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I. INTRODUCTION

Definition

The money market is a wholesale market for low risk, highly liquid,

short-term1 & long term debt instruments. It serves as an avenue

through which banks and financial institutions can offload their

excess liquidity or meet their funding requirements. To the

government an organized money market represents a means for it

to implement its monetary policies in a more efficient manner.

Moreover, it provides it with a liquid market for securities through

which it can finance its own borrowing requirements.

Trading in the money market only began in Pakistan in February

1991 with the switchover of the Government from on-tap to auction

system. As per the previous system interest rates on T-Bills were

fixed at 6% and anyone could buy as many of the securities as one

liked through this on-tap system.

This market can be classified into:i. Primary market

i. Secondary Market

Primary Market:

The primary market constitutes the government of Pakistan selling

its securities through the State Bank of Pakistan. This is done

through T-Bill auctions and PIB auctions, T-bill auctions held

fortnightly and PIB auctions as per government requirements (no

fixed schedule). Through these auctions the government invites

bids for its Market Treasury Bills in fixed tenors of 3, 6 and 12

months and for its PIBs for 3,5,10,15 & 20 years. Presently only

1

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designated Primary dealers are allowed to participate in these

auctions with their own funds, which is usually a corporation. A pre-

auction target for T-bill is announced a day or so and PIB auction is

announced 14 days prior to auction in advance to indicate the

amount that the SBP intends to pick up. The amount that is

eventually picked up depends on both the actual requirement of the

government as well as the bidding pattern. The bid at which an

institution enters the auction is denoted by the price at which it

proposes to purchase a specific amount of T-Bills or PIBs. The higher

the bid the lower the cost of funds to the Ministry of Finance and

therefore the greater the chance of the bid being accepted. An

institution can submit more than one bid in the same tenor for

different prices and amounts.

Designated Primary Dealers:

1. Habib Bank Ltd

2. United Bank Ltd

3. National Bank of Pakistan

4. Muslim Commercial Bank

5. Prime Commercial Bank

6. Union Bank Ltd

7. Citibank

8. Standard Chartered Bank

9. Abn Amro Bank

10. Jahangir Siddiqui Capital Markets

11. Pak Oman Investment Company

12. American Express Bank

Secondary Market:

The securities issued in the primary market are then traded in the

secondary market, which basically constitutes the various financial

institutions trading among themselves through brokers. The two

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markets are inextricable linked in the sense that the rates at which

bids are accepted in the auction have a direct bearing on the rates

prevailing in the secondary market. These auction cut-offs also

reflect the State Banks current monetary policy and players in the

secondary market develop an interest rate outlook based on their

interpretation of the trends found in these rates. Besides this the

market rates are also dependant on a number of market

fundamentals such as inflation expectations, the foreign exchange

situation, budget deficit, the liquidity situation in interbank etc.

Purpose of Money Market

The need for financial institutions to indulge in money market

transactions arises primarily from the reserve requirements

imposed by the State Bank. All commercial banks are required to

maintain 25% Statuary Liquidity Requirements (SLR) of their

Demand and Time Liabilities (DTL)2 in FIBs, PIBs (5% of the DTL) T-

Bills, KESC Bonds and other specially approved government

securities. NBFIs on the other hand have to maintain 14% of their

DTL in government-approved securities, which constitute TFCs, NIT

Units and WAPDA Bonds, in addition to the securities approved for

commercial banks. Commercial banks and NBFIs also have to

maintain a certain portion of their DTL in a cash reserve maintained

with the SBP at 0% interest. This ratio is known as the CRR (Cash

Reserve Requirement) and stands at 7.00% for commercial banks

and 1% for NBFIs.

MAJOR PLAYERS

2 Demand & Time Liabilities comprise of current and checking accounts under the head of demand liabilities,

and all time deposits under the head of time liabilities.

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II. MONEY MARKET INSTRUMENTS

T-Bills: T-Bills are short term securities issued by the State Bank on

behalf of the Ministry of Finance through auctions or OMOs (Open

Market Operations). They are zero-coupon bonds issued at a

discount, have a par value of Rs 100 and a maturity of three, six or

twelve months. Bank borrowing is one of the various measures the

government takes to fill its budgetary deficit and this bank

borrowing currently takes place against T-Bills. 20% of the interest

earned on T-Bills is retained by SBP as advance income tax.

Price of a T-Bill: Assume a 6 month T-Bill with a par value of Rs.

100 and a yield of 7.23% is to be sold in an auction. Its price would

be calculated in the following manner:

= 100

(1+T-Bill yield)tenor

= 100

(1.0723) 180/3653

= 96.6161

PIBs: These are long term bonds of three, five, ten, fifteen, twenty

& 30 years, maturity issued at market price and carrying a different

coupon rate according to the interest rates scenario. Since Dec 14th

2000 the SBP start issuing fresh PIBs for a number of reasons. For

one thing, T-bills offer the SBP a better opportunity to monitor

interest rates in the short term. Moreover, another reason for

issuing PIBs is to set up a yield curve and corporate, mutual funds

3 The number of days of each T-Bill issue are specified at the time of issue and therefore vary. For instance

each 6 month T-Bill may not necessarily be of 180 days and can often vary from 180-182 days.

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etc to invest in long term,. Commercial banks are restricted to

maintaining a PIB portfolio that is within 5% of their DTL (Demand &

Time Liabilities). A calculation for the price of PIB is demonstrated

on page 14.

Features of PIBs

Withholding tax is 10%

Shut period of 3 days

Coupon will redeemed Semi Annually

Primary Dealers can only participate in the auction and can

short sell 5% of the target.

Short Selling period is 14 days prior to auction date.

TFCs: TFCs are redeemable capital instruments and may be issued

by a company directly to the general public, which includes

institutions. Unlike straight bonds, they are redeemable capital and

are of long tenors i.e. more than one year. They are quoted on a

price basis rather than yield to maturity. Earnings from TFCs are

taxable @10% (Withholding tax) in the case of institutions, whereas

in the case of individual investors there is no withholding tax and

zakat is deducted @2.50%. Some of the TFCs are listed on the stock

exchange and are traded in the capital as well as in the money

market. TFCs are a most promising instrument for bond market

development. Over the past few years, a modest beginning has

been made with the floating of a number of public issues. The

issuing of TFCs by any corporation offers various advantages to

both the issuing organization as well as the investors. Some of

these advantages are:

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Advantages for the Issuer:

They provide an alternative for long term financing

since direct loans are usually not available for such

long tenors due to the uncertain interest rate scenario.

Issuers can diversify their funding sources and obtain

funds from a cross section of society including

individuals as well as financial institutions. This widens

the overall pool from which the corporate can borrow.

The gradual repayment of the principal makes the

burden of repayments lighter for the issuer.

Advantages for the Investor:

For a risk-averse investor TFCs offer attractive returns

as compared to other alternatives.

TFCs are exempt from capital-gain tax, thus providing

an attractive investment opportunity on an after-tax

basis.

Being traded on all the three stock exchanges, TFCs

provide a fairly liquid investment alternative.

They contribute to the SLR of NBFIs

COIs: COIs (Certificates of Investment) are issued by investment

banks in exchange for deposits and constitute the source most

commonly used by investment banks to obtain funds. By law COIs

can have a minimum tenor of 30 days and a maximum of 5 years.

Leasing companies however, need to take special approval from the

State Bank in order to issue COIs of less than a three month tenor.

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The law also requires that the rate on all the COIs of the same

tenor, issued by the company must be the same, regardless of the

status of the depositor. The salient features of COIs are as follows:

COIs can be of a tenor from 30 days to 5 years.

The rate of return on the COIs depends on the

profitability of the issuer.

COIs are in direct competition with clean rates since

the return from COIs is subject to a 10% withholding

tax.

Some COIs allow premature encashment, which cannot

be less than the minimum maturity set by the State

Bank. Further, early encashment results in a loss of

return to the holder.

COIs are not backed by any specific assets and are

rated above senior debt.

COIs are non-negotiable instruments.

WAPDA Bonds: These are fixed coupon bonds issued by the Water

and Power Development Authority. Seven issues have been floated

so far, of which only three have been retired to date. The seventh

issue was privately placed. Each issue has a different structure in

terms of the rate offered, date of issue, collateral, guarantee etc. Of

the outstanding issues the only one guaranteed by the Government

of Pakistan is the fourth issue. WAPDA is also planning to float

another issue bearing the following features:

Tenor 5 years

Rate (floating) SBP discount rate + 2%

Year 1 Floor of 12.5%

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Year 2-5 Floor of 12.5% and Cap of 16%

KESC Bonds: In order to refinance KESCs outstanding fuel

payables, issued many bonds over a five-year tenor, the institution

on January 31st, 1999 floated a Rs. 11.50 billion TFC issue, referred

to as KESC Power Bonds. These PBs are accorded approved security

status whereby commercial and investment banks are allowed to

hold the instrument in their Statutory Liquidity Reserve (SLR) and

are freely transferable. The maturity date for these bonds is

February 1st, 2004 and they bear a coupon rate of 17.50% p.a. Profit

repayment is on a semi-annual basis with principal repayment on a

declining basis with an initial two-year grace period.

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III. TYPES OF TRANSACTIONS

Repurchase Agreements (Repos and reverse Repos):

Repos are basically a means of raising funds by selling government

approved securities at a fixed rate, with the intention of

repurchasing them at a specified future date. For the party selling

the security (borrower of funds) the transaction is referred to as a

repo whereas for the party purchasing it (lender of funds), the

transaction is referred to as a reverse repo. Funds transacted

through repos do not fall under the category of demand and time

liabilities and therefore 5% cash reserve is not required for them.Presently this type of transaction is the most common among

financial institutions because of its flexibility, simplicity and security

of principal.

Example:: Bank A wants to borrow Rs. 100 million

from Bank B for a period of one month. Bank A has

securities so it can enter into a repo in order to raisethese funds. Bank B offers to lend Rs. 100 million @

9.00% (per annum). Bank A now has the option of

borrowing these funds against T-Bills or FIBs.

Option 1 T-Bills:

ParticularsIssue Date May 4th 2000Current Date June 29th 2000Tenor 6 monthsMaturity Date November 2nd,

2000DTM (Days to 126

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Maturity)MTM (Mark to

Market)

7.73%

Repo Rate 9.00%Tenor of Deal 1 month (30

days)

First price (P1)= Face Value

1+{(MTM Rate/365) x DTM}

= 100

1+(.0773/365 x 126)

= 97.4009

Second Price (P2 or Repo price)= P1 x [1+(Repo rate x

term of repo) ]

365

= 97.4009 x [1(+0.09 x 30)]

365

= 98.1213

P1 (in Rs.)= 97.4009 x 100,000,000= Rs. 97,400,916.58

100

P2 (in Rs.)= 98.1213 x 100,000,000= Rs. Rs.

98,121,399.81

100

Option 2 FIBs:

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ParticularsIssue Date December 15th

1992

Maturity Date December 15th

2002Current Date June 29th 2000Tenor 6 monthsRepo Rate 9.00%Tenor of the

deal

1 month (30

days)

(PIBs are issued according to market trend (as opposed to T-Bills),

therefore the first price is always equal to the face value.)

First Price (P1)= Face Value=100

Second Price (P2)= P1 x (1+Repo Rate x Days of

transaction)

365Banks dealing in government securities maintain book based

security accounts known as Subsidiary General Ledger Account

(SGL) with SBP. On the date of the transaction i.e. June 29th 2000

Bank A will send an SGL to the State Bank directing it to transfer

the specified securities to the lenders account. The lender on the

other hand will issue a State Bank cheque in favour of the

borrower of the value of the first price. At maturity, the same

transaction will be reversed with the borrower issuing a cheque

of the value of the repo price whereas the lender will send an

SGL directing that the same securities be returned to the

borrowers SGL account.

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Security Lending/Borrowing: If a bank is falling short of

securities it may either lend funds by entering into a reverse repo or

it may simply borrow them from another bank under a securities

lending agreement. In such a transaction the borrower of securites

borrows funds in call from another bank and then lends to the same

bank in repo at a spread, which becomes the cost of securities.

Example:Supposing Bank A is short of securities and

wishes to enter into a securities borrowing agreement

with Bank B for Rs. 300 million for one month, at a cost

of 1.75%. The issue that bank B decides to lend is May

4th 2000, 6 months T-Bill with the MTM being 7.73%.

The transaction will take place as follows:

On July 1st 2000 (Value date): Bank Bank A will

lend Rs. 292,323,348 (P1) to Bank B in repo @

9.00% against the 6-month issue, May 4th,

2000.simultaneously, Bank B will also lend Rs.

292,323,348 to Bank A in call @ 10.75%.

On August 1st, 2000: Bank B returns Rs.

294,557,820.2 which is the maturity amount for

the one month repo transaction, whereas Bank A

will pay Rs. 294,992,300.2 to Bank B as the callamount. The difference between these two

amounts, Rs. 434,480 then constitutes the 1.75%

cost of security borrowing to Bank A.

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Outright Sale/ Purchase of Government Securities: Outright

transactions involve the direct transfer of securities from one owner

to another without any sort of future obligation being a part of the

transaction. The seller of the securities claims the profit/ interest for

his holding period and foregoes the right to any future

profit/interest on the security. The tax burden in outright

transaction is borne by the purchaser of the security. In order to

price an FIB the future coupon payments as well as the face value

are discounted at the YTM (Yield to Maturity)4 and the accrued

interest is added to this figure.

E.g. Assume a Rs. 100,000,000, 10 year PIB bearing a coupon

of 15%, issued on July 14th 1992. The price of the PIB may be

calculated as follows:

Security 10 year PIBIssue Date July 14th

1992Price 110.5565Settlement

Date

July 6th 2000

Face Value 100,000,000

Transacted Amount = Face Value x Price

100

= 100,000,000 x 110.5565

4 YTM expresses the annual ratio of the total of all coupon income for the holding period and redemption

profit/ loss to the amount of investment. The formula for YTM can be expressed as:

YTM = [{Coupon + (Redemption value Bond Price)/ Number of years to maturity}/ Bond Price] x 100

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100

= 110,556,500

Accrued Interest = Coupon Rate x Accrued Number of days x

Face Value

Coupon Period (in days)

= 7.50% x 174 x 100,000,000

182

= 7,170,329.67

Total Cost/ Cheque Amount = Transacted Amount +

Accrued

Interest

= 110,556,500 + 7,170,329.67

= Rs. 117,726,829.7

Based on the above particulars the YTM can be approximated as

follows:

YTM = [{15 + (100 110.5565)/ 2.0219}/ 110.5565] x

100

= Approximately 8.845%

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IV. OTHER TRANSACTIONS

Coupon Washing: In order to avoid taxes and still collect the

coupon on the PIBs that a commercial bank holds, banks sometimes

indulge in a transaction known as coupon washing. In such a

transaction the bank holding the PIBs sells them to an institution

that is exempt from taxes or paid excess tax on PIB returns a week

or so before the coupon is due with the intention to buy them back

after the coupon has been paid. The institution collects the coupon

on the due date and on maturity of the deal sells the coupon back

to the initial owner at a slightly lower price that incorporates theinstitution charges for coupon washing. The coupon that the

institution received on behalf of the commercial bank is also

returned. Details of the calculation are appended at the end of

report.

Security Parking: All commercial banks have to comply with an

upper limit in their FIB portfolio due to which they cannot invest

more than 5% of their DTL in PIBs. In cases where a bank does hold

more PIBs than it is allowed to, it can engage in a transaction known

as security parking, whereby it parks its excess securities for a

specified period of time with a financial institution that can afford to

hold more PIBs for the moment. Detailed calculations of such a

transaction are appended at the end of this report.

Mismatching transactions: Such transactions are often

structured with a clients peculiar needs in mind and is based on

implied forward rates5. For example a bank may have a borrowing

5 Implied Forward Rates are rates derived from observed spot yields of differing maturities. All spot yields

have forecasts of future short-term interest rates embedded in them. E.g. Three month rate one month forward

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position for three months, but with the value date being one month

forward. However, he may feel that the three-month rate that might

prevail one month from now is higher than the three-month rate

that he may get at present. In order to lock in the low rates

prevailing in the term structure right now he can borrow funds for

four months today and lend them for one month at such a rate that

his break-even rate (i.e. the rate upto which he can afford to borrow

three month funds at the maturity of his one month deal) is below

that which he expects to prevail for three month funds after one

month.

Conversely, a bank may feel that rates are expected to go down in

future and therefore may wish to lock in the higher rates available

to him at present. If such a bank does not have funds of his own

that he can place in a tenor he may borrow funds in a shorter tenor

(for instance, one month) and lend the same funds for a longer

tenor (such as three months). On the maturity of his first deal (in

which he borrowed funds) he may in fact fund his lending at a lower

rate provided his view of declining rates does materialize. Another

kind of mismatched transaction is based on effective cost. For

instance, if a bank needs to borrow funds for six months however,

at present hes getting six-month funds at 9.00%. On the other

hand he can borrow three-month funds at 7.50% and at the same

time borrow three-month funds value three months forward at

8.50%. The effective cost of these two transactions comes out to

8.00% for six months, which is lower than the six-month cost of

funds prevailing right now. It would therefore be far more feasible

for him to enter into the two transactions today rather than borrow

six months straight.

= {(4 month rate x 120 days) (1 month rate x 30 days)}/ (120- 30)

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BOND STRATEGIES BASEDON IMPLIED FORWARD RATES

In the case of bonds the implied forward rates imbedded in the term

structure can be analyzed in contrast with the view a portfolio

manager may hold about interest rates in order to exploit any

differential present. For example, if a portfolio manager feels that

interest rates in the future are higher than the implied forward rates

imbedded in the term structure at present he would be inclined to

hold a bearish position on his portfolio. That is to say he would

prefer to sell his bonds at present since he feels that the price he

would get for the same bonds in future is likely to be much lowerthan the prevailing prices. Conversely, if the manager feels that the

interest rates in the future are likely to be lower than the implied

forward rates prevailing presently he will be inclined towards a

bullish attitude on his portfolio.

V. REGULATORY FRAMEWORK

The two main regulatory bodies in Pakistans money market are:

The State Bank of Pakistan

The Ministry of Finance.

THE STATE BANKOF PAKISTAN

As the central bank of Pakistan, the SBP is the key regulatory body

in the country. It is regulated by the SBP Act of 1955, which outlines

the banks primary responsibilities as the controller of the countrys

money supply and foreign exchange reserves, as well as the

guardian of the interest of all the depositors in the financial

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be maintained everyday. Government approved securities

are defined differently for commercial banks and NBFIs.

For the former they comprise T-bills, PIBs, FIBs and KESC

Bond. For NBFIs they consist of all these along with TFCs.

Open Market Operations: OMOs are a tool for

controlling the money supply directly. For instance, if there

is a liquidity crunch in the market and funds are trading

close to the discount rate, the SBP is likely to intervene by

injecting funds through either a scheduled OMO or a

special OMO which would eventually be expected to bring

about a slide in the rates through its effect on the demand

and supply situation prevailing in the market. Likewise, if

there is surplus liquidity in the market, or if the SBP has its

own borrowing requirement, it may borrow funds from the

commercial banks through an OMO thereby having the

opposite effect on market rates. OMOs are regularly

conducted every alternate Thursday whereas a special

OMO can be announced any time during the week as and

when the need arises. The tenors for which funds can be

injected through an OMO are usually for 3 days to 1 week,

two weeks and one month. On the other hand, funds are

normally picked up in an OMO for either 1-month, 3

months, 5 months or outright sale of T-Bills (the latter

being a little less than six months). The reason for the

outright sale tenor not being exactly equal to six months isthe fact that the SBP here floats a T-Bill that has already

been issued to it by the Ministry of Finance against the

latters own borrowing from the central bank.

THE MINISTRYOF FINANCE

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This ministry represents the government in the debt auctioning

system. Its responsibility is to provide adequate funds for the

government, which may be generated through direct and indirect

taxes, foreign aid, foreign borrowing and domestic debt.

Government expenditures can be funded by its revenue receipts or

by borrowings. Tax and non-tax revenues form the revenues

whereas domestic and foreign debt comprise the government

borrowings. One of the roles of this regulatory body is to strike a

balance between revenues and expenditures and hence determine

the size of the fiscal deficit. The objective of containing the budget

deficit has been far from achieved as the overall deficit has gone

way above its targets. For the fiscal year 1999-2000 the initial

budget deficit target was 3.6% of GDP, which was later revised to

4.50% of GDP. However, the actual budget deficit for this period

was 6.30%.

There are basically three avenues available to the government in

order to bridge its budgetary gap: bank borrowing, non-bank

borrowing and other inflows comprising of miscellaneous heads

such as bilateral and multilateral funding. With the limits on bank

borrowing set by the IMF, non-bank borrowing is a preferred option

available to the government. The main reason for these restrictions

is the crowding-out effect such borrowing can result in as far as

private sector credit is concerned. If both corporates as well as the

government are competing for funds from the same pool (i.e. the

inter-bank market) the interest rates are bound to experience

upward pressure. Non-bank borrowing comprises of funds mobilized

through prize bonds and national saving schemes. With the recently

imposed restrictions on institutional investment in NSS, in order to

bridge its budgetary gap the government is relying more on

external inflows. In the absence of these external inflows the

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government is left with no other option but to increase its bank

borrowing which could in turn result in the interest rate shooting up.

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VI. IMPACT OF EXTERNAL FACTORS ON

THE MONEY MARKET

Since the money market is based on the basic principles of demand

and supply, any external factor affecting either of the two plays an

important role. Even though factors such as a sudden political event

(freezing of foreign currency accounts etc) cannot usually be

predicted, there do remain a few cyclical changes in the economy,

which have a significant and somewhat predictable impact on the

market. In this section we will elaborate on some of these economic

cycles.

SBP BORROWING FOR COMMODITY OPERATIONS: Since Pakistan is

primarily an agricultural based economy, the recurring cycles

prevailing in the agricultural sector often have a significant impact

on the trends in the money market. The government has set

specific targets for financial institutions for the minimum financing

that they have to provide the agricultural sector. These are often

short-term loans for purposes such as purchase of essential

seasonal inputs e.g. seeds during the sowing season etc. the

demand for funds in the agricultural sector therefore can result in a

temporarily tight position in the money market since for funds to

leave the system in the shape of loans to farmers and then return

as deposits made by the recipients of those funds often takes

atleast three to four weeks. An example would be the cotton

season. Since cotton exports form a significant part of the countrys

export earnings the sector receives considerable financial support.

The sowing of this crop starts from April-June whereas the

harvesting takes place in October-December. Credit for cotton

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starts to flow out from the system from November to May. Another

example would be the import of a commodity such as wheat. These

follow a particular pattern with major imports in April, May and June.

During this time the government need for funds increases and thus

the market experiences a shortage of funds.

The sugarcane-crushing season is another cycle to be considered.

The sugar mills have to book the harvest in advance in order to

ensure a consistent supply of sugarcane for their mills. For this

purpose advance credit has to be provided to them, which results in

a significant portion of the systems liquidity tied up in advances to

suppliers. Even though such advances only result in a changing of

pockets and the money effectively stays in the system, it can

however have impacts on the status of the major lenders and

borrowers in the market.

YEAR/QUARTER-END REQUIREMENTS: At the end of the fiscal year as

well as the quarter end the money market usually experiences a

liquidity crunch for a number of reasons. For one thing, the IMF

keeps a check on the NDA (Net Domestic Assets) at the end of each

quarter. Due to this the SBP cannot afford to lend in the market for

a duration crossing these quarter end dates, which is one of the

reasons why the market is often tight during these periods.

Secondly, the SBP also has to collect taxes at these times on behalf

of the government which in turn result in outflows from the system.Another factor that comes into play is the government borrowing

from the State Bank itself. The government throughout the year

borrows from the SBP for various purposes such as deficit financing

and project development. When the SBP lends to the MoF at such

times it results in an asset shown on SBPs books and which it

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eventually will have to fund through bank borrowing. This position

has to be squared at quarter and year ends which is why the State

Bank often ends up mopping excess liquidity at such times leaving

the market fairly tight in most cases.

SBP BORROWING FOR BUDGETARY SUPPORT:The government has

budgetary targets to meet throughout the year in terms of the total

revenues it earns in the form of taxes, duties etc versus the total

expenditure on development and other projects. In cases when this

budgetary deficit is larger than the target initially set by the

government or, as is the case at present, by an international

regulatory authority such as the IMF, the only other option left to

finance this gap is through bank borrowing. This bank borrowing

results in a direct upward pressure on the rates prevailing in the

inter-bank market.

IMPACTOF FOREIGNEXCHANGE MARKET:The foreign exchange market

has a significant impact on the activity in the money market. A brief

overview of the foreign exchange market would help in

understanding the relationship between both the markets. Liquidity

in the foreign exchange market is based on imports, exports and

remittances. Trade imbalance results in demand for foreign

exchange, which in turn results in a downward pressure on the local

currency. In times when this pressure becomes excessive or

prolonged it results in speculation over the chances of an official

devaluation. Importers holding this view would therefore be inclinedto book dollars in advance causing the dollar to trade at a premium.

Theoretically, according to the exchange rate parity the premium at

which a currency trades in relation to the other should be equal to

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the interest rate differential between the two currencies6. In cases

where the premiums are higher than the interest rate differential it

calls for the need for a correction in the rupee rates. If not, it

presents an arbitrage opportunity. For example, a banker can

borrow 6 month rupee funds in call @9.25%, enter into a USD buy-

sell transaction at a premium of 7.00% and then keep those funds

in its Nostro earning a return of 5.00% on these deposits. On

maturity of the buy-sell transaction, it can sell the dollars at the said

premium, pay off the rupee loan at the same time enjoying an

arbitrage of 2.75%. Such an arbitrage opportunity would result in

greater demand for call funds causing in turn the call rates to go up

thereby causing this spread to narrow and resulting in an automatic

correction of the rates prevailing in the money market.

6 The currency that has a higher interest rate should theoretically trade at a discount whereas the one with a

lower interest rate should trade at a premium. For instance the interest rates on the dollar are presently 7%

(six month LIBOR) whereas the interest rate on the rupee is 7.4% (six month T-Bill return) indicating that the

dollar should trade at a premium.

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VII. RISKS INVOLVED IN MONEY

MARKET

The various risks that come into play for the players in the moneymarket are:

Interest Rate risk

Liquidity Risk

Credit Risk

Sovereign Risk

As brokers in Pakistan are not allowed to take positions on their

books, the risks are somewhat limited. Brokers are, however,

exposed to price risk in the sense that if they get hit on a price by a

bank and fail to complete the transaction because the other party

may have gone offline and in the meantime the market moves

against the bank that had accepted the price, the broker involved

may be asked to compensate for the loss. Brokers are also

responsible for the physical settlement of the transaction. They

have to make sure that the cheques are deposited at the State

Bank, the SGL collected from the bank and deposited at the State

Bank before the dealing time ends, which is at 1:30 pm from

Monday through Thursday and 12:30 pm on Friday and Saturday.

Any shortfall in fulfilling this responsibility may also result in

penalties. Moreover, some brokers have been known to be

blacklisted and some have also been fined in the past. Their names

however, cannot be mentioned.

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