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.

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.

CHAPTER THREE

RESEARCH METHODOLOGY

3.0 Introduction

This chapter 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.

3.1 Research Design

A descriptive research design was used because it is flexible in both quantitative and qualitative approaches of data collection. Descriptive research design was 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 used a total of 50 respondents and was regarded representative of the study population and provided a manageable volume of data.  The sample size was determined by Slovings’ formula below;

n = 571+57 (e2) where n is the sample size, N is the population and e is margin error (5%).

n = 1351+135 (0.052)

n = 571+57 (0.0025)

n = 571+0.1425

n = 49.89

n = 50 respondents

The study used both purposive and simple random sampling. Purposive sampling is one of the most cost-effective and time saving sampling methods available, it was effective in exploring anthropological situations where the discovery of meaning can benefit from an intuitive approach.

Simple random method was also used because it helps to reduce on the biasness of purposive data and was mainly 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. 

3.3 Data type and sources

The data to be collected was primary and secondary in nature. Primary data was collected from respondents through the use of questionnaires and interview sessions. The secondary data was collected from Library, research reports, journals, articles inform of literature review, text books which provided information related to the study.

3.4 Data Collection methods and instruments

The study involved both questionnaires and interview methods;

The questionnaire was used because large amounts of information can be collected from a large number of people in a short period of time and in a relatively cost effective way, can be carried out by the researcher or by any number of people with limited affect to its validity and reliability, the results of the questionnaires can usually be quickly and easily quantified by either a researcher or through the use of a software package, can be analysed more ‘scientifically’ and objectively, when data has been quantified, it can be used to compare and contrast other research and may be used to measure change.

Semi-structured interviews were also used to generate additional information from the respondents. The interview guide was used 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 management included data editing before leaving the area of study to ensure that there are no mistakes or areas left blank and if any mistakes are found they was corrected before leaving the field. This also involved editing raw data to detect errors and omissions, classifying data according to common features, and tabulation to summarize and organize it.

Descriptive statistical techniques was used to analyze quantitative data and interpret the findings of the study that was presented in tables and charts from which frequencies was used with the help of statistical packages for social scientists (SPSS)to establish percentages, frequencies and statistical means of the research variables. The qualitative data was analysed by 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. The data collected was arranged in order to obtain accurate, clear and uniform data. In editing the researcher ensured that errors and omissions was detected and eliminated. 

3.6 Limitations and Delimitations of the study

The time allowed to do this research was not enough to allow exhaustive study and obtain all the essential information for much more suitable conclusions. To overcome this, the researcher drew a work plan for the study in order to balance it with other activities.

The researcher further was faced with a problem of some respondents not providing information due to fear, however to overcome this, the researcher explained to respondents that the information was only for the academic purpose and the information provided is confidential.

Another limitation was the scarcity of recent literature relating due to lack of text books in the library. However, the researcher sourced information from the internet, newspapers and previous reports.

There was also unrealistic expectation from the respondents for example money which the researcher didn’t have. The researcher convinced the respondents that the information required was to be used for academic purposes only.

CHAPTER FOUR

DATA PRESENTATION, ANALYSIS, INTERPRETATION AND DISCUSSION OF FINDINGS

4.0 Introduction

This chapter presents the study findings in reference to the research objectives. Focus was put on presentation and discussion of findings in line with study objectives. The chapter first presents respondents’ background features, while other sections present the study findings study objective. The response rate was 100%, as all the 70 respondents responded positively to the study.

4.1 Findings on background characteristics 

This aspect of the analysis deals with the characteristics of the respondents of the questionnaires.  The results obtained are presented below;

Table 4.1.1: Gender of respondents

Source: Primary Data

From the table above, male respondents formed the highest percentage 30(60%) compared to the female with only 20(40%). Males were found to be more active in participation which explains their highest number. However, both were considered since it was important to get views of women in the study. 

Table 4.1.2: Marital status of respondents 

Table 4.1.3: Age of Respondents

Source: Primary Data

The majority (46%) of the respondents were predominantly between the ages of 31 and 40 years. Also (22%) of the respondents were in the age bracket of20- 30years. 31 and 40years had the highest number because these are the most active age group hence they are actively involved in management, therefore they had rich experiences and could also appreciate the importance of the study.

Table 4.3: Highest Level of Education

Source: Primary Data

The table above shows that most of the respondents (62%) were diploma holders, 38% were degree holders therefore, provided information was based on the academic knowledge, skills and experience they have gain in management. Most respondents had attained education certificates because it is one of job requirements at the organization. The level of education was important to this study because the information provided would be based on the knowledge gained in foreign exchange risk management and profitability.

4.2 Foreign exchange practices used

The study sought to examine foreign exchange practices used at the institution. The results were obtained and are presented below;

Respondents were asked to identify where there was a policy for managing foreign exchange risk and results show that the financial institutionshas a foreign exchange risk management policy. From the findings, chief accountant as well as other similarly senior employees in the accounts and finance department was responsible for foreign exchange management of the financial institutions. This implies that managing foreign exchange risk is a function that is effectively delegated to those who were more directly involved or better placed to manage the risk on a regular basis.

Table 4.4: Foreign exchange risk management practices used

Source: Primary Data 

The findings indicated that at different time periods forward contracts (22%), currency swaps (18%), currency futures (18%) and currency options (18%) were used to manage foreign exchange fluctuations. In terms of the financial means that the organizations used to manage foreign exchange fluctuations in the study period, the study findings indicate that the financial institutionsadopted different financial means at different periods. However, findings indicated that the financial means most used was the choice of currency in which company debt was denominated (24%). 

Table 4.5: Operational means to manage foreign exchange fluctuation

Source: Primary Data

The study was interested in finding out how often the financial institutionsreviewed used various operational means to manage foreign exchange fluctuation. The results indicated that matching cash inflows and outflows (42%) as well as matching assets and liabilities (38%) were the most preferable operational means to manage foreign exchange fluctuations. In addition to this, netting different currencies` exposures (6%) and choice of invoicing currency (12%) were also utilized in some periods. 

In an interview with one respondent in a managerial position, he was quoted saying that:

“Whenfinancial institutionsare trading Forex,they are trading one currency against another. He said that an example would be when financial institutionsare trading Dollars for Euros. Most people have experienced this when visiting another country with a different currency. Because the rate for which financial institutionscan trade money fluctuates over time, it is also possible to earn money with currency trading. 

The only rule financial institutionshave to follow says ‘buy low, sell high’. Of course this is not as easy as it sounds as financial institutionsnever know in advance what would be considered ‘low’ and ‘high’. However, if they know which factors influence the rate of a currency, they can make predictions about the future rate of this currency. An important aspect to know when trading is called the ‘spread’ of the currency.The Forex market is very complicated and affected by many factors. Nevertheless, the price is always a result of all supply and demand forces”.

4.3. How foreign exchange practices affect profitability offinancial institutions.

The study sought to examine how foreign exchange practices affect profitability of financial institutions. Results were obtained and are presented below:

Table 4.7: How foreign exchange affect profitability of financialinstitutions.

Source: Primary Data

Respondents haddifferent options to most of the questions posed as presented in the findings in table above. Notable agreements are observed with the statements that the use of foreign exchange management strategies results in reduced foreign exchange exposure hence minimal losses as most of the respondents (64%) agree while 36% of them strongly agree. The neutral responses suggest some level of in differentness with foreign exchange risk retention regardless of the state of affairs. This underscores the commitment among financial institutions to avert risks at all cost. 

Furthermore, 70% of the respondents strongly agree while 30% of them agree with the firm often carries out foreign exchange exposure projections in different currencies. This is intended on reducing the level of risks thus, improving profitability of the financial institutions.

Also, 86% of the respondents strongly agree with firm sets extensive budgeting systems to handle currency risk projections. This implies that the financial institutions are aware of risks in future, thus it sets budgetary systems that will meet currency future risks.

Results show that, 54% of the study respondents strongly agree that we have an up-to-date system that helps to handle currency risk projections. This is of the implication that the financial institutions always update its system that handles currency risk projection inorder to enhance profitability in the financial institutions.Majority of the study respondents (100%) strongly agree with there are revenue projections incorporating foreign exchange rate movements in this firm. This implies that as a strategy to ensure that there is high performance in the firm; revenue projections are available so that shortages do not hit the institution at late date. Also 80% strongly agree with we minimize exposure through early payments of foreign currencies before they are due. While 70% of them strongly agree that we also match costs with revenues denominated in similar currencies to reduce the impact (matching strategy) and 60% of the respondents strongly agree that at times we also forego foreign currency denominated financing if its anticipated that exchange rates was volatile later.

4.4 Challenges faced by financial institutions as a result of foreign exchange and their solutions.

Study respondents were required to show their level of agreement on the challenges facing financial institutions as a result of foreign exchange practices. Results were obtained and are obtained below;

Table 4.8: Complexity of the market

Source: Primary Data

Results show that majority of the respondents (50%) strongly agree with complexity of foreign exchange market has affected the profitability of financial institutions, 30% of them disagree, 20% of the respondents agree. This implies that a complexity of the forex market contributes highly to the poor performanceof most financial institutions since the majority of the study respondents were positive. 

Table 4.9: Lack of trading strategy

Source: Primary Data

Also, most of the respondents (56%) agree while 44% of them strongly agree with lack of trading strategy. This implies that lack of trading strategy affects the operation of financial institutions in forex market thus minimizes the profitability level of the institutions is affected.

Table 4.10: Threat of Human emotion

Source: Primary Data

Table shows that 54% of the study respondents strongly agree with threat of human emotion while 46% of the respondents agree. This implies that adopting an emotive approach by financial institutions 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.

Table 4.11: Complexity of technology used

Source: Primary Data

The table above shows that, 70% of the respondents strongly agree with complexity of technology used can positively affect financial institutions while 30% of them strongly disagree. This implies that technological changes immensely affect the profitability of most firms.

CHAPTER FIVE

DISCUSSION OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

5.0 Introduction

The data was analyzed using description and percentages. This chapter therefore presents the discussion of the study in sub-chapters on the basis of the specific objectives set to achieve as analyzed in chapter four, the conclusion, and recommendations. 

5.1 Discussion of findings

The most common foreign exchange risk reduction strategies in the institutions from the findings are forward contracts and choice of currency in which company debt is denominated. 

The study also found that the use of operational means, particularly the matching of cash inflows and outflows and the matching assets and liabilities, had a significant impact on profitability of the. The findings of this study collaborate the findings of Blum, et. al (2001), who noted that companies mostly manage their foreign exchange exposure by maintaining assets in the currency in which the liabilities are denominated, that is, on-balance sheet hedging. The study concludes that given the significance of operational means on profitability, companies should seek ways to diversify their approaches for operational means to include all possible hedging techniques. 

According to study findings, the use of foreign exchange management strategies results in reduced foreign exchange exposure hence minimal losses, the firm often carries out foreign exchange exposure projections in different currencies. This is intended on reducing the level of risks thus, improving profitability of the financial institutions. Firm sets extensive budgeting systems to handle currency risk projections. This implies that the financial institutions are aware of risks in future, thus it sets budgetary systems that will meet currency future risks. This is in line Featherson, Littlefield and Mwangi (2006) who noted that 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.

5.2 Conclusion

The study also concludes 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 microfinance institutions. This study did not find choice of invoicing currency being used by microfinance 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 institutions. Specifically, the study concludes that microfinance should aim at obtaining greater foreign revenues and profits through diversifying beyond local borders to the regional, African 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.

5.3 Recommendations

Organizations should not only cover foreign exchange risk alone but rather could be preceded by introductory contents on the practical market challenges facing the financial institutions. 

Financial institutions and generally all firms in Uganda with and without international operations effectively manage their risk to minimize their losses to exchange rate risk. 

The study also recommends that firms should look at instituting a sound risk management system and also needs to formulate their hedging strategy that suits their specific firm characteristics and exposures. 

The study recommends that financial institutions should explore avenues to enhance capacities within them for managing foreign exchange risk. They should explore the route of continued education for those in workplaces through short term training that should be very practical oriented. This could involve professional organizations for finance specialists, accountants and consultants. Such training should ideally be out of site because of the need to meet participants from diverse businesses and orientations for training and assessment to avoid internal interruptions. 

5.4 Suggestions for Further Research

Further studies should be carried out on;

• The effect of interest rates on profitability of financial institutions.
• The effect of credit risk management and financial risk management to the profitability of financial institutions in Uganda.

REFERENCES

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APPENDICES

APPENDIX I: QUESTIONNAIRE

Dear respondent,

I am Kabejja Alice Nanyombiconducting a research on “Effects of Foreign Exchange on the Performance of Financial Institutions”. Therefore I kindly request you to spare a few minutes of your busy schedules to fill this questionnaire to enable me accomplish this task. Your honest and sincere responses are highly appreciated for academic purposes and shall be treated with utmost confidentiality. I thank you very much for your cooperation.

CHAPTER A: BACKGROUND INFORMATION 

(Please tick in the appropriate Box)

1. Sex: Male   Female 
2. Age:   20 – 30 years 31 – 40 years                41 – 50 years   

              51 – 60 years 60 and above    

3. Level of Education:

Primary Secondary Diploma Degree 

Post –graduate Others (specify) …………………………   

CHAPTER B: FOREIGN EXCHANGE PRACTICES USED

4. Does your organization have a policy for managing foreign exchange risk? 

Yes No  

5. What does your organization use as the financial means to manage foreign exchange fluctuation?

1. Forward contracts
2. Currency swaps
3. Currency options
4. Currency futures

Others specify………………………………………………………………………………….

6. How often has your organization used the following operational means to manage foreign exchange fluctuation?

Choice of invoicing currency

Matching cash inflows and outflows

Netting different currencies‘ exposures

Leading and lagging

Matching assets and liabilities

Other [please specify] …………………………………………………………………………

CHAPTER D: HOW FOREIGN EXCHANGE AFFECT FINANCIAL PROFITABILITY.

7. In this chapter, tick the best option by using strongly Agree (SA), agree (A), Not Sure (NS), Disagree (D).

CHAPTER D: CHALLENGES AND SOLUTIONS OF FOREGIN EXCHANGE

8. Does your institution face challenges as a result of foreign exchange?

Yes

No 

9. In your opinion, what challenges does the institution face as a result of foreign exchange? Please tick (√) the appropriate alternative where SA-strongly agree, A- agree, NS- Not Sure, SD-strongly disagree D-disagree 

10. In opinion, what do you can be done to minimize these challenges in your institution? Please tick (√) the appropriate alternative where SA-strongly agree, A- agree, NS- Not Sure, SD-strongly disagree D-disagree 

THANK YOU FOR YOUR TIME