CHAPTER TWO
LITERATURE REVIEW
2.0 Introduction
This chapter 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 forexmarket 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 financial institution (denominated in the local currency of the financial institution’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 financial institution (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 financial institution. 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 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.
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.
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, financial institutions have made left profits due to many new firms and this is usually hard to correctly predict (lel and Nianian, 2007).
One of the biggest issues facing financial institutions is complacency, especially if they fail to fully comprehend the complexity of the market. The forex market is the largest and most volatile financial environment in the world, and it is therefore crucial that traders establish a core knowledge base and prepare for what is in store. However, this can be solved by opening a demo trading account through online brokerage firm, as this allows firms to practisetheir strategy in a real time but simulated environment (Deheijaet al., 2005).
Stacy (2010) further stated that the lack of a trading strategy is a major challenge that financial institutions as a result of foreign exchange. Without a viable trading strategy, it is almost impossible to achieve success within the forex market. When operating in such a volatile and changeable environment, it is imperative that financial institutions boast a certain level of determinism, and establish a strategy that is compatible with its investment philosophy. This will ensure that financial institutions are comfortable with its strategy, and therefore able to implement it in the quest for long term gains. To determine which method of trading is right for it, organizations need to acquire as much knowledge as possible about both the market and derivatives involved.
Automated trading has become hugely popular in recent times, primarily because it executes trades based on predetermined algorithms and eliminates unpredictable human emotion. Adopting an emotive approach as a trader can seriously hinder the chances of success of most financial institutions, as it may cause them to abandon a potentially successful strategy after a poorly judged transaction or sudden loss. In short, financial institutions that are governed by emotion make snap financial decisions, which make it impossible to pursue long term gains. To balance this, however, it is important to remember that human instinct will emerge as a valuable tool to gain experience of the forex market.
2.5 Solutions to the challenges faced by financial institutions as a result of foreign exchange market
2.6 Conclusion
The foreign exchange market is one of the most vital markets in the world. Individuals, institutions, and the global financial system as a whole rely upon the ongoing effective functioning of this market. The market is constantly evolving, and it remains imperative that the industry work to strengthen the foundation of the market, and help to ensure that its integrity is upheld. Particularly in the wake of recent scandals, there is a role for industry participants to restore and maintain market integrity through support and development of best practices. 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 financial institutions in Uganda. This study therefore seeks to add literature on the effect of foreign exchange on profitability of financial institutions in Uganda.
