EFFECTS OF FOREIGN EXCHANGE ON PROFITABILITY OF FINANCIAL INSTITUTIONS: A CASE STUDY OF CENTENARY BANK, 

NAJJANANKUMBI BRANCH

LIST OF ACRONYMS

CAMEL Capital Adequacy, Asset Quality, Management Efficiency, Earnings Ability and Liquidity

GDP Gross Domestic Product

CAR Capital Adequacy Ratio 

Forex Foreign Exchange

ABSTRACT

The study was carried out at Centenary Bank, Najjanamkumbi branch with the purpose of examining the effects of foreign exchange on profitability of financial institutions. The research objectives were to identify various foreign exchange practices used in financial institutions, to assess how foreign exchange practices affect profitability of financial institutions and the challenges faced by financial institutions as a result of foreign exchange and their solutions. The study used a descriptive research design where both qualitative and quantitative approaches of data collection were adopted using questionnaires. The study found out that the use of operational means (hedging), particularly the matching of cash inflows and outflows and the matching assets and liabilities, had a significant impact on profitability of financial institutions. This study did not find choice of invoicing currency being used by financial institutions to be a practice that was widely used to manage foreign exchange risk. The study concludes that foreign exchange practices effect on the profitability of financial institutions. Specifically, the study concludes that financial institutions should aim at obtaining greater foreign revenues and profits through diversifying beyond local borders to the region, Africa as well as world markets. The practical relevance of the research findings in foreign exchange risk management practices lies in the fact that, even though there are a number of financial hedging techniques such as use of derivatives that are available to manage foreign exchange risk, these measures tend to be rather too sophisticated and difficult to implement countries. The study therefore concludes that foreign exchange risk management practices have an effect on the profitability of microfinance institutions.It was recommended that organizations should not only cover foreign exchange risk alone but rather could be preceded by introductory contents on the practical market challenges facing the microfinance institutions industry.

CHAPTER ONE

1.0 Introduction

This chapter 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 financial institution 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 financial institution 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 was need to assess the effect of foreign exchange on profitability of financial institutions.

1.3 General objective of the study

The study assessed the effects of foreign exchange on profitability of financial institutions.

1.4 Specific objectives

The study was guided by the following objectives;

1. To identify various foreign exchange practices used in financial institutions.
2. To assess how foreign exchange practices affect profitability of financial institutions.
3. To investigate the challenges of foreign exchange in financial institutions and suggest best practices to minimize them.

1.5 Research questions

1. What various foreign exchange practices are used in financial institutions?
2. How do foreign exchange practices affect profitability of financial institutions?
3. What are the challenges of foreign exchange in financial institutions and how can they be minimized?

1.6 Scope of the study

The study aimed at examining the effects of foreign exchange on profitability of financial institutions. It was 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 was 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 was valuable to investors because it will provide information on the foreign exchange risks which will help them make sound decisions.

The study was 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 was very important to researchers who will easily get to know what needs to be done in the area of study.