Back Ground of the Problem:

The ideal stock exchange basically functions as a secondary market and supports
the performance of primary markets. It also encourages investment in stock trading
by maintaining rules and regulations for investors’ protection that ensures trade will
be fair and investors will receive exactly what they are paying for. The exchange
also supports state-of-the-art-technology and the business of brokering, which helps
traders in buying and selling their securities quickly and efficiently. The ideal stock
exchange, thus, intends to perform the following functions for the economy:

Raises capital for businesses:

It helps in raising capital for running and expanding business by selling shares to
the investing public. Thus, the proper functioning of the stock exchange is integral
to progression of productive business activities.

Mobilizes savings for investment:

It helps utilize resources by providing opportunities to investors of each level and

makes them invest their savings rather than keeping them in their bank accounts.
This mobilization of resources promotes business activities and benefits different
economic sectors like textile, agriculture etc. Thus, economic growth is facilitated.

Creates investment opportunities for small investors:

For Pakistan, participation of small investors in investment activities is extremely

important since the sum of these small investments makes up a good percentage of
total investment in the country. Thus, the stock exchange provides a platform for
small investors too to play a role in the economy’s development.

Government capital-raising for development projects:

Governments can raise money for development projects by issuing bonds in the
stock exchange like other companies. Thus, the stock exchange becomes an
important variable in the function of government expenditures for the development
of the country.
Empirically, the performance of stock markets have been shown to positively
correlate with economic growth even after controlling for other factors associated
with long-run economic growth such as initial conditions, size of government,
inflation etc. Thus, for developing countries, the performance of the stock market is
a vital indicator of the state of economic growth in the country. The ideal stock
exchange’s performance enriches the confidence of domestic and foreign investors
due to better economic growth, which then results in facilitating it even more as
overall investment increases due to higher confidence. This, as the reader will have
figured out from the above statement, results in a cycle of sustained economic
growth as long as the stock market operates ideally.

Lastly, an ideal stock exchange takes full advantage of the globalized state of the
world. Links among financial markets have enlarged and giant international
financial players are showing their presence all over the world. This has resulted in
the importing of stock exchange activities abroad and now many international firms
cross-list on international exchanges. The ideal stock exchange then makes use of
state-of-the-art-technology to facilitate international trading of securities and
increase the confidence of foreign participators. The stock exchange, thus, becomes
a platform for domestic investors to tap into larger economies too.

Problem:
A high degree of volatility and uncertainty presest at Karachi Stock Exchange is
hampering the Stock market to perform its functions. It is a well known fact that
stock exchanges all around the world are prone to the problem of market volatility.
However, excessive volatility not only hinders the basic motive of investors, but also
leads them to face severe market crisis such as the imposition of the floor.
Unfortunately, Karachi Stock Exchange is the most speculative market in the world
when measured in terms of daily trading volume. This extreme volatility has led to
the drop in stock market such as in May 2008 by 19.78 percent which is the ‘worst’
percentage loss for a single month since May 2000 when it dropped by 19.17
percent. Moreover, when compared on global scale, Index volatility around active
global exchanges averages around 15 to 25% p.a. while comparative volatility for
Karachi Stock Exchange is approximately 200 to 300% of global average in 2004
and 2005. The massive volatile situation is possible due to the concentration of
trading by brokers in only a few stocks such as PPL, PSO, MCB, NBP and POL which
limits the prospects of the exchange to grow on sound footings. Moreover the
fluctuations in the prices of commodities in international market like oil, Political
instability in Pakistan and lack of derivative instruments for hedging are also
considered as causes of market volatility.

Because of such a high volatility of kse the market is losing confidence of investors,
and kse is unable to perform its very functions for which it is created.

FRAME WORK
Literature Review:
1. Drimbetas, Evangelos, Sariannidis, Nikolaos and Porfiris,
Nicos(2007) 'The effect of derivatives trading on volatility of
the underlying asset: evidence from the Greek stock
market', Applied Financial Economics, 17: 2, 139 — 148
The study focuses on how the introduction of derivatives in the market
decreases the volatility of the spot market. Derivatives give
information about the spot prices and moreover act as a hedging
instrument thus decreasing the speculative business. The articles
focuses on empirical evidence from Greek stock market and using
different statistical techniques show how volatility in the market
decreases after the introduction of derivative instruments.
2. Mustafa, Khalid. Testing of efficiency in emerging markets:
a case study of karachi stock market.

The article investigates the efficiency of Karachi stock exchange using

different statistical techniques. This study has empirically investigated the
efficiency of the Karachi stock market. The random walk hypothesis was
tested on daily, weekly and monthly data from December 1991 to May 2003
with three non-over-lapping periods and one combined period. The empirical
results indicated that the Karachi stock market was inefficient in all three
types of data. This implies that the Karachi stock market did not follow the
random walk model. This lack of efficiency in the market is the prime cause
of volatility since it implies that market prices does not represent the true
present information and therefore much fluctuations can be expected in
futute.
 3. Uppal, Jamshed Y., and Inayat U. Mangla. "Regulatory
Response to Market Volatility and Manipulation: A Case
Study of Mumbai and Karachi Stock Exchanges." The Lahore
Journal of Economics (2006). Print.

The study explains volatility in KSE and tries to compare it with India. The
study is very useful in understanding the causes of volatility in KSE and role
of Policy makers in this regard. The study focuses on how Indian become
successful in curbing increase volatility in the stock exchange while Pakistani
Policy makers are unable to do so. The study also highlights that a stronger
competitive environment in India is very helpful for them to curb the
volatility and to control the increasing the increasing volatility. While in
Pakistan lack of competition in case of KSE is hampering the way forward for
curbing Volatility.

4. S. Sergi, Bruno, Masood, Omar (2008),’ How political risks

and events have influenced Pakistan's stock markets from
1947 to the present’ International Journal of Economic Policy
in Emerging Economies, Volume 1,pg427-444

The study highlights the role of political instability on the stock market of
Pakistan. The articles comes to conclusion the political instability is the much
embedded in the business of Pakistan that it carries a risk premium of 7.5%
to 12%. The article also claims that such type of political instability will
remain unchanged in the coming periods.

5. Roe, Mark J. and Siegel, Jordan I., Political Instability: Its

Effects on Financial Development, Its Roots in the Severity
of Economic Inequality (July 24, 2009). Available at SSRN:
http://ssrn.com/abstract=963214

The article focuses on how political instability impedes financial growth and
result in poor performance of the financial institutions. The study shows that
since 1960s when the data is properly gathered and recorded there exist a
very important relationship between political instability and financial
backwardness.

Definitions of the Terms:

Volatility A statistical measure of the dispersion of returns for

a given security or market index. Volatility can either
be measured by using the standard deviation or
variance between returns from that same security or
market index. Commonly, the higher the volatility,
the riskier the security.

Efficient Market Efficient market is one where the market price is

an unbiased estimate of the true value of the
investment. Market efficiency does not require that
the market price be equal to true value at every
point in time. All it requires is that errors in the
market price be unbiased, i.e., that prices can be
greater than or less than true value, as long as these
deviations are random
Derivatives A financial
instrument whose characteristics and value depend
upon the characteristics and value of an underling
instrument, typically a commodity, bond, equity or
currency. Examples of derivatives
include futures and options.

Stock Broker A stock broker or stockbroker is a regulated

professional broker who buys and sells shares and
other securities through market makers or Agency
Only Firms on behalf of investors

Political Instability:
Stock market reflects the political stability of the country. It is evident that
during incidents of emergency, assassination of Bhutto and judges
reinstatement issue the marked depicted a sudden downturn, while any
positive news has positive impact on the market like re-election of President
Musharraf, lifting of emergency, transparent election of 08 etc.

The effect of political situation may cause the index to go up or it may cause
the index to go down. Since political situation in Pakistan is very less
predictable therefore the KSE index shows continuous ups and downs from
2007 to 2008. These continuous ups and downs result in the increase
volatility of the KSE.

PPl, MCB, NBP, and POL stocks as market movers:

The KSE 100 index is moved by very few stocks which are traded in big
volumes in the marked. Therefore if anything goes wrong with these stocks
the whole index goes down. We in our analysis tries to explain the that the
performance of KSE index is basically indicated by four stocks PPL, MCB,
NBP, POL. The KSE 100 index is regressed on these stock in order to
understand is there any relation between these stocks and Index and
moreover are these stocks control the performance of index.

Regression of KSE on PPL:

Source | SS df MS Number of obs = 6

-------------+------------------------------ F( 1, 4) = 58.34

Model | .537275573 1 .537275573 Prob > F = 0.0016

Residual | .036835564 4 .009208891 R-squared = 0.9358

-------------+------------------------------ Adj R-squared = 0.9198

Total | .574111138 5 .114822228 Root MSE = .09596

------------------------------------------------------------------------------

lkse | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lppl | 1.015731 .1329793 7.64 0.002 .6465216 1.384941

_cons | 3.736436 .7000249 5.34 0.006 1.792855 5.680016

The results show that if there is beta is 1.015 showing that if there is one
percent change in the stock price of PPL then the KSE index will move one
percent. This is very important relationship because it shows that both
stocks move in almost identical direction. Moreover since R- squared is also
very high number it means that much of the change in KSE index is
explained by PPL stock. Now in order to test significance of beta one can see
that beta lies between the confidence interval of Beta. Therefore the PPL
stock price and KSE 100 index are very much related.
The above graph shows the percentage change in PPL on x-axis and
percentage change in KSE 100 index on y-axis. As the percentage change in
PPL increase the percentage change in KSE also increases.

Regression KSE on MCB:

Source | SS df MS Number of obs = 10

-------------+------------------------------ F( 1, 8) = 78.27

Model | 6.22899993 1 6.22899993 Prob > F = 0.0000

Residual | .636704279 8 .079588035 R-squared = 0.9073

-------------+------------------------------ Adj R-squared = 0.8957

Total | 6.86570421 9 .762856023 Root MSE = .28211

------------------------------------------------------------------------------

lkse | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lmcb | .7927614 .0896102 8.85 0.000 .58612 .9994028

_cons | 5.015169 .4003516 12.53 0.000 4.091956 5.938381

In this case our Beta comes out to be .79. this means that if there is one
percentage change in the price of MCB there is .79 percentage change in the
price of KSE 100 index. Moreover in order to check the significance of Beta
we can see that Beta lies between 95 % confidence interval.

The graph above also shows that how as the percentage change in PPL
prices on x-axis change correspondingly the KSE index on Y-axis also
changes in the same direction.
Regression KSE on PSO:
The regression of KSE 100 index on PSO is done then . Following results of
our regression came out.

Source | SS df MS Number of obs = 10

-------------+------------------------------ F( 1, 8) = 45.61

Model | 5.84110009 1 5.84110009 Prob > F = 0.0001

Residual | 1.02460412 8 .128075515 R-squared = 0.8508

-------------+------------------------------ Adj R-squared = 0.8321

Total | 6.86570421 9 .762856023 Root MSE = .35788

------------------------------------------------------------------------------

lkse | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lpso | 1.916013 .2837162 6.75 0.000 1.261762 2.570264

_cons | -2.085763 1.566846 -1.33 0.220 -5.698916 1.52739

Again a very high value of Beta came out that shows one percent change in
prices of PSO stock result in 1.9 percent change in KSE stock. Moreover our
beta is also within 95% confidence interval.

The high Value of R-square shows that much of changes in percentage

change in KSE is depicted by PSO, which means that PSO is very important
stock of KSE 100 index and it is strong enough to move the direction of
whole index.

Also looking at the graph of percentage change in KSE and PSO it is clear
that both moves in the same direction. When PSO stock price goes up, KSE
index also goes up.
Regression KSE on NBP:
Then KSE is regressed on NBP in order to show how NBP is important to
estimate the KSE index.

Source | SS df MS Number of obs = 8

-------------+------------------------------ F( 1, 6) = 47.53

Model | 2.67814222 1 2.67814222 Prob > F = 0.0005

Residual | .338042635 6 .056340439 R-squared = 0.8879

-------------+------------------------------ Adj R-squared = 0.8692

Total | 3.01618486 7 .430883551 Root MSE = .23736

------------------------------------------------------------------------------

lkse | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lnbp | .713353 .103466 6.89 0.000 .4601807 .9665252

_cons | 5.609799 .466985 12.01 0.000 4.467128 6.75247

Again the beta came out to be .7133 showing that one percent change in
price of MCB results in .713 percent change in the price of KSE 100 index.
Again the R-square came out to be very high showing that much of the
deviation in the KSE index is explained by MCB stock.

The graph shows that as the percentage change in MCB stock change the
KSE index changes simultaneously.

Role of Brokers:
“Brokers mostly act as principals and not as intermediaries (this has led
to)...extremely high turnover ... extensive speculation ... (and) ...very little genuine
investment activity, (with) hardly any capital raised .....To restore investor
confidence: (i) stock exchange management should be freed from broker
influence .... and (ii) government must support and be visibly seen to be supporting
the SECP's reform agenda.” 1

The brokers in the Karachi Stock Exchange mostly traded as principals rather than
intermediaries. They trade between clients of same brokers or collude with other
brokers to manipulate the market. The March 2005 crisis resulted from brokers
trading between themselves to first increase the level of index so that outside
investors could be attracted to the market and then they exited the market leaving
outside investors to trade themselves. The graph below mentions the trading
between 8 brokers who trade between themselves to manipulate the market.
Further on, the ways brokers manipulate has been highlighted in more detail.

1 Khawaja, Azim A., and Atif Mian. "Unchecked intermediaries: Price manipulation in an emerging stock
marketstar, open." Journal of Financial Economics. Science Direct, 2005. Web.
Broker A: Moosani Securities; Broker B: Akeel Karim Dhedhi Securities; Broker C: Worldwide Securities; Broker D:
A.H.K.D Securities; Broker E: Mr. Munir Ahmed Khanani; Broker F: Motiwala Securities; Broker G: Mr. Muhammad
Anas Kapadia.

Arif Habib is big broker at KSE, here we want to see the profits of Arif Habib
as the deviation of the KSE 100 index. Since standard deviation of KSE index
is good indicator of market volatility we want to see is there any relation with
the profits of brokers and market volatility.

The above graph depicts that the movement of standard deviation of KSE
index which is an indicator of Volatility and resulting change in Profit of One
of very important securities firm Arif Habib.

During the crash of 2005 and high volatility during this year the profit of Arif
habib securities firm show a continuous increase. This shows the conflict of
interest between principal and agent. Since securities firm act as agent while
investors act as principal, during 2005 of increase volatility many investors
lost a lot money but the agent (Arif Habib) still keep on making money during
these years. The calculations of the above graph is attached in appendix.

Lack of Derivatives:
Derivatives are very important instruments for a market. Pakistan’s financial
market has never been very efficient and lack of information regarding stock prices
has been at root of many problems in the past. Research on Greek stock market
furnishes evidence that the introduction of derivatives induces a reduction in
volatility of the index and increases its efficiency by facilitating information
generation and evaluation. A study conducted by Fazal Husain and Tariq Mehmood
notes that Pakistan Stock Market can not be declared as leading indicator of
economic activity , therefore, derivative market in Pakistan has lot to add to the
information and assessment of the market.
Above graph shows four year daily volatility profile of KSE 100 index. The graph
shows high degree of volatility in 2002 and in 2005. Such a high degree of volatility
will lead to manipulation of market and losses for real investors. One of the prime
reasons of such a high volatility is lack of hedging opportunities available in
Pakistani exchanges. With introduction of wider range of derivative market
products, reinforced with strong investment banking mechanism, investors will be
better able to mange their risk by hedging, thus ensure a more stable financial
market.

International commodities price:

In order to understand the impact of various regional and international factors like
increase in the prices in the oil market we regress the percentage change in the
KSE on the Bombay stock market.

Source | SS df MS Number of obs = 10

-------------+------------------------------ F( 1, 8) = 22.78

Model | 5.08121123 1 5.08121123 Prob > F = 0.0014

 Residual | 1.78449298 8 .223061622 R-squared = 0.7401

-------------+------------------------------ Adj R-squared = 0.7076

Total | 6.86570421 9 .762856023 Root MSE = .47229

------------------------------------------------------------------------------

lkse | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lindia | 1.20955 .2534268 4.77 0.001 .6251465 1.793953

_cons | -2.203676 2.240916 -0.98 0.354 -7.371237 2.963885

Since beta lies between 95% confidence interval this means that it is significant,
now interpreting the results of our regression we can say that one percent change
in Indian stock market results in 1.2 percentage change in KSE. But R-square is not
large enough which shows that there are some other factors which are not included
in the model that explains the percentage change in KSE. But this is clear that there
is significant amount of change in KSE that explained by some external factors that
effect both BSE and KSE.

The graph shows the movement of KSE and BSE. Both stock exchange show some
similarity in their movement because of external factors.

Conclusion:
There is very high volatility of KSE and different factors that causes this
volatility is explained. KSE index depends a lot on very few stocks and
therefore the sudden movements in prices of these stocks results in high
volatility. Moreover Political instability, lack of derivatives instrument, conflict
of interest between broker and investor and International factors all result in
high volatility of index.
 Appendix

Fig 1.

Date PPl MCB PSO NBP

July,
2000 28.1 173
July,
2001 21 124.1
July,
2002 24.05 138.5 21.25
July, 261.3
2003 42.5 5 33.5
July, 257.2
2004 109.95 51.55 5 72.45
July, 378.2
2005 171.5 85.75 5 105.5
July,
2006 249.5 221.3 347.3 224
July, 326.7 259.9
2007 264.8 5 354.8 5
July, 278.2 126.0
2008 221.8 5 393 4
July, 153.3 227.9
2009 179.59 2 9 66.77

Fig 2