market Cap Saudi Electricity 9.70% 4.98% 4.42% Al Mawashi Al Mukarish 0.18% 0.11% 0.19% National Shipping 0.73% 0.80% 0.58% Arriyadh Dev 0.22% 0.35% 0.16% Saudi Industrial Development 0.11% 0.14% 0.08% Gassim Agriculture 0.08% 0.16% 0.09% Saudi Public Transport co 0.22% 0.27% 0.18% Saudi Automotive Services 0.07% 0.15% 0.10% 11% 7% 6% Source: Markaz Analysis



The downturn of GCC stock markets during 2006 was accompanied by drying up of market liquidity (Figure 1). Fall in liquidity (value traded) is curiously accompanied by growth in volumes (Figure 2) signifying that mid and small cap stocks are being increasingly pursued for speculative reasons at the cost of large cap blue chips.

Figure 1: Liquidity Squeeze*

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Liquidity is the heart of a market. While GCC markets have grown during the past few years in size, it has failed to mature in terms of market breadth. Narrow market structure leads to price spikes resulting in increased volatility. d. High Volatility GCC countries experienced relatively very high risk compared to other international indices. Among GCC, Saudi Arabia, Dubai, Abu Dhabi and Qatar exhibited high levels of risk while Kuwait, Oman and Bahrain has been at levels comparable to other international markets. The increase in risk for Saudi Arabia has been remarkable from 24% to 49% literally doubling. (Figure 3)

Fall in liquidity is accompanied by growth in volumes. GCC markets experienced very high volatility in the past.



Figure 3: Volatility (Standard Deviation)

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e. Lack of Institutional Investment Participation of institutions in the capital market lends stability and credibility as institutional investors are considered to be more rational and long-term oriented than individual investors. Though a difficult thing to measure, a broad proxy would be the mutual fund segment. It is understood that other categories of institutions in the GCC like pension funds, central banks, etc prefer to invest through mutual funds. Table 4 provides statistics pertaining to mutual funds. Except Saudi Arabia and Kuwait, all other markets have very meager institutional participation. Curiously enough, in spite of a respectable figure, Saudi Arabia continues to be the most volatile and speculative market in the GCC.

Table 4:Institutional Participation

Mutual Fund

Assets Market Cap

Saudi Arabia 22452 326000 6.89% UAE 1612 160000 1.01% Kuwait 5200 143000 3.64% Oman 37 16150 0.23% Bahrain 16 12170 0.13% Qatar 68 60940 0.11%

Source: Markaz Analysis, Data as of Dec 2006 in USD Million

The representation of institutions in the GCC market is sparse.



B. Application Areas In this section, we highlight some application areas for derivatives within the context of GCC capital markets.

Short Selling Options strategies Trading Volatility & Structured Products

a. Short Selling It is interesting to note that historical stock market speculative excesses have been committed not only on the bull side but on the bear side as well. While speculation per se is good for the market, excesses are not. Both over-valuation and under-valuation of stocks reflect market inefficiencies. A short sale is a sale of securities which the seller does not own at the time of effecting a sale. The theoretical pinning to this is very simple. In a scenario where a particular stock is under valued, market participants will identify this and buy up the stock with the result that the stock price tends to rise eliminating under-valuation. In this case, the market participant makes a profit and the market’s pricing efficiency will also improve. The same logic can be applied to over-valued stocks. Similar to earlier logic, market participants will now sell over-valued stocks which will reduce the market price and improve pricing efficiency. Hence, there is nothing immoral about this. However, short-selling strategy is not as straight forward as the strategy of buying under-valued stocks. In the case of short-selling, the short seller has to borrow the stocks sold short during the entire process till he returns the borrowed stock. While there is nothing undesirable about short-selling, history is replete with abuses on short-selling making the need to regulate this more than what is necessary. This is because short-selling could result in a loss that can be indefinite. In a long-only strategy, the maximum loss could be at best 100%. In a short-sale, the potential loss can be much higher because there is no limit to price rise. Short-selling in a context where floating stock is small (as is the case with many stocks in GCC) may lead to manipulative practices viz., short squeeze. A short squeeze arises when bulls are able to corner the supply of stock and bid up the price artificially. Existence of short-selling is not a precondition for improved market efficiently, provided the market is blessed with active and well-informed investors. However, in the absence of active and well-informed investors, encouraging short-selling with appropriate regulatory checks and balances will certainly improve market pricing efficiency. This, in turn, will lead to efficient resource allocation. Also, short-selling is much more beneficial if applied in a portfolio context than in individual stock context. If there is a rise in market prices, the investors will incur loss on their portfolios of short-sales but would be compensated by the gains on their actual investment holdings. In short, short selling promotes more active search for over-valued stocks and more speedy adjustment of market prices to company performance.

Short-selling refers to selling a stock that is not owned. Shorting (selling high and buying low) is not allowed in GCC.



b. Option Strategies Covered Call Strategy A covered call is an option strategy that involves writing (selling) a call option on a stock that the investor owns. This strategy is one of the most basic and widely used where investors can generate increased income from the underlying stock which can be either purchased simultaneously with writing the call option or is already held. In both cases the underlying shares will fully "cover" the obligation created as a result of writing the call option contract. However, the strategy gives investor a limited profit potential of the premium received while the downside risk in limited to the stock price minus the premium. (Refer Appendix: 2 for Illustration)

Protective Put Strategy A protective put is an option strategy that involves buying a put option on a stock that the investor owns. The protective put is the most famous strategy that is used to hedge against the decrease in the value of the shares owned. It is called a protective put because the gain on the put option purchased will "protect" the investor from any loss arising from decrease in the value of the owned share. (Refer Appendix: 2 for Illustration) Both covered call and protective put can find extensive application in the GCC region. The high level of strategic holding by families in leading blue chip companies provides excellent ground for generating income through writing call options. Similarly, large exposure to GCC stock market can be effectively protected through buying put options.

c. Trading volatility Traditional equity trading is mainly based on speculating the market movement of the underlying equity and can be done through two strategies. The first one is to buy low and sell high which is a long strategy while the second is to sell high and buy low which is called shorting (not allowed in GCC markets).

On the other hand, volatility trading entails strategies designed to speculate on changes in the volatility of the market rather than on its direction. Volatility is traded through many products or tools of which the simplest and most famous is options. Option is a product which can provide investors with plenty of opportunities and trading alternatives to generate returns under almost all market conditions.

Defining Volatility Volatility is the term that is used to measure how actively the price of an underlying instrument (stock, future, or index) changes within a period of time. It is also one of the most important variables to pricing options. Volatility traders have two volatility parameters that are involved in the decision-making process. These parameters are:

Volatility can be either historical or implied.

Covered call strategy involves writing call option on a stock that the investor owns.



1) Historical Volatility: It is statistical measure to quantify historical volatility. It is generally measured with the use of standard deviation (dispersion around the mean) expressed in percentages for different time periods. For example you can compute a 20 day, 40 day or 120 days of volatility.

2) Implied Volatility: As described by its name, it shows what the market predicts as the volatility of the underlying instrument to be over its life. For instance, the implied volatility of an option contract can be derived by plugging in its market price in an option pricing model such as the Black-Scholes.

Trading Options Recall that investors need to have a tool in order to trade volatility. In this report we will use the options as an illustrative tool to show how volatility can be traded. There are essentially two types of trading strategies that are used by the option traders

1) Strategies that are based on taking a speculation on the direction of the price movement of the underlying equity or "directional trading".

2) Strategies that are based on taking a bet on the market volatility of the option contract or "volatility trading".

Directional Trading Traders who rely on directional trading to make profits have first to take a guess on the movement of the underlying equity price and then establish the corresponding position in the option market. It is advantageous to implement this strategy using options than direct equity exposure as options provide many benefits. (Appendix 3). Volatility Trading Similar to the fundamental equity trading approach where traders seek to identify overvalued and undervalued stocks based on a comparison between the equity market price and its intrinsic value, the volatility traders will compare the implied volatility of an option contract with the historical volatility. Trading actions can be summarized as follows:

Scenario Trading Action Implied Volatility > Historical Volatility Sell Volatility Implied Volatility < Historical Volatility Buy Volatility

Thus if the implied volatility is higher than the historical volatility, then this would be an indication that the option contract is overpriced, and consequently, "selling volatility" is recommended and vice-versa. This is illustrated by using the implied volatility vs. historical volatility chart of the Intel Corporation stock. (Figure 4)

One sells volatility when the historical volatility is lower than the implied volatility.



The chart demonstrates the fact that implied volatility exhibit a mean reverting characteristics i.e., if the implied volatility of the stock shoots up or down in response to a major event that is expected by the market, it will eventually move back "revert" towards its mean. Historical Volatility Cones Volatility Cones initially proposed by Burghart and Lane (1990) are often used by option traders to figure out whether the implied volatilities traded in the market are cheap or expensive. The volatility cone chart is a very useful tool to predict the future volatility of the stock as it presents important characteristics of the volatility of a particular stock. It is also useful in comparing the predicted future volatility of a stock with its actual realized volatility. To illustrate we'll use the volatility cone chart of the Intel Corporation Stock.

Historical Volatility ConeIntel Co. Mar 05 to Feb 07

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Source: Markaz The mean reverting behavior of volatility is evident in the above cone chart which shows the distribution of the Intel stock volatility over different periods for a 2-year range of data. Starting from the extreme left on the X- axis, we can see that over 30 days period, the volatility has ranged approximately from 13% to 39%. Over 120 days period during the last 2 years the volatility has ranged from approximately 19% to 28%. The mean volatility has ranged from 23% to 25%. As one moves further out in time the lines converge towards the mean, and the mean becomes stable. Thus the volatility is indeed "mean reverting". Another implication that can be

Intel Corporation

Source: IVolatility.com

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Figure 4

Historically Volatility, like stock prices, is “mean-reverting”. Structured products are designed to meet specific investor needs.



observed from the volatility cone chart is that the range (max – min) of the shorter periods (30 days) volatilities is wider than that of the longer periods (120 days) which indicates that the shorter the period the more the variation of the volatility around its mean. Kindly refer Appendix 4 for volatility cone charts for the GCC region. It is worth noting that in order to make the volatility trading process effective, traders should maintain a delta neutral position which can be achieved through dynamic hedging techniques where the underlying market price risk can be eliminated. c. Structured Products A structured product is a financial instrument that mostly combines a conventional asset class such as equity or a fixed income security with a derivative instrument. Structured products are usually designed to meet the investors' specific needs taking into consideration the existing market conditions.

There are many advantages for investing in the structured products which includes:

• Capital Protection • Enhanced Returns • Controlling risk (volatility) • Portfolio Diversification • Utilize Current Market Trend

Each structured product is unique by itself. Among the many types of structured products the most popular is the capital protected equity products or "the capital guaranteed notes". It provides to some extent a risk free ownership of the underlying asset (stock, index, a basket of stocks). Capital Guaranteed Notes A capital guaranteed note is a note which guarantees the investor a certain percentage of capital while giving a chance to participate in the upside movement of the value of an underlying stock or basket or index. The percentage of the capital guaranteed (C %) and the upside participation rate (R %) can be structured based on investor preference. The higher the percentage of capital guaranteed (C %), the lower the participation rate (R %) as illustrated below:

Structured Products

Single Stock Basket of Stocks Equity Index Bonds Mutual Funds Hedge Funds Commodities ETFs, etc

Call Options Put Options Exotic Options Swaps Futures, etc

Derivatives find extensive application in capital guaranteed notes.



Capital Guarantee

Normal Upside Participation Rate Range

90% 85% 100% 100% 40% 55% 105% 5% 15%

If the performance of the underlying asset that the note is linked to is denoted by (P %), then the Payoff of the note at maturity would be: Payoff = Initial Investment * C% + Initial Investment *R%*P% (Refer Appendix: 2 for Illustration) Dynamic Strategies (CPPI) Constant Proportion Portfolio Insurance (CPPI) is an investment strategy whereby funds are allocated dynamically between two types of assets, a risky growth asset such as equities and non-risky asset like bonds, cash etc. The allocation is determined by a prescribed formula and designed to preserve capital at a future date. CPPI has played a crucial role in the structured equity markets. CPPI provides capital protection by reducing equity exposure in declining markets and increasing it in rising markets. At maturity the investor gets the capital guaranteed plus appreciation in the dynamic basket invested both in risky and risk free asset. (Refer Appendix: 2 for Illustration) C. Current Status (GCC) In this section, we trace the growth and development of derivatives market in the GCC region. As noted earlier, only Kuwait has some form of derivatives in the form of options and futures/forward market. The genesis and workings of this is presented below. a. Options Market With rapid growth worldwide, trading options did not exist in the Middle East Stock Exchanges or in the Arab Stock Exchanges until Kuwait Financial Centre S.A.K. “Markaz” initiated a proposal to provide the options service in Kuwait Stock Exchange in year 2002. Markaz suggested establishing a system for trading in options through a Fund viz., “Forsa Fund” to work as a market maker for options trading in the first stage. After analyzing the characteristics of the Kuwait Stock Exchange (KSE), its nature of risks and determining the needs of investors, Markaz suggested a complete mechanism for option trading at KSE after taking into account the current mechanism in international markets. Many trials and simulations were carried out using historical data for system compatibility with the KSE and measuring the risks resulting from option trading in markets. Testing and measurements were made continuously till March 2005 when KSE allowed Call options to be traded by Forsa Fund. Trading on the first day (March 28, 2005) was on 13 stocks and 75 contracts with a total strike value of KD 2,378,150.000. Options value and volume traded fell during year 2006 compared to year 2005 mainly on the back of weak market sentiment. (Figure 5). This reduced the total net premium (Net Premium=Premium received-amount paid back to investor in case he sells the option back before expiry) generated from this activity. (Figure 6)

Markaz initiated a proposal to provide the options services in Kuwait.



Figure 5: Options Value & Volume Traded

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How it works Forsa option contracts are currently traded in the secondary market on 45 listed stocks in the Kuwait Stock Exchange. The contracts are between the Market Maker (Forsa Fund) and the Option Buyer (trader). By this contract, Forsa Fund confers the option buyer the right but not the obligation to buy (in the case of call options) or sell (in the case of put options) a specific number of stocks at a specific price called the strike price before or at a specific date called the expiration date. In return, the option buyer will pay Forsa Fund the price of the option contract or the option premium. Therefore, the option buyer during the term of the contract, may exercise his right to buy (in the case of call options) the underlying stocks from Forsa Fund at the strike price, or exercise his right to sell (in the case of put options) the underlying stocks to Forsa Fund at the strike price. If the investor does not exercise the option during the term of the contract, the validity of the contract will expire at the expiration date. It should be noted that KSE presently permits only call options. Any statement above on the put option is purely for explanatory purposes only and does not imply its existence. In order to provide the necessary liquidity to the market, the Forsa Fund will daily quote bid and ask prices to all the option contracts it writes with a purpose of creating a trading environment that confers the trader the opportunity to sell or exercise the contract. (Refer Appendix: 2 for Illustration)

Forsa fund provides daily liquidity through quoting bid and ask prices for all option contracts.



Mechanism of option Trading Forsa Options are traded at the trading floor of the Kuwait Stock Exchange (KSE) after the close of the spot market from 12:45 PM till 1:15 PM. The Fund as a market maker will provide the investors with the bid and ask prices for all the existing option contracts. Investor who wishes to trade in Forsa options should be a registered trader at KSE. He has to route his orders through the brokers in KSE. After the execution of the deal, the broker provides the investor with a contract showing the details of the option trade. The investor has three ways in which he can settle the Option Contract.

He can sell the contract back to the buyer i.e. Forsa Fund. Forsa Fund is obliged to provide bid price for all the Option it sold and be ready to buyback the Option from the buyer of the Option.

He can exercise his right to buy, in case of Call Option and right to sell, in case of put option. Forsa Fund is obliged to perform the contract. If the investor wishes to sell or exercise his contract back, it should be done through the same broker who executed the original trade. &

Take no action and let the Option expire where if the Option is in the money, the contract will be automatically cash settled. The settlement cycle of the option contracts is the same as that of the spot and the forward markets. The brokerage and commission charges will be applied as per the KSE Rules.

Major Players At the moment, only Kuwait Financial Center S.A.K “Markaz” through the Forsa Fund can make market in call options. Brokerage and Commission Charges The brokerage, clearing and settlement fees charged for option trading in Kuwait Stock Exchange are charged to both the option buyer and the market maker. The total fees for each of the option buyer and the market maker is 5.5% of the contract value and this is actually reflected in the large Ask-Bid spread (around 10.5%). Brokerage Fees: 1.25% (one leg) Clearing and settlement Fees: 1.5% (one leg) To illustrate, in the NBK call option example presented previously the option buyer and the market maker has each to pay KD 70 (2,550 * 2.75%) at the time the contract is initiated and KD 79.2 (2,880 * 2.75%) at the time the contract is settled. Statistics regarding Kuwait options market is presented in Appendix-5 b. Forwards & Futures Forwards Market According to the rules and regulations for trading forward contracts at the Kuwait Stock Exchange, a forward contract represents an agreement between the forward buyer (trader) and the forward seller (market maker) in which the buyer agrees to buy a certain number of shares from the seller for a fixed price (equity spot price) during a future period of time.

Forward contract represents an agreement between the buyer and seller in which the buyer agrees to buy a certain number of shares from the seller for a fixed price during a future period of time. Nearly 75% to 80% of investors offset their contracts in spot market.



At the inception of the forward contact, the forward buyer will pay an upfront premium (price of the forward contract) to the market maker plus 40% of the equity spot price as an initial margin. In return, the seller will deposit the shares with the Kuwait Clearing Company (KCC) that will preserve them to the buyer who should settle the remaining 60% of the value of the equity specified in the forward contract to the market maker before the maturity of the forward contract. If the buyer decides not to pay the remaining 60% (incase the price of the underlying stock decreased), then at maturity the ownership of the shares will return back to the market maker leaving the buyer with a loss of the premium paid as well as the 40% initial margin. Any corporate actions related to the shares under the forward contract are preserved with KCC to be submitted to the buyer once he settles the remaining 60% balance. In case the forward contract expires without settling the remaining 60% balance the dividends are returned to the seller along with the underlying shares. In order to reduce the market makers’ credit risk in case the spot price of the underlying declines significantly – a 40% decline would wipe out the buyers down payment margin – the buyer has to pay a 10% margin call minimum to keep the contract active or can voluntarily close the contract. Failing to do either of the above results in the contract being terminated and the stock and dividends etc. returned to the seller, who retains the original margins. If the stock cannot be liquidated promptly, in this case, the seller could lose money on the liquidation. Currently the forward market offers contracts for 3, 6, 9 and 12 month periods and operates after the spot trading session (12:45PM to 01:15PM). This market is very suitable to the KSE trading environment where the majority of the speculators buy forward contracts to gain financial leverage, and if they make money they sell the shares out in the spot market thereby settling the balance payment before maturity of the contract. Based on historical figures and KSE trading atmosphere, 75% - 85% investors offsets/early settle their contracts in spot market. The Portfolio will receive the final payment balance before maturity of contracts. This enables the portfolio to reinvest the capital before its maturity date. There is a gain in time value of period where final payment is received in advance. During periods of decline, 60% of the investors whose contracts have fallen below the coverage level prefer to pay the margin calls. The reason being that the investor’s psyche does not allow him to let go of a contract in which he has invested the upfront payment of 40%. The buyer receives the Margin Calls and thereby minimizes his risk further by 10% (minimum). A graphical presentation on the workings of the forward market is presented in Appendix: 6 Futures Market The futures market operates in a completely similar manner as the forward market except that the future market operates during the spot trading session (9:30AM to 12:15PM). Because forwards are traded after the close of the spot market, the manager has to maintain a minimum inventory holding and be able to find the liquidity to cover it, whereas in the case of the futures market, traders would first request for the shares, whereby the market maker would make the direct purchase of shares from the spot

Futures market operates very similar to forward market. There are 17 players in the futures/forward market as against 1 in options.



market and pass them on to the trader through the future contract after adding the premium and commissions. Thus there will be no need to accumulate stocks unlike the forward market. Market Players Unlike options market where there is only one market maker, the futures and forward market enjoys many players. An indicative list of players is provided in Appendix: 7. Statistics regarding Kuwait futures market is presented in Appendix-6 D. Road Map A major motivation for introduction and growth of derivatives in the GCC region is that it can enable transfer of risk between individuals and firms in the economy. More simply, it is like buying and selling insurance. While the risk-averse investor buys insurance, a risk-seeking investor sells the insurance. Past researches have produced very encouraging findings, some of which are summarized below.

Introduction of derivatives do not destabilize the underlying market. On the contrary, it improves liquidity and reduces informational imbalances in the market.

Derivatives play a very important role in terms of price discovery and in completing the market.

They provide a solid basis for institutional investors and mutual fund managers for risk management. This role as a risk management tool clearly assumes that derivatives trading do not increase market volatility and risk. For e.g., put options will reduce the volatility in the market as “irrational exuberance” would be corrected much before it becomes a bubble and affects the socio economic set up/ordinary investors. Put options will help the market reach its true level faster and help prevent manipulative practices.

Availability of derivatives (especially equity derivatives) has enabled traders to transact large volumes at much lower transaction costs relative to the cash market. This, in turn, will increase market depth and volatility, two major limitations of GCC markets.

Studies also point to the fact that introduction of options seemed to have helped stabilize trading in the underlying stocks. It is observed that volumes in the underlying stocks increase after the introduction of stock options.

Studies have also found that after the introduction of options, prices tend to reflect new information more quickly leading to narrowing of bid-ask spreads.

The Road Map In terms of an action plan for GCC regulators, we suggest the following: 1. Set up a Derivatives Exchange: Exchange-Traded Derivatives can

be a solid basis to start the process than OTC. Derivatives which trade on an exchange are called “Exchange-Traded Derivatives”, while a derivative contract which is privately negotiated is called an OTC derivative. Trades on an exchange generally take place with anonymity and go through a clearing corporation while that of OTC do not. Hence, forming a derivatives exchange will be the most important first step to be taken.



2. Draft Regulatory Framework: GCC capital markets are neither emerging markets (from an economic strength point of view) nor a developed market from a market microstructure point of view. Hence, it is pertinent to form a committee of highly experienced and qualified people drawn from various financial institutions to come up with a customized regulatory framework for the orderly governance of derivatives. A lot can be learned from the experience of some of the Asian capital markets that have successfully set-up such frameworks.

3. Introduce Index Equity Derivatives: Equity derivatives are the most common worldwide, especially index futures followed by index options and security-specific options. Internationally, options on individual stocks are common; futures on individual stocks are not that common. Index based equity derivatives (options and futures) are quite popular among investors as they are excellent hedging tools and also present few regulatory headaches when compared to leveraged trading on individual stocks. This has led to regulatory encouragement of index futures and discouragement against futures on individuals stocks.

4. Introduce Short-Selling: As we explained earlier, market efficiency can be significantly enhanced through introduction of short-selling. Just as we have margin requirements on the long-side, we can have similar regulatory checks to prevent misuse of this important tool. If dealt with properly, short-sales can check bear-side excesses in a falling market.

5. Introduce Stock Equity Derivatives: With a well stabilized index based equity derivatives, the risks of stock-based equity derivatives is well contained.

As we can see from the above, except for Kuwait none of the other GCC markets have taken any of the steps suggested above. Even in the case of Kuwait, introduction of derivatives in the form of call options did not adhere to a structured process as explained above. There are still gaps to be addressed (Appendix: 8).



Appendix 1: Growth of Derivatives Market in Asia Global exchange-based trading in equity derivatives has almost doubled over the last three years from $54 trillion in 2002 to $114.1 trillion of notional value (on 6.3 billion contracts by end-2005). The volume of global trading in 2006 had already reached $96.1 trillion as of August 2006. On Asia’s exchanges, equity derivatives have witnessed the most rapid growth of all traded derivative products (foreign exchange, interest rate, equity, commodities, and credit derivatives). Equity derivative trading in emerging Asia has mushroomed from $16.5 trillion in 2002 to $40.3 trillion in 2005 (and $37.1 trillion by the end of August 2006), and now represents 38.6 percent and 43.9 percent of worldwide equity derivatives turnover by notional value and number of trades respectively. This mainly represents very rapid growth in Korea, which hosts the world’s most active derivatives market––the Korean Futures Exchange. Equity derivatives are mainly traded on organized exchanges rather than OTC. Annual OTC equity derivatives trading in Asia (excluding Japan) is only around $100 billion (BIS, 2005). Most equity derivatives are exchange-traded (ETD), as opposed to foreign exchange and interest rate derivatives, which are mostly traded OTC. Formalized and regulated exchanges are leading the growth in Asian derivative markets, which can be divided into three categories: (i) fully demutualized exchanges (Hong Kong SAR and Singapore), which offer a wide range of derivative products; (ii) partially demutualized exchanges (Korea, India, and Malaysia), which have specialized in equity futures and index products; and (iii) derivative markets with no or marginal exchange-based trading and limited OTC derivative trading (China, Indonesia, the Philippines, and Thailand). Equity derivatives markets are much less well-developed in other emerging Asian countries. In general, high levels of ETD tend to be associated with high equity trading in deep and sufficiently wide cash markets, mainly because the development of derivatives necessitates sufficient liquidity of cash markets (including pricing benchmarks) to ensure efficient price discovery. Since 2000, growth in overall derivative trading only in Korea, Hong Kong SAR, and Taiwan POC has outstripped growth of both domestic market capitalization and cash trading in equity markets. These countries currently exhibit high turnover ratios of almost 1½ to more than 36 times of outstanding stock, while average global turnover ratios of equity derivatives tend to converge to one (BIS, 2004; and WFE, 2005). Since most of equity derivative contracts are traded in these countries, their high turnover ratio has kept aggregate equity derivative trading in emerging market Asia at more than 10 times GDP, stock market capitalization, and stock trading. Although stock exchanges in countries such as China, Indonesia, Malaysia, Thailand, and the Philippines also have strong trading activity in cash markets, similar to that in emerging market and mature market countries with established derivative markets, trading in equity derivatives remains very limited. Contract sizes in emerging Asian countries have more than doubled, from $8,200 in 2003 to $19,000 by August 2006, but they still lag behind global averages. Contract sizes of equity derivatives in countries like India and Malaysia are still less than half of the notional amount per trade in Asia and less than a third of the notional amount per trade in the United States. Besides Hong Kong SAR, only the equity derivative market in Korea offers contract sizes in emerging Asia similar to mature market economies. The strong development of equity derivatives in Korea and India reflects a robust operational and legal infrastructure (Fratzscher, 2006). For example, both countries have well-designed trading platforms, which provide access to both domestic and foreign institutional investors. Indonesia has just established the Jakarta Futures Exchange and introduced equity index futures at the Surabaya Stock Exchange. The Thailand Futures Exchange (TFEX), in operation since 2004, started trading its first stock index future only in April 2006. In the Philippines, equity derivatives have not been traded since the Manila Futures Exchange closed in 1997. By comparison, countries that are lagging have (for example) weak trading infrastructures, shortcomings in relevant laws that create uncertainty about whether derivatives contracts can be enforced (or even whether trading derivatives is permitted), tax provisions that are unfriendly to derivatives, bans on short selling, and restrictions on investment by foreigners. Reaping the full benefits of equity derivatives markets by fostering their wider development also requires careful management of risks to financial stability. In Asian countries without formal derivative exchanges, the rising popularity of OTC derivatives entails greater emphasis on disclosure and transparency, good governance and risk management. Systemic risk is



potentially reduced when trading occurs in well-structured and formally regulated exchanges that impose appropriate margin requirements and position limits, administer centralized clearing and settlement, engage in market surveillance, undertake adequate disclosure, and mutualize risks through loss-sharing arrangements, capital deposits of members, and international excess-of-loss insurance. It is also reduced when supervisors and regulators can ascertain the exposure of systemically important financial institutions to derivatives markets. Sizable retail trading of derivatives may pose its own challenges and could (in principle) entail significant knock-on effects on real sectors; for example, a market downturn that inflicted widespread losses on households could affect confidence and spending. A good understanding of all these issues is incumbent on country officials charged with safeguarding financial stability. Source: Asian Equity Markets: Growth, Opportunities & Challenges by Catriona Purfield, Hiroko Oura, Charles Kramer, and Andreas Jobst. IMF Working Paper WP/06/266. Appendix 2: Illustrations 1. Covered Call An investor owns 1000 shares of NBK at KD 2.000. He also sells a 1 month call option contract on NBK for 1000 shares at a strike price of KD 2.000 for a premium of 50 Fills, which he receives per share from the buyer of the Option. This position initiated is called a Covered Call because the investor is covered with the stock in case the buyer exercises his right to buy the shares at the strike price. The strategy is favored when the investor expects the share price to exhibit a small movement over the lifetime of the option contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock owned, and/or provide a limited amount of protection against a decline in underlying stock value. Profit and loss of the trade Trade Details Stock Value 1000 shares at KD 2 each = KD 2000 Number of call options sold 1000 Strike Price KD 2.000 Option premium per share 50 Fills Total option premium received KD 50 Scenario Payoff Rationale If Share price moves to KD 3 KD 50 The option premium which is KD 50, since the option holder

will exercise the option and the underlying shares will have to be delivered.

If Share price stays flat at KD 2

KD 50 The option will expire worthless and hence the option writer keeps the premium which is KD 50

If Share price falls to KD 1 (KD 950)

Loss of underlying stock value which is KD 1 per share i.e., KD 1000. Profit on premium received which is KD 50. Net loss: KD 950



-200

-150

-100

-50

0

50

100

1.80 1.85 1.90 1.95 2.00 2.05 2.10 2.15 2.20

Stock Price

Prof

it/ L

oss

Profit / Loss

Covered Call Writer 2. Protective Put For example if an investor is holding 1000 shares of NBK at a price of KD 2.000 and the investor buys a 1 month put option contract of 1000 shares at strike KD 2.000 then it is called as a protective put strategy. Stock View The strategy is implemented with a positive view on the stock; however the investor wants to hedge his downside risk. Buying a put option is like buying insurance for the stock and hence if the stock does not go down in price, he loses only the premium paid. Profit and Loss of the trade

Trade Details Stock Value 1000 shares at KD 2 each = KD 2000 No of put options bought 1000 Strike Price KD 2.000 Option premium per share 50 Fills Total option premium paid KD 50

Scenario Payoff Rationale If Share price moves to KD 3

KD 950 The underlying position value improves due to stock price appreciation. However, the put option expires worthless and hence the premium paid is wasted.

If Share price stays flat at KD 2

-KD 50 The put option will expire worthless and hence the loss will be the premium paid.

If Share price falls to KD 1 -KD 50 Sine the option is in the money, the option holder will exercise his option. Profit on exercising the option will be KD 1000. However the underlying equity position also loses its value to the extent of KD 1000 and hence they are neutralized. Hence, the net loss will be equal to the premium paid which is KD 50



-200

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100

150

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Stock price Profit / Loss

Protective Put Writer 3. Capital Guaranteed Note A 3-year 100% capital guaranteed note with a participation rate of 45% Linked to a Kuwait Basket of Shares. The note provides 100% capital guarantee at maturity which is 3 years thereby eliminating the downside risk. On the upside, it gives 45% of the appreciation in the Kuwait Basket of shares over the 3 year period. This note will be suitable for an investor who has a bullish view on the Kuwait market and seeks to have exposure to it, but on the other hand wants to fully protect his capital. Structure The issuer of the guaranteed note will receive a capital of KD 1000 from the investor who purchased the note. The issuer will invest the proceeds in buying: 1) A zero coupon bond that matures in 3 years. The price of the bond will be the present value of the

capital received PV (KD 1000)5.55% or KD 850. The bond will guarantee that the issuer will be able at maturity to pay the capital that was initially received from the investor.

2) A call option on the Kuwait Basket with 3 years to expiry that will cost approximately 33.3% of the total value of the Kuwait Basket. Hence by paying the remaining KD 150 for the call Option, the issuer will get a 100% exposure (participation) to a basket of total value of KD 450 (150/33.33%) which is equal to 45% of the amount of capital invested by investor (KD1,000) thereby 45% of capital invested is exposed to market returns. In other words, the participation rate is calculated by dividing the relative amount left for the options (15%) by the relative option premium (33.33%) or 45%.

Hence such a structured product is a combination of a zero coupon bond (asset class) and a call option (derivative instrument).



Thus if the performance of the Kuwaiti basket is 60% at maturity, then the investor will receive KD 1000*100% + KD 1000*45%*60% or KD 1,270, and if the Kuwaiti basket did not perform positively, then the investor will receive only his capital invested or KD 1000. 4. CPPI

Suppose a 5 years 100% capital guaranteed CPPI structure is issued with minimum investment of KD 1000. The issuer will invest the proceeds in:

A zero coupon bond that matures in 5 years. The price of the bond will be the present value of the capital received PV (KD 1000)6% or KD 750. The bond will provide the capital protection.

The issuer invests the remaining amount (KD 250) in a risky asset, together with an amount borrowed from the money-market. The amount borrowed will be normally equal to the amount invested in the zero coupon bond so that the total amount invested in the risky assets is equal to the initial investment., Thus total amount borrowed will be KD 750 which makes the total investment in the risky asset KD 1000. The cost of the borrowing needs to be paid from the return generated by the risky asset. The investment in the risky asset will grow if the return generated is higher than the borrowing cost of KD 750. The risky asset portfolio is rebalanced periodically and if the returns are zero or less, than the only the guaranteed capital is paid at maturity. If there is any positive return generated by the risky asset, than the investor gets KD 1000 (capital guaranteed) + any excess return generated by the risky asset.

There are others types of CPPI structure too where the capital is not guaranteed with the use of a zero coupon bond but other combination are created to provide capital guarantee. However, the basic design remains the same that the asset is allocated between a risk free asset and a risky asset and rebalanced according to the market condition.

Invest the remaining KD 150 (1000 – 850) Invest KD 850

Contributes 45% of the upside of the basket at

maturity

Returns KD 1000 at maturity

Issuer of the Structured Note

Receives KD 1000

Buy a 3- yrs Zero Coupon Bond with

face value of KD 1000

Buy a Call Option with 3- yrs maturity on the

Kuwait Basket

Investor

Pays KD 1000 at inception

Pays KD 1000 plus 45% participation at maturity



5. Call option A call option contract was issued by Forsa Fund on 06-Jan-2007 with the following terms: Underlying Stock: National Bank of Kuwait (NBK) Strike price: KD 2.160 Avg. Traded Price KD 2.162 Implied Volatility 27.53% Quantity: 10,000 Expiration date: 27-June-2007 Ask price: KD 0.255 Bid Price: KD 0.229 The buyer of this contract on 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amount of KD. 2,550/-. (Ask price * number of stocks i.e., KD 0.255 * 10,000 = KD. 2,550/-) The Average traded price for the NBK share increased to reach KD 2.246 on 09-Jan-2007 and the corresponding Ask and Bid prices increased to KD 0.311 and KD 0.280 respectively. So the option buyer can settle his contract as follows: Sell the option back to the market maker (Forsa Fund) at the Bid price (KD 0.280). Profit: 25 Fils (0.280 - 0.255) per stock or KD 250. Return: 9.8 %. Or Buy 10,000 stocks of NBK from the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. In this case, the option buyer pays KD 21,600/- to the market maker without the deduction of the premium paid (KD 2,550/-). 6. Put option Assume the Put option contract was issued by Forsa Fund at 06-Jan-2007 with the following terms: Underlying Stock: National Bank of Kuwait (NBK) Strike price: KD 2.160 Avg. Traded Price KD 2.162 Implied Volatility 27.53% Quantity: 10,000 Expiration date: 27-June-2007 Ask price: KD 0.129 Bid Price: KD 0.116

Borrowed

Invest KD 7 5 0

Returns KD 1000 at maturity

Issuer of the CPPI Structured Note

Receives KD 1000

5 - yrs Zero Coupon Bond with face

value of KD 1000

Dynamic Asset

Rebalancing between Risky Asset and Risk

less Asset

Investor

Pays KD 1000 at in ception

Pays KD 1000 plus return on

the risky asset portfolio

KD 750 KD 250

Bank

Return generated

from the portfolio



The buyer of this contract at 06-Jan-2007 has to pay to the market maker (Forsa Fund) a premium amount of KD 1,290/-. (Ask price * number of stocks i.e., KD 0.129 * 10,000 = KD 1,290/-) Assume the stock price on 07-Feb-2007 decreased to KD 2.007, the Ask and the Bid prices will therefore increase to KD 0.238 and KD 0.214 respectively. The option buyer can settle his contract as below: Sell the option back to the market maker at the Bid price (214 Fills). Profit: 85 Fills (214-129) per stock or KD 850 Return: 65.8 %. Or Sell 10,000 stocks of NBK to the market maker (Forsa Fund) at the strike price of KD 2.160 per stock. In this case, the option buyer receives KD 21,600/- from the (Forsa Fund) and transfers 10,000 NBK stocks to the market maker’s account. Please note that currently put options are not available in KSE. Appendix 3: Benefits of Options Buying options provides the following benefits: i) Limited risk, unlimited profit Options will ideally suit a trader where trading options is distinguished by the small capital required (in comparison with trading stocks in the cash market) and the speed of entering and exiting positions (by selling the option contract back to the market maker as a substitute for exercising the right of settlement in kind). These advantages help in reaping profits in trading. For example, if the option buyer predicts the increase in the stock price, he can attain profits by buying the call options and if he expects a fall in the stock price, he can profit by buying put options. In both cases, the option buyer can sell the option back to the market maker before the expiration date for profit taking. ii) Leverage Trading in options can allow the investor to benefit from a change in the stock price without having to pay the full value of the stock, thus allowing him to make a higher return from a smaller initial outlay. The following table shows the difference between the return of investment in options and the return of direct investment in the underlying stock: Characteristics Buying the option Buying the stock

Stock price/ strike price( Fils ) 1000 1000 Quantity ( Stock) 1 1 The premium ( Fils ) 35 ------ Total investment 35 1000 Stock price before expiration 1050 1050 Total profit ( Fils per Stock ) 50 50 Net profit ( Fils per Stock ) 15 50 Investment return 43% 5% As shown in the table, the option contract provides leverage as they maximize the profit in comparison with buying fully-paid stocks. This is because the premium represents only a slight portion of the price of the underlying stock and still makes the same amount of profit; this leads to higher returns for the invested capital. iii) Insurance (Hedging Tool) Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash. An example of this is called Protective Put.



Kuwait General Market IndexJan 05 - Jan 07

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6%

8%

10%

0 30 60 90 120 150 180 210 240 270

Min Median Max Last

Bahrain General Market Index

Jan 05 - Jan 07

0%

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12%14%

16%18%

20%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Dubai General Market Index

Jan 05 - Jan 07

0%2%4%6%8%

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14%16%18%20%

0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Saudi General Market Index

Jan 05 - Jan 07

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10%

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0 30 60 90 120 150 180 210 240 270

Min Mean Max Last

Appendix 4: Volatility Cone Charts for GCC Markets



Abu Dhabi General Market Index

Jan 05 - Jan 07

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10%15%20%25%30%35%40%45%50%

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Min Mean Max Last

Qatar General Market Index Jan 05 - Jan 07

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0 30 60 90 120 150 180 210 240 270

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Muscat General Market Index

Jan 05 - Jan 07

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Min Median Max Last



Appendix 5: Options Statistics for Kuwait

Premiums (KD) Volume Underlying

Value (KD)Value Paid

(KD) Volume % Vol Volume % Vol Volume % Vol

101 341,641 3,526,000 6,721,480 446,676 3,115,000 88.34% 0 0.00% 411,000 11.66%106 693,871 21,719,000 13,926,460 654,466 14,723,000 67.79% 500,000 2.30% 6,496,000 29.91%107 514,523 19,537,000 9,127,465 386,481 11,692,000 59.85% 10,000 0.05% 7,835,000 40.10%108 537,796 6,099,000 11,411,520 600,741 5,243,000 85.96% 0 0.00% 856,000 14.04%204 1,921,654 24,108,000 26,214,000 2,082,356 20,025,000 83.06% 0 0.00% 4,083,000 16.94%205 852,227 37,274,000 13,727,550 1,079,813 30,959,000 83.06% 0 0.00% 6,315,000 16.94%219 757,053 26,370,000 12,410,440 711,525 20,231,000 76.72% 0 0.00% 6,139,000 23.28%221 644,509 26,107,000 13,240,360 722,136 18,791,000 71.98% 100,000 0.38% 7,216,000 27.64%402 715,566 27,178,000 10,307,665 474,278 16,407,000 60.37% 0 0.00% 10,771,000 39.63%404 136,465 3,855,000 2,820,800 136,420 3,560,000 92.35% 40,000 1.04% 255,000 6.61%414 478,521 16,974,000 7,013,260 391,096 11,813,000 69.59% 0 0.00% 5,161,000 30.41%418 436,650 21,238,000 7,306,250 411,325 13,724,000 64.62% 0 0.00% 7,514,000 35.38%501 1,304,092 21,354,000 22,225,880 2,244,486 18,874,000 88.39% 85,000 0.40% 2,395,000 11.22%502 1,477,793 21,272,000 20,244,170 1,151,357 15,031,000 70.66% 145,000 0.68% 6,096,000 28.66%504 227,879 3,657,000 3,222,660 116,272 3,408,000 93.19% 0 0.00% 249,000 6.81%514 1,473,933 20,619,000 22,860,780 1,164,723 14,777,000 71.67% 10,000 0.05% 5,832,000 28.28%605 1,967,389 7,837,198 36,517,458 2,131,321 6,763,198 86.30% 9,000 0.11% 1,065,000 13.59%608 190,080 5,120,000 3,610,100 143,583 3,500,000 68.36% 0 0.00% 1,620,000 31.64%613 893,740 7,676,000 16,528,420 866,492 7,320,000 95.36% 0 0.00% 356,000 4.64%614 819,425 5,150,000 8,912,000 350,228 2,917,000 56.64% 0 0.00% 2,233,000 43.36%702 661,321 21,617,000 10,751,735 1,079,870 18,603,000 86.06% 100,000 0.46% 2,914,000 13.48%

Total 05 17,046,128 348,287,198 279,100,453 17,345,642 261,476,198 75.1% 999,000 0.29% 85,812,000 24.6%101 409,638 4,572,000 3,084,242 331,010 4,259,000 93.15% 0 0.00% 313,000 6.85%106 392,019 12,215,000 7,084,207 364,536 10,203,000 83.53% 0 0.00% 2,012,000 16.47%107 394,110 8,450,000 4,635,010 312,399 6,530,000 77.28% 0 0.00% 1,920,000 22.72%108 474,954 4,161,000 3,361,879 344,410 3,597,000 86.45% 0 0.00% 564,000 13.55%204 468,725 6,817,000 4,566,786 257,745 4,523,000 66.35% 0 0.00% 2,294,000 33.65%205 1,139,164 25,483,000 18,229,875 678,675 15,799,000 62.00% 0 0.00% 9,684,000 38.00%210 235,053 13,495,000 7,409,772 155,124 9,742,000 72.19% 0 0.00% 3,753,000 27.81%217 204,398 3,438,000 1,582,172 258,995 2,520,000 73.30% 0 0.00% 918,000 26.70%219 331,972 13,117,000 7,049,404 213,444 9,021,000 68.77% 100,000 0.76% 3,996,000 30.46%220 496,680 19,753,000 10,209,285 794,866 15,815,000 80.06% 110,000 0.56% 3,828,000 19.38%221 273,957 9,694,000 6,652,750 118,407 5,249,000 54.15% 0 0.00% 4,445,000 45.85%222 115,880 3,716,000 1,997,510 75,523 2,746,000 73.90% 0 0.00% 970,000 26.10%226 369,407 19,448,000 10,474,214 282,979 12,421,000 63.87% 0 0.00% 7,027,000 36.13%302 23,428 1,057,000 962,120 26,267 1,052,000 99.53% 0 0.00% 5,000 0.47%401 80,091 7,723,000 3,744,724 41,960 4,498,000 58.24% 0 0.00% 3,225,000 41.76%402 263,120 13,500,000 9,088,740 149,061 9,070,000 67.19% 0 0.00% 4,430,000 32.81%403 200,765 4,451,000 2,189,876 149,562 3,741,000 84.05% 0 0.00% 710,000 15.95%404 96,540 2,925,000 1,777,415 108,030 2,400,000 82.05% 0 0.00% 525,000 17.95%405 40,608 4,635,000 2,285,428 14,790 2,290,000 49.41% 0 0.00% 2,345,000 50.59%410 166,629 14,359,000 9,289,220 92,413 7,409,000 51.60% 0 0.00% 6,950,000 48.40%412 27,555 2,390,000 1,535,720 16,660 1,745,000 73.01% 0 0.00% 645,000 26.99%414 118,377 6,630,000 4,245,450 79,308 4,190,000 63.20% 0 0.00% 2,440,000 36.80%418 165,247 6,992,000 3,701,205 123,098 5,667,000 81.05% 0 0.00% 1,325,000 18.95%501 1,211,921 11,756,000 8,036,360 898,429 9,469,000 80.55% 0 0.00% 2,287,000 19.45%502 301,349 8,856,000 5,672,870 282,751 7,123,000 80.43% 0 0.00% 1,733,000 19.57%504 109,388 3,974,000 2,015,050 100,080 2,925,000 73.60% 0 0.00% 1,049,000 26.40%506 287,809 10,838,000 6,589,680 448,560 9,205,000 84.93% 0 0.00% 1,633,000 15.07%513 255,157 8,011,000 4,215,512 115,612 5,212,000 65.06% 0 0.00% 2,799,000 34.94%514 155,353 2,784,000 1,787,875 85,510 1,940,000 69.68% 0 0.00% 844,000 30.32%522 210,411 8,139,000 5,656,710 176,961 6,092,000 74.85% 0 0.00% 2,047,000 25.15%603 759,461 5,120,000 3,110,040 587,467 4,470,000 87.30% 0 0.00% 650,000 12.70%605 597,253 3,675,000 2,289,337 555,285 3,192,000 86.86% 0 0.00% 483,000 13.14%607 53,547 2,692,000 2,145,730 35,640 2,200,000 81.72% 0 0.00% 492,000 18.28%608 80,540 2,440,000 1,272,580 37,090 1,670,000 68.44% 0 0.00% 770,000 31.56%610 494,070 6,953,000 4,348,205 351,495 5,830,000 83.85% 0 0.00% 1,123,000 16.15%613 195,504 1,910,000 1,291,580 140,310 1,689,000 88.43% 0 0.00% 221,000 11.57%614 678,863 6,737,000 3,944,764 425,169 4,952,000 73.50% 0 0.00% 1,785,000 26.50%622 43,710 4,562,000 2,126,180 12,471 2,067,000 45.31% 0 0.00% 2,495,000 54.69%701 97,503 4,068,000 2,608,651 74,531 3,278,000 80.58% 0 0.00% 790,000 19.42%702 570,674 17,742,000 10,376,310 300,236 11,174,000 62.98% 0 0.00% 6,568,000 37.02%

Total 06 12,590,830 319,278,000 192,644,438 9,616,857 226,975,000 71.1% 210,000 0.07% 92,093,000 28.8%Total 29,636,958 667,565,198 471,744,891 26,962,499 488,451,198 73.2% 1,209,000 0.18% 177,905,000 26.6%

Expired ContractsCodes

Sold Contracts Repurchased Contracts Exercised Contracts



Appendix 6: Futures/Forward Illustration

Contract Initiated

Stock Price (KD)

% Margin Required

Margin Paid

% Interest

for 3 months

Premium Paid

Price of the

Forward Contract

Total Down

Payment

Final Payment Required

t = 0 1 40% 0.4 3.25% 0.0195 1.0195 0.4195 0.6

Additional Requirements Action Taken by the Buyer

Trading Day

Stock Price (KD) Additional

% Margin

Margin Required

(KD)

Remaining Balance

(KD)

Continue to hold the contract

Close the contract

Net P&L of the

buyer if contract is closed

t = 1 1.2 0% 0 0.6

Hold the Contract in anticipation of a potential increase in the Stock Price

Sell the shares in the market at KD 1.2 and pay the remaining balance

0.1805

t = 2 0.8 0% 0 0.6

Hold the Contract in hope for a recovery in the Stock Price

Sell the shares in the market at KD 0.8 and pay the remaining balance

-0.2195

t = 3 0.59 10% 0.06 0.54 Pay additional 10% margin to the market maker

If the additional margin is not paid, the KCC will closed the contract (total loss of down payment)

-0.4295

t = 4 0.5 10% 0.054 0.486 Pay additional 10% margin to the market maker

If the additional margin is not paid, the KCC will closed the contract (loss of down payment + 10% additional margin)

-0.4795

t = m (Maturity) 1 0% 0 0.486 Contract expires

Sell the shares in the market at KD 1 and pay the remaining balance

-0.0195

Appendix 7: Futures/Forward Market Players (Kuwait) Kuwait And Middle East Finance Invest Co Wafra International Investment Co. Kipco Asset Management First Investment Company Securities Group Company K.S.C The Securities House National Investments Company Bayan Investment Co. K.S.C.C International Financial Advisers K.S.C. Global Investment House Coast Investment & Development Co. Al-Muthanna Investment Co. Al-Madar Finance And Investment Co. Al-Aman Investment Co. Noor Investment Co. Gulf invest International Co. Manafee Investment Co.



Appendix 8: Kuwait Derivatives: Road Map

Action Point

Road Map

Develop a mechanism for Introducing call options into KSE

Accomplished

Introduce put options into the KSE.

Until and unless put options are allowed, the role of derivatives as a hedging mechanism cannot be complete. Put option is the primary tool through which portfolios are hedged.

Expanding the number of market makers Presently Kuwait Financial Center S.A.K through its Forsa Fund is allowed to operate as a market maker on a covered call basis. This restricts the market growth. We would welcome encouraging other institutions to act as market makers in order to significantly grow the options market in the GCC.

Allow investors to write options through the market maker (MM).

Many high net worth investors hold significant strategic stake in leading Kuwait companies. These are not traded and normally dormant. Allowing these strategic investors to write options will enable investors to reap additional income via options premium. This will also provide the needed liquidity to the market and enhance the price discovery function.

Reduce the brokerage, clearing and settlement fees

The current fee structure at around 5.5% is way above international standards. In the presence of such extraordinary fees compared to other international markets, the volume of option contracts is not expected to grow.

Allow the price to change during the trading hours of options.

This will allow option contract to be priced more efficiently in a way that fulfills the investors' greatest demand/supply situation, thereby increasing the volume of options traded during the day.

Start a book order mechanism to create a competition with the market maker.

This will enhance the option trading mechanism and will move the market from the "choice of buying or selling at the market maker's proposed price" to the "choice of buying or selling at the investors' price"

Trade options during the market trading hours.

Currently options are traded off the market hours. Including the options trading during the trading hours (as is the case with other international markets) will enhance the participation levels.

Allow options on Index Introduction of equity derivatives has always been through index options. Enabling market makers to write and sell index options will provide excellent hedging tool to both institutional investors and retail investors



Appendix 9: GLOSSARY OF IMPORTANT TERMS BRIC: Stands for Brazil, Russia, India and China Correlation: A relationship between two variables. Circuit Breakers: The highest and lowest prices that a stock is permitted to reach in a given trading session. Once reached, no trading occurs on that stock until the following session. also called price limit or daily trading limit. Emerging Markets: A financial market of a developing country, usually a small market with a short operating history. GCC: Gulf Co-operation Council countries comprising Saudi Arabia, UAE, Kuwait, Qatar, Oman & Bahrain. Moving Average: A technical analysis term meaning the average price of a security over a specified time period (the most common being 20, 30, 50, 100 and 200 days), used in order to spot pricing trends by flattening out large fluctuations. This is perhaps the most commonly used variable in technical analysis. Moving average data is used to create charts that show whether a stock's price is trending up or down. They can be used to track daily, weekly, or monthly patterns. Each new day's (or week's or month's) numbers are added to the average and the oldest numbers are dropped; thus, the average "moves" over time. In general, the shorter the time frame used, the more volatile the prices will appear, so, for example, 20 day moving average lines tend to move up and down more than 200 day moving average lines. Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, at a specified price (the strike price) during a specified period of time. Portfolio: A collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices. Range: The high and low transaction prices of a given security or commodity during a given period. Also called trading range. Relative Volatility: The standard deviation of an investment's or portfolio's return divided by the standard deviation of another portfolio. Relative volatility is used to compare the risk levels of different portfolios. Risk: The quantifiable likelihood of loss or less-than-expected returns.

Standard Deviation: The standard deviation of a series is a measure of the extent to which observations in the series differ from the arithmetic mean of the series. The standard deviation of a series of asset returns is the measure of the volatility, or risk, of the asset.

Technical Analysis: A method of evaluating securities by relying on the assumption that market data, such as charts of price, volume, and open interest, can help predict future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis assumes that market psychology influences trading in a way that enables predicting when a stock will rise or fall. For that reason, many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock. Underweight: Having too little of, relative to other things. In the case of a portfolio, containing too little exposure to a given company, sector or country. opposite of overweighed. Volatility: The relative rate at which the price of a security moves up and down. Volatility is found by calculating the annualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility. Source: www.investorwords.com



Markaz Latest Published Research

1. GCC Equity Funds: The Asset Allocation Challenge (September 2006)

Synopsis: The report examines issues behind asset allocation for GCC equity funds. The study points out that fund managers have overweight Kuwait and underweight Saudi Arabia. Compared to their market share, allocation to Qatar, Bahrain and Oman was observed to be high. Nearly 10 funds were observed to allocate highest to their home country, implying “home bias”. The report concludes that current overweight to Kuwait and underweight to Saudi Arabia looks justified given the historical performance and current valuation. Relative to the overall market, blue chips appear expensive in many markets. Future out performance can come through stock selection among mid-cap and small-cap segment. However, geographical allocation will remain the key challenge.

2. GCC Leverage Risk: How real it is? (November 2006) Synopsis: The report examines the risks behind increased exposure of GCC financial system to stock market. The report observes that while bank lending has increased proportional to economic growth, the share of personal/consumer loans has gone up significantly leading to the risk perception. While the increase has been significant, they are not alarming when benchmarked with other leading emerging markets. The report considers four key variables: Size, Asset Intermediation, Cross border activity and Capital market representation. The report also analyses the linkage between bank credit growth and interest rate margin. According to the report, UAE appears vulnerable to leverage risk given the high bank credit share to the economy and the extent of personal loan exposure. Vulnerability assessment for Kuwait, Qatar, Bahrain & Saudi Arabia was ranked medium while that of Oman assessed low. The report also observes that GCC banks have risk-averse portfolios backed by more than adequate capital adequacy ratios. Stress tests conducted by central banks points to adequate resilience.

3. GCC for fundamentalists: A top-down framework (December 2006) Synopsis: The report establishes a framework involving fundamental variables likely to affect GCC stock markets for the year 2007. The report examined nine important variables: economic factors, valuation attraction, economic liquidity, fund managers average, earnings growth potential, moving average, investor sentiment, geopolitical developments and market liquidity. On a scale of 1-5, Oman top scored at 2.93, followed by Bahrain (2.85) and Kuwait (2.84). Saudi Arabia scored 2.66 while UAE was at the bottom with a score of only 2.18. Accordingly, the report suggests overweight to Kuwait, Oman and Bahrain, neutral weight to Saudi Arabia and underweight to UAE. Among GCC sectors, the report assigns positive ratings to banking, telecom, and services sectors; neutral rating to industrial sector and negative rating to real estate sector.

4. Managing GCC Volatility (February 2007) Synopsis: The report devises risk-based portfolio strategies to benefit from the high-risk environment of GCC stock markets. The report discusses four strategies: Relative vol, Contrarian, Technical and Options-based strategy. To obtain a copy, contact: Kuwait Financial Centre S.A.K. “Markaz” - Client Relations & Marketing Department Tel: +965 224 8000 Ext. 1804 Fax: +965 2414499 Postal Address: P.O. Box 23444, Safat, 13095, State of Kuwait Email: [email protected]



Disclaimer This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait. The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable but in no way are warranted by us as to its accuracy or completeness. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. Markaz has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.

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