EFFECTS OF FOREIGN EXCHANGE ON PROFITABILITY OF FINANCIAL INSTITUTIONS
A CASE STUDY OF CENTENARY BANK, NAJJANANKUMBI BRANCH
SECTION ONE
1.0 Introduction
This section presents the background of the study, statement of the problem, general and specific objectives of the study, research questions as well as the scope and significance of the study.
1.1 Background to the Study
Foreign exchange is an integral part in every institutions decision about foreign currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications (Barton, Shenkir, and Walker, 2002). Selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered. The need for currency risk management started to arise after the break down of the Bretton Woods system and the end of the U.S. dollar peg to gold in 1973 (Papaioannou, 2001).
Foreign exchange practices include both internal and external hedging strategies. Internal hedging (also called operational hedging) refers to the use of internal organizational strategies to manage currency exposure and includes all those techniques that do not require external parties. The basic goal of hedging is to eliminate exposure. The most obvious way to reduce the exposure is not to have an exposure. Operational hedging involves activities such as matching of cash inflows and outflows, intercompany netting of receipts and payments, leading and lagging, transfer pricing agreements, pricing policies and asset-liability management (Nathan, 2000). Papaioannou (2006) argues that since currency hedging is often costly, a firm may first consider such natural‖ hedges before hedging externally as it would be cheaper do so. External hedging (or financial hedging) involves use of financial derivatives like futures and forward contracts, options, derivatives as well as money market transactions. Papaioannou (2006), notes that hedging instruments are currently available with different varieties and complexity, and that they include both over-the-counter and exchange-traded products. Over-the-counter currency hedging instruments include currency forwards and cross-currency swaps, while exchange-traded products include currency options and currency futures.
Like any other institution that has a cross-border obligation denominated in hard currency, financial institutions also can be affected by convertibility and transfer risks. In both cases, the MFI may have the financial capacity to make its hard currency payments, but cannot do so because of national government restrictions or prohibitions on making foreign currency available for sale or transferring hard currency outside the country. These risks are known respectively as convertibility risk and as transfer (or remittance) risk. Organizations exposed to foreign exchange risk have three options. First, they can choose to do nothing about their exposure and accept the consequences of variations in currency values or the possibility that their government may impose restrictions on the availability or transfer of foreign currency. This is not a recommended path. Second, they can “hedge” against their exposure. For example, they can purchase a financial instrument that will protect the organization against the consequences of those adverse movements in foreign exchange rates. Finally, they can partially hedge against the risks, or limit their hard currency exposure to set levels (Nathan, 2000).
Every currency zone has an interest rate is set by the central bank. This rate is the most influential number for the forex market. Higher rates make it more attractive to possess a certain currency. The interest rate is a reflection of all other economic indicators. View a list of the interest rate of every major central bank. This is how it looks the worldwide interest rate (Wahab, 2015). Despite the success of many financial institutions, millions of low-income individuals in developing countries still do not have access to financial services. High operating costs and capital constraints within the MFI industry have prevented financial institutions from meeting the enormous demand. Additionally, Dehejia et al (2005) show that the demand for credit by the poor is not inelastic. The high interest rates charged may be limiting the ability of financial institutions to serve poorer potential clients. Thus, the researcher seeks to examine the effect of foreign exchange on the financial profitability of financial institutions.
1.2 Statement of the Problem
Financial institutions undertake to cover risks that may be denominated in currencies other than their home currency. The rapid increase in private sector, international investment in microfinance, plus a dose of common sense, makes foreign currency risk management an important topic for microfinance lenders and borrowers. Seventy percent of cross-border, fixed-income investments are denominated in foreign currencies (meaning currencies other than the currencies in which the Financial institutions are operating), leaving financial institutions with significant foreign exchange exposure. During the most recent global financial crisis, some financial institutions that depend on foreign currency have suffered heavy foreign exchange losses that threaten their overall viability (Littlefield and Kneiding, 2009). Previous studies have focused on the practices adopted by financial institutions in managing foreign exchange risk without relating these management practices to profitability. With increased foreign donor funding to financial institutions, the fluctuations in exchange rates tend to pose significant foreign exchange risk hence the management of the foreign exchange ultimately affects the profitability. Therefore, the there is need to assess the effect of foreign exchange on profitability of financial institutions.
1.3 General objective of the study
The study will assess the effects of foreign exchange on profitability of financial institutions.
1.4 Specific objectives
The study will be guided by the following objectives;
- To identify various foreign exchange practices used in financial institutions.
- To assess how foreign exchange practices affect profitability of financial institutions.
- To investigate the challenges of foreign exchange in financial institutions and suggest best practices to minimize them.
1.5 Research questions
- What various foreign exchange practices are used in financial institutions?
- How do foreign exchange practices affect profitability of financial institutions?
- What are the challenges of foreign exchange in financial institutions and how can they be minimized?
1.6 Scope of the study
The study will aim at examining the effects of foreign exchange on profitability of financial institutions. It will be carried out at centenary bank which is located in Najjanankumbi branch – Wakiso district, the bank is located approximately 5km (3.1mi) by road, south of the central district of Kampala. The study will be carried basing on information collected for a period of 10years from 2007 to 2016.
1.7 Significance of the study
This study is important to various stakeholders in the financial sector because it will provide an insight into the effects of financial risk management on profitability of financial institutions. Financial institutions are the most reliable savings and credit facilities available in Uganda.
Policy makers will use the recommendations of this study finding to explore avenues to enhance capacities within financial institutions for managing foreign exchange risk.
The study will be valuable to investors because it will provide information on the foreign exchange risks which will help them make sound decisions.
The study will be useful to academicians as it will provide information that can be used as a basis for further research. The study will also propose areas for further research which will be very important to researchers who will easily get to know what needs to be done in the area of study.
LITERATURE REVIEW
This section reviews literature related on foreign exchange risk, foreign exchange practices, determinants of financial profitability and effect on financial profitability.
2.1 Overview of foreign exchange
Foreign exchange dates back to ancient times, when traders first began exchanging coins from different countries. However, the foreign exchange it self is the newest of the financial markets. In the last hundred years, the foreign exchange has undergone some dramatic transformations. Trading volume has increased rapidly over time, especially after exchange rates were allowed to float freely in 1971 (Headley, 2010).
Headley further stated that before the year 1998, the foreign exchange market was only available to larger entities trading currencies for commercial and investment purposes through banks, now online currency trading platforms and the internet allow smaller financial institutions and retail investors access a similar level of liquidity as the major foreign exchange banks, by offering a gateway to the primary (Interbank) market.
The FOREX refers to the Foreign Currency Exchange Market in which over 4,600 International Banks and millions of small and large speculators participate worldwide. Every day this worldwide market exchanges more than $1.7 trillion in dozens of different currencies. With the current growth rate the market is projected to grow to more than $1.9 trillion per day by the year 2006. With such volume, one can assume that the forex market is extremely volatile, changing at a moment’s notice, depending on conditions within that country (Sekmen, 2011).
According to Headley (2010), the basic concept behind the foreign exchange (or forex) market is for trading currencies, one pair against another. It’s the world’s largest market, consisting of almost $2 trillion in daily volume and is growing rapidly. The value of one currency is determined by its comparison to another currency via the exchange rate. The major currencies traded most often in the foreign exchange market are the euro (EUR), United States dollar (USD), Japanese yen (JPY), British pound (GBP) and the Swiss franc (CHF).
2.2 Foreign exchange Practices
Dawson et al., (1994), define a swap as an exchange of liabilities denominated in a different currency involving two parties who agree to exchange specific amounts of two different currencies at the outset in their home currency. The two parties make periodic payments over time in accordance to predetermined rule to reflect differences in interest rates between the two currencies involved. A cross-currency swap is generally used at the start of a loan period. Cross currency swaps allow two counterparties to exchange specific amounts of two different currencies at the outset and to make repayments over time. In a currency swap, interest payments in two currencies are exchanged over the life of the contract, and the principal amounts are repaid either at maturity or according to a predetermined amortization schedule.
Marshal, (1997), examined the extent of derivatives and the reasons for their use by carrying out surveys in 250 large UK companies. They found a wide spread use of both forwards and options (96% and 59% respectively). They pointed out that comparing to the primary reason for the use of forwards were company policy, commercial reasons and risk aversions, a good understating of instrument, and price were prominent. While the primary reason to use options was company management.
Bodnar and Richard, (1998), indicate that the most frequently used method is forward exchange contract. With forwards, the firm can be fully hedged. However, some risks including settlement risk that exchange rate moves in the opposite direction as either forecast, and counter party risk which the other party is unable to perform on the contract, the high cost of forward contracts will sometimes prevent firms to exercise this tool to fully hedge their exposures.
According to Fatemi and Glaum, (2000), foreign exchange forward is an agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement at a predetermined future date, or within a predetermined window of time. Foreign exchange forwards help investors manage the risk inherent in currency markets by predetermining the rate and date on which they will purchase or sell a given amount of foreign exchange. The portfolio is thus protected against a possible negative currency move and there are no additional price complications in execution from doing a spot trade. Deliverable forwards are contracts that are settled with the physical delivery of the foreign currency. Non-deliverable forwards are cash-settled for the gain or loss on the value of the contract.
Fatemi and Glaum, (2000), found out that most of the use derivative instruments for hedging purposes and that translation exposure were the foreign exchange exposure that most firms were greatly concerned with. Bradley and Moles, (2002), argued that there is a significant relationship between firm’s exchange rate sensitivity and the degree to which it sells sources and funds itself internationally.
According to Moles, (2002), foreign Exchange risk arises from the mismatch between the assets held by an MFI (denominated in the local currency of the MFI’s country of operation) and the loans that fund its balance sheet (often denominated in USD or a stronger currency). An unexpected depreciation of the local currency against the USD can dramatically increase the cost of servicing debt relative to revenues. It can also negatively affect the creditworthiness of the MFI (hence the ability to raise new funds) and even generate a negative net income, with serious consequences for the long-term financial stability of the MFI. Financial institutions are particularly vulnerable to foreign exchange rate risk, since they operate in developing countries where the risk of currency depreciation is high. Furthermore, extreme currency depreciation tends to be highly correlated with a general deterioration of local economic conditions, which can cause higher loan delinquencies and a reduction in profitability of financial activities. Several studies have attempted to provide insight into the practices of foreign exchange.
Moles, (2002), like any other institution that has a cross-border obligation denominated in hard currency, financial institutions also can be affected by convertibility and transfer risks. In both cases, the MFI may have the financial capacity to make its hard currency payments, but cannot do so because of national government restrictions or prohibitions on making foreign currency available for sale or transferring hard currency outside the country. These risks are known respectively as convertibility risk and as transfer (or remittance) risk. Organizations exposed to foreign exchange risk have three options. First, they can choose to do nothing about their exposure and accept the consequences of variations in currency values or the possibility that their government may impose restrictions on the availability or transfer of foreign currency. This is not a recommended path. Second, they can “hedge” against their exposure. For example, they can purchase a financial instrument that will protect the organization against the consequences of those adverse movements in foreign exchange rates. Finally, they can partially hedge against the risks, or limit their hard currency exposure to set levels.
According to Abor, (2005), leading and lagging involves delaying the original payment but within a company’s divisions or subsidiaries. If the currency of a subsidiary is sought to appreciate, it may accelerate its payment (leading) and realize the payment before the currency appreciates. The reverse is true if a currency is expected to depreciate, then the company will delay its payment (lagging). However, the first should only take into account the gain or loss from the currency but also the cost for increasing or decreasing the liquidity. Further, a lead strategy, involves attempting to collect foreign currency receivables only when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. On the other hand a lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate.
Lel and Nianian, (2007), outline that as a relative new financial derivative used to hedge foreign exchange exposure, currency swaps have a rapid development. Since its introduction on a global scale in early 1980’s currency swap market has become one of the largest financial derivative markets in the world.
Lel and Nianian, (2007), an option is a unique financial instrument or contract that confers upon the holder or the buyer thereof the right, but not an obligation, to buy or sell an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer can simply let the right lapse by not exercising it. On the other hand, if the option buyer chooses to exercise the right, the seller of the option has an obligation to perform the contract according to the agreed terms. The asset underlying a currency option can be a spot currency or a futures contract on a currency. An option on a spot currency gives the option buyer the right to buy or sell the said currency against another currency, while an option on a currency futures contract gives the option buyer the right to establish a long or short position in the relevant currency futures contract. Options on spot currencies are commonly available in the interbank over-the-counter markets, while those on currency futures are traded on exchanges.
According to CFTC,(2009), netting is the reduction in the number of transactions that a firm needs to make in order to cover an exposure. It requires the firm to have a centralized organization of its cash management. The centralization means that the companies collect foreign currency cash flows between subsidiaries and groups them together as inflows and outflows in the same currency. The objective of netting is to save transaction costs by netting off intercompany balances before arranging payment. This is where multinational groups engage in intergroup trading i.e. related companies located in different countries trade with one another. The advantages are: reduction in foreign exchange purchase costs, commission, selling and buying rates, and less loss in interest from having money in transit. Loss due to netting positions by swap dealers can be as little as10% for agricultural commodities and quite large for energy and metals.
Sekmen, (2011), price adjustments involves changing prices in different manners. When the local currency of a subsidiary is devaluating, the subsidiary can increase the price, so as to cancel the effect of devaluation. This technique is particularly used in countries where devaluation is high and where derivative markets are efficient. However, as a disadvantage of this method, prices cannot be raised without any consideration about competitors because if prices increase too much the client will choose an equivalent cheaper product/service from a competitor. Flexibility may be exhibited in the ability to pass through changes in the price of inputs or in the general level of prices to consumers through frequent price adjustments.
2.3 How foreign exchange practices affect financial profitability of financial institutions
Evan et al., (1985), defines foreign exchange as a program of assessment (identification and quantification) and counterstrategies to mitigate exchange rate risk and saves firm`s economic value. Evan further adds foreign exchange risk is a financial risk to manage value creation and loss prevention in a firm by internal and external financial tools. Taggert and McDermott, (2000), assert that forex related firms are subject to foreign exchange risk on the payables and receipts in foreign currencies.
According to Moles, (2002), foreign Exchange risk comes about as a disparity between the assets held by a bank and the loans that fund its balance sheet. An unexpected depreciation of the local currency against the USD can dramatically increase the cost of servicing debt relative to revenues. It can also negatively affect the creditworthiness of the bank (hence the ability to raise new funds) and even generate a negative net income, with serious consequences for the long-term financial stability of the bank. Banks are particularly vulnerable to foreign exchange rate risk, since they operate in developing countries where the risk of currency depreciation is high.
According to Carter et al., (2003),use of foreign exchange management strategies results in reduced foreign exchange exposure hence minimal losses. According to Carter et al., (2003), changes in exchange rate can influence a firms current and future expected cash flows and ultimately, stock prices. The direction and magnitude of changes in exchange rate on firms value are a function of a firm’s corporate hedging policy which indicates whether the firm utilizes operational hedges and financial hedges to manage currency exposure and the structure of its foreign currency cash flows.
Operational exposure occurs where the market position of a firm changes as a result of the effect of exchange rate changes on competition, prices and demand. Translation risk is also related to assets or income derived from offshore enterprise. Translation exposure occurs through currency mismatch and it is related to assets or income derived from offshore enterprise (Madura, 2003).Dufey, (2005), contend that risk management departments without well trained personnel to man the departments are less effective and the company will many a time be prone to such currency risks.
El-Masry, (2006), translation risk occurs where the value of the existing obligations are worsened by movements in the foreign exchange rates. Transactional exposure arises from future cash flows such as trade contracts and also occurs where the value of existing obligations are affected by changes in foreign exchange rates. Economic risk relates to adverse impact on entity /income for both domestic and foreign operations because of sharp, unexpected change in exchange rate.
According to Featherson, Littlefield and Mwangi, (2006), foreign exchange risk arises when fluctuation in the relative values of currencies affects the competitive position or viability of an organization. Firms are exposed to foreign exchange risk if the results of their projects depend on future exchange rates and if exchange rate changes cannot be fully anticipated. Generally, companies are exposed to, Transaction exposure, Economic exposure and Translation exposure (El-Masry, 2006; Salifu et al, 2007).
Stacy and Williamson, (2010), examine risk management and performance in a sample of firms in 14 companies listed on the Johannesburg stock exchange. They find that better risk management is associated with better performance in the form of Tobin’s q and ROA.
Lee, (2010), shown that firms that have robust currency risk management frameworks have higher firm performance. The main characteristics of good risk management identified in these studies include; leadership of the risk team, adequate compensation of the risk team and compliance with laws & best practice. There is a view that companies with risk management departments are better corporate performers. In recent times on the contrary, emphasis has geared towards general employee training in currency risk management. Piet and Raman, (2012), say spot rate changes are offset by changes inflation though small firms may depend on unstable currency rates for profits.
2.4 Challenges faced by financial institutions as a result of foreign exchange market
According to Abor (2015) presently, the most profitable market where dealers can make some earnings is the Foreign exchange market. Foreign exchange dealing is the trading of numerous currencies and it edges out the standard stock exchange market as a good place to earn more cash for different reasons. More than $1.8 trillion dollars are exchange everyday on the foreign exchange market compared to the less than one hundred billion dollars that are exchange everyday in the U.S. stock exchange market.
This transforms to more important liquidity which means that deals are filled almost instantly utilizing real time information. Aside from that, with more dealers, there is more chance to see important deals that you can participate on. This foreign exchange market also never stops on functioning so you can deal in the foreign exchange market twenty-four hours a day, six days in a week. With the help of existing foreign exchange technology, you can further improve your dealing activity and with a good dealing technique, dealers can earn profits faster than before (Abor, 2015).
The foreign exchange market is mainly based on the monetary denomination of numerous countries. While there are a lot of problems that are affecting different countries all over the world, the problem is much smaller is what you can encounter in the equity market. In this market, organizations like Enron and other failed business groups can surprise people and this is usually hard to correctly predict (lel and Nianian, 2007).
Profitable dealing in any financial market will depend on how well you manage the problems that you will encounter. With the foreign exchange market, much of dealing techniques are mainly based on the patterns and other vital factors which have been tested through the course of time and with additional testing to be more useful when being utilized for deciding on dealing parameters. This innate stability compared with other dealing markets combine with using online foreign exchange software gives a good opportunity for the dealer to start earning profits in a minimum amount of time (CCTC, 2009).
These foreign exchange software dealing tools, the utilization of mathematical formulas and other techniques have proven to be very beneficial in the foreign exchange market. Aside from that, they automate data gathering and technical tasks of dealing. Even the home based dealer can use the power and different features of the foreign exchange market software. You must also take the time to read foreign exchange software reviews so that you can apply in your own dealing what you will learn from them (CCTC, 2009).
2.4.2 Solutions to the challenges of foreign exchange
Forward, option and swap deals; Classic tools to effective hedge of risk exposures widely available at the financial markets. However, Increases the volatility of profit (without hedge accounting) and it also requires sophisticated risk assessment and hedging strategy due to the complexity of risks (Gábor, 2012).
Natural hedge strategies and renewal of customer/supplier agreements. This will ensure risk handling strategy can be adjusted to the business model of the company. However, requirement is the possibility of transfer of the FX risk to customers / suppliers and might result in falling customer demand (Molnár, 2012).
Increase/decrease of outstanding foreign currency denominated loans. This can be an alternative risk hedging tool of derivatives and also favourable in the case of FX denominated overdraft (Gábor, 2012).
Hedge accounting can help eliminate the negative effects of derivatives closed in line with business purposes. It can also align accounting treatment with business model can be favourable in taxation (Gábor, 2012).
According to Molnár (2012), book keeping in FX can decrease the volatility in balance sheet and/or income statement if the business is based on significant FX denominated transactions. Not always an optimal solution due to the nature of the business model and the significant IT development could be required to operate.
According to Sekmen (20110 states that restructuring of business processes can be favourable to risk exposures in the balance sheet. However, Alternatives can be limited by the business model, current and future market conditions.
Financial institutions need additional funding to meet demand, and debt capital is the most likely source for this funding. Foreign exchange rate risk is significant, and though it is only one factor in a decision to lend to a bank, it is a strong deterrent. Finally, the existing foreign exchange practices are prohibitively expensive, either to the client or the institution. Most of these studies have focused on foreign exchange practices in developed nations whose financial position is different from that of Uganda. The ones done in Uganda have focused on different industries other than the Microfinance institutions. Thus there is no literature focusing on various foreign exchange practices by microfinance institutions in Uganda. This study therefore seeks to add literature on the effect of foreign exchange on profitability of financial institutions in Uganda.
RESEARCH METHODOLOGY
This section presents the research design, area of the study, study population, sample size, sample techniques, the data collection instruments, the procedures of data collection, ethical considerations, and data analysis.
A descriptive research design will be used because it is flexible in both quantitative and qualitative approaches of data collection. Descriptive research design will be used because it is effective to non-quantified topics and issues, the possibility to observe the phenomenon in a completely natural and unchanged natural environment and the opportunity to integrate the qualitative and quantitative methods of data collection which other designs do not provide.
3.2 Sample Size, Selection and Procedure
The study will use a total of 50 respondents and will be regarded representative of the study population and will provide a manageable volume of data and allowed the researcher to make accurate estimates of thoughts and behavior of a larger population. The sample size will be determined by the formula below;
n = where n is the sample size, N is the population and e is margin error (5%).
n =
n =
n =
n = 49.89
n = 50 respondents
The study will use both purposive and simple random sampling. Purposive sampling is one of the most cost-effective and time saving sampling methods available, it is effective in exploring anthropological situations where the discovery of meaning can benefit from an intuitive approach.
Simple random method will be used because it helps to reduce on the biasness of purposive data and will mainly be used on clients, it is free of classification error, and requires minimum advance knowledge of the population. Its simplicity also makes it relatively easy to interpret data collected in this manner. Therefore simple random best suits situations where not much information is available about the population and data collection can be efficiently conducted on randomly distributed items.
The data to be collected will be primary and secondary in nature. Primary data will be collected from respondents through the use of questionnaires and interview sessions. The secondary data will be collected from Library, research reports, journals, articles inform of literature review which provided information related to the study.
3.4 Data Collection Instruments
The study will involve the following instruments;
Questionnaires will be used to collect data from key informants mainly because they can read and write, they had busy schedules thus not interfering with them and can answer at their convenient time. Questions will be constructed in simple English that can easily be interpreted. They will be taken to respondents by the researcher and picked at an appointed date.
The researcher will strived to get first-hand information by making appointments with individual respondents to answer questions related to the study topic. Semi-structured interviews will be used to generate additional information from the respondents. This involved a more interactive interface with respondents. The interview guide will be used as an instrument of data collection because it helps the researcher to acquire information which would have if using other methods and it saves time for the researcher and the respondents since only key questions are asked.
3.5 Data management, Presentation and Analysis
The data will be qualitatively analysed. It will involve identifying the major themes arising from the respondents’ answers; assigning codes to these themes; classification of the major responses under the main theme; and integrating the responses into the report in a descriptive and analytical manner. Quantitative data will be analyzed to give percentages, and statistical figures. For the analysis Microsoft Excel statistical packages will be used. Once the questionnaires are checked for completeness and correct recording, it will be then entered into the developed database for subsequent analyses. The researcher will validate entries through regular checks to ensure data will be recorded accurately.
3.6 Limitations and Delimitations of the study
The time allowed to do this research will be not enough to allow exhaustive study and obtain all the essential information for much more suitable conclusions. Here to overcome this, the researcher will draw a work plan for the study in order to balance it with other activities.
Low responsiveness of some respondents due to fear of giving information. The researcher will
