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Foreign exchange rish in financial institutions in Pakistan

Abstract

Companies’ especially multinational companies and financial institutes like banks and insurance companies are now exposed to foreign currency risks caused by unexpected movements in exchange rate. In order to survive in this competition age companies have to manage this foreign exchange risk in a planned and good manner.

The purpose of this study is to describe the different types of risks faced by financial institutions in Pakistan. These risks may include translation risk, transaction risk and operating risk. Research also includes the management and measurement of foreign exchange risk and studies the different methods of hedging this risk.

The research was conducted through internet, analyzing the financial reports of different financial institutes and face to face interviews conducted from different executives of different financial institutes.

Foreign exchange risk has a great impact on the cash flows and operating profits of an organization while doing business abroad and organizations have to familiar to manage and hedge this risk by using different derivatives and choose the best method that is suitable to organization.

Managing the foreign exchange risk through hedging and use of derivatives is very common in these days. Organization often uses leading and lagging technique and less uses the swaps and invoice currency methods.

1- Introduction

In this section the back ground of the research will be presented. On the basis of back ground we will make a research question and then followed the proposition for a financial institution’s foreign exchange risk.

1.1 Background of the study

With the fast development of economic globalization since 70’s of last century, today companies operate in as integrated world marketplace. The international market produces the global producer, supplier, customer and also global competitors. Now a day’s money has no national boundaries. Meanwhile the increasing global business has brought many new problems and opportunities for organizations. They also facing different kinds of risks involving operation risk, investment risk and financing risk etc. to be familiar with those risks and how to hedge and control these risks is very important for organizations. Especially the foreign exchange risk is placed at the top of the risks to be concerned for an effective management.

Multinational corporations and multinational enterprises are the entities that operate in at least two countries in both ways i.e production and rendering services. Recently foreign exchange risk has got the increasing importance in both sectors corporate and literature. Focusing on different aspects, a no of studies have been done in order to develop the theory and provide the facts of corporate sector in foreign exchange risk. Some of them like Charles, Ronald and Herman tried to study the exchange rate behavior and others like Anderson Bollerslev, Diebold and Paul attempted to study the volatility of exchange rates.

Present monitory system is illustrate by a mix of floating and managed exchanged rate policies that every country perused in its best interest. Any appreciation of a currency against other will bring export down and vise versa. Financial institutions must understand the foreign exchange risk in order to compete, survive and grow in their business of exports and to avoid from competition in imports.

________________________________________________________________________

http://en.wikipedia.org/wiki/Multinational_corporation

1.2 Research questions

What exchange risk does a financial institute face and whether they hedge it or not.

Whether these institutions used derivatives instruments to hedge exchange rate risk or not.

What derivatives are used by these financial institutions in order to hedge the exchange risk?

How these organizations measure the exposure of foreign exchange.

What would be the objectives of foreign exchange risk management in financial institutions in Pakistan

1.3 Purpose

Main purpose of this research is to describe the actual condition of foreign exchange risk in financial institutions in Pakistan. And how these organizations manage this risk and what efforts are done by these organizations to hedge the risk.

1.4 Disposition

Chapter one: Introduction

Content: This part is that where the research topic was introduced along with the importance of the foreign exchange risk management, the background of study and our purpose of study. The research problem and questions has been brought up, and we provide reader with our research purpose.

Chapter two: Literature review

Content: it is the literature review part. It will include the theory of foreign exchange risk management concepts of foreign exchange risk, its classification, characteristics, and different methods and techniques to manage and hedge this risk.

Chapter three: Research methodology

Content: This part is about the methods and techniques used for research purpose that how the data will be gathered analyzed and how to reach the conclusion.

Chapter four: Empirical findings

Content: In this part of thesis research will be done with the help of annual reports of different organizations. The study will help in analyzing that how these organizations manage this risk and what techniques are used by them.

Chapter five: Comparative Analysis

Content: In this chapter we will compare the data gathered from different financial institutions and find out the managing methods used by them.

Chapter six: Conclusions and Recommendations

Content: this part will contain the summary of our findings, implication and results answering the research questions of existing theory. It will also contains the recommendation for future research that may evaluate this research

2. Literature Review

It is the review of literature regarding the foreign exchange risk management. It also includes the concepts, characteristics by types and different methods of hedging this risk.

2.1 Foreign exchange risk

2.1.1 The concept of foreign exchange risk

What is foreign exchange risk? Different authors and researchers define exchange risk in different ways. Niso abuaf defines “foreign exchange risk is the chance that fluctuation in the exchange rate will change the profitability of a transaction from its expected value?. (P.29)This definition is in terms of financial risk.

Cornell and Shapiro (P.45) also define foreign exchange risk as “variability in the value of a firm as measured by the present value of its expected future cash flows, caused by uncertain exchange rate changes. In this definition both the researchers emphasize the firm’s cash flows.

Hekman (60) defines exchange risk in terms of control of firms as the possibility that operating and financial results may exceed or fall short of budget.

Foreign exchange rate risk is the potential gain or loss resulting from a change in exchange rate. It is the risk arising from the adverse movements in exchange rate to the earnings and capital. It is the impact of adverse movement in currency exchange rate on the value of open foreign currency position. Banks faced this risk that arises from maturity mismatching of foreign currency positions. Banks also face the risk of failure to pay of counter party in foreign exchange business. While such type of risk crystallization does not cause primary loss, bank may undertake new transaction in cash/spot market for replacing the failed transactions.

____CGAP Portfolio, “Are MFIs Hedging Their Bets? Issue 1, April 2005

Major categories of exchange rate changes are given as follow:

Depreciation: it is the ongoing decline in the value of currency in the relevance of another currency.

Devaluation: it is the sharp fall in the value of currency in comparison of another currency.

Appreciation: it is the gradual increase in the value of currency in comparison of another currency.

For example, a financial institution that has not managed its foreign exchange risk will

Lose money through currency depreciation when the value of local currency falls as compared to the currency in which the liability is held. That is, if a financial institution

say bank has borrowed in US Dollars and giving debt in local currency PKR will suffer a loss if the value of rupee falls against Dollars. It must have more PKR to service the Dollar based debt.

2.1.2 Classifications of foreign exchange risk

Ankrom (1974) was the first writers who classify the foreign exchange risk in different categories. Many other writers and researcher also classified foreign exchange risk in different types. These authors include Walker (1978), Whilborg (1980), Dumas (1984), and Shapiro (1989). Following are three main kinds of foreign exchange risk,

Translation exposure

Transaction exposure

Operating exposure

These risks are further defined by Shapiro in 2006.

“Translation exposure, also known as accounting exposure, arises from the need for purpose of reporting and consolidation, to convert the financial statements of foreign operations from the local currency (LC) involved to home currency (HC). If exchange rate has changed, liabilities revenues, expenses, gains and losses that are denominated in foreign currency will result in foreign exchange gain or loss.?

This exposure generally affects the balance sheet and those items of income statement that already exist.

“Transaction risk, result from transactions that give rise to know, actually binding future foreign-currency-denominated cash inflows or cash outflows. As exchange rate change between now and when these transactions settle, so does the value of their associated foreign currency cash flow, leading to currency gains or losses.?

This exposure affects the cash flows of an organization which can be the result of an existing contractual obligation. For example this risk may affect the transactional account like receivables (export transactions) and payables (import transactions) or repatriation of dividends.

“Operating exposure, measures the extent to which currency fluctuations can alter a company’s future operating cash flows, that is, its future revenues and costs. The firm faces operating exposure the moment it invests in servicing a market subject to foreign competition or in sourcing goods or inputs abroad. This investment includes new-product development, a distribution network, foreign

Supply contracts, or production facilities.?

This risk also affects cash flows but impacts revenues and costs associated with future sales.

The combination of two exposures i.e transaction exposure and operating exposure is also called economic exposure as said by Shapiro. This economic exposure actually affects the firm’s present value of future expected cash flows from exchange rate movement. Economic risk concerns the effect of exchange rate changes both on revenues (domestic sales and exports) and operating expenses (domestic input costs and imports). It is very crucial for firms to establish a strategy of managing the foreign exchange risk as they have the clear identification of various types of currency risks along with their measurement.

2.2 Measurement of foreign exchange risk

For the multinational firms, they must have to face the foreign exchange risk. It is very important for them to exactly measure the foreign exposure faced by their organization.

2.2.1 Measurement of translation risk

History describes four principals method for translation. These are given as follow:

The current/non current method

The monitory/non monitory method

The temporal method

The current rate method

These can be understood from following table:

Note: while translating the income statement sales revenues and interests are generally translated at average historical exchange rate that prevailed during the year, whereas depreciation is translated at appropriated historical rate. Cost of goods sold and some general and administrative expenses are translated at historical exchange rate and other items are translated at current rate.

“C?= it stands for current rate. That means assets and liabilities are recorded at current prevailing rate. It is the rate at balance sheet date.

“H?= it shows historical rate. Assets and liabilities are recorded at historical rate that was prevailed during the period.

After knowing all the methods of translating the issue arises is that which method should be used among these four methods while translating? Financial accounting standard board (FASB) in its standard 8 which relates to the governance of treatment of translation of foreign currency financial statements from 1975 requires that organizations should use the temporal method for translation of financial statements and the resulting gain or loss from translation should be included in income statement. But this treatment was argued that this produced gains or losses which were not the economic reality of the organization’s business. So any hedging for this translation risk under this method seems not realistic meaning. From the invention of standard 52 published by Financial Accounting Standard Board to the end of 1981, which replaced the FAS 8, require that organizations must use the current rat method for translation purpose. FAS 52 introduced the functional currency, which is identified by each organization for basic economic environment and selected for each of the organization’s foreign entities. If the functional currency is foreign currency, the standard requirement is to use the current rate method for any translation gain and loss that is taken directly to the share holder’s equity. Whereas if the functional currency is the parent’s company currency, then the rule described by FAS 8 should follow. The above mentioned issues can be referred to the Adrian Buckley’s book named “Multinational Finance? (2004) (P145-152).

http://pages.stern.nyu.edu/~igiddy/fxrisk.htm, “The Management of Foreign Exchange Risk? by Ian H. Giddy

And Gunter Dufey

2.2.2 Measure of economic exposure

as Adler and Dumas (1980,19840defined foreign exchange risk as the regression of asset’s value on the exchange rate and recommended that exchange rate risk of organizations can be calculated by the sensitivity of stock return to exchange rate activities. Many other researchers like Popper (1997), Bodnar and Gentry (1993) And recently Martin and Mauer (2003, 2005), have been done to explore the foreign exchange exposure. Whereas Holton (2003) indicated that when measuring the foreign exchange risk is difficult it is due to the difficulty of measuring the economic risk. For the measurement of economic risk the method used is value-at-risk (VAR). in broader sense value at risk is defined as the maximum loss for a given risk over a given period of time with z% confidence. This definition was given by micheal papaioannou (2006).

2.3 Foreign Exchange Risk Management

2.3.1 Corporate Objectives of Risk Management

After knowing the foreign exchange risk and its measurement faced by the organization, the company should choose to whether hedge this risk or not and further know how this risk should be managed. Oxelheim and wihlborg (1987) with mutual participation produced the idea of currency risk which is given as follow,

“Risk aversion: it relates to the desire of reduction of variability of cash flows in business?

“The target variable: in summaries form these are the efforts of the organization to maximize or to stabilize, measurement in accounting or cash flow, measurement in nominal or real terms.?

An effective foreign exchange risk management requires definite objectives viewing management’s approach toward the foreign exchange risk. The decision making of hedging or not to hedging the foreign exchange exposure depends upon the attitude of company’s management towards exchange risk management. Hedging strategy varies from organization to organization. Whenever there is a risk the risk aversion companies try to hedge this risk whereas the risk taking companies’ leave this risk unhedged. This is the idea arises from management of financial risks that management of financial risk is unnecessary and the gain and loss is will at last equalize in term of equilibrium relationship in the international financial market. This idea was given by Dufey and Sirininasulu in 1984: “Foreign exchange risk does not exist; even if it exists, it need not be hedged; even it is to be hedged, corporations need not hedge it.? It is the general concept that the organizations involved in exports and imports should hedge the risk of foreign risk exposure as a risk averse attitude. In real terms companies prefer to manage the risk within an acceptable limit instead of adopting neither of the two attitudes.

Management should be in charge for ensuring to take suitable and reasonable actions based on after-tax term to decrease the risk.

2.3.2 Theoretical appraisal of managing foreign exchange exposure

it is the basic strategy of the organizations to hedge the foreign exposure that they increase hard currency assets and decrease the soft currency assets, at the same time decreasing the hard currency liabilities and increasing the soft currency liabilities. However, many debates relating to the hedge the translation exposure exist in finance literature. Pramborg (2002) pointed out that transaction exposure hedging comes to add value for Swedish companies whereas there is no value addition from translation exposure. Butler (1990) suggested that it support the general suggestion of the finance literature not to worry about this type of risk, so it might not be hedged. A reason for not hedging this risk is that translation exposure risk is uneconomic as it is based on historical book value and has no direct effect on organization’s cash flows. Thus organization should concern to the exposure faced to the cash flows.

Earlier experimental studies by Belk and Glaum (1990) and Aobo (1999) who have investigated the foreign exchange risk management in UK and US multinationals, show that the management of transaction exposure is the focal point of company exchange risk management for the transaction risk control the real cash flows.

As compared to translation and transaction risk operating risk is less defined and more difficult to manage. It could be defined as the sensitivity of an organization’s future cash flows to the unexpected change in foreign exchange rate and any change in aggressive environment caused by these currency movements. Belk and Glaum (1990) found that firms were less worried about the real impact of exchange rate varies on the competitive position of the companies. Bradley and Moles (2002) find that there is a strong relations ship between exchange rate sensitivity and the extent to which it sales, sources and funds itself worldwide. Shapiro (2006) argued that it could be concluded that organization’s operating exposure is attributed to distinguish a company’s product is, the internationaly expand its competitors is, the ability to shift production, the sourcing of inputs among countries, and the variation in real exchange rate. It is assumed that the firms more involved in foreign markets the greater would be the operating risk faced by the organization.

Shapiro (2006) concluded that firms can easily hedge their transaction risk, competitive exposure (operating exposure) are long term and can not be dealt with exclusively through financial hedging techniques, they relatively require making the long term operating adjustment. Strategic reorientation of operating policies related to pricing, sources, location of production and financing needs not only financial managers but also requires the corporate managers. Moffet and Karlsen (1994) illustrate the use of production, financial and promotion policies to manage economic currency risk as natural hedging. Being a part of globalization business environment, diversification of international operations is very important for multinational corporations to handle operating risk. So this can give the companies to maintain competitive advantage and protective reactions to unfavorable exchange rate changes. Whenever service cost or domestic production cost is affected by exchange rate changes as compared to those of producing in foreign country, the firm can move product sourcing from those countries whose currency is devalued or plant transfered there. Strategic marketing and production regulations in general are for ‘cost-effective’. Another operational process used to hedge operating exposure is financial management, which are formating the firm’s assets and liabilities. One option is to funding the portion of a firm’s assets used to create export profits so that changes in foreign assets values caused by an exchange rate change are compensate by virtual changes in the debt expense in the same currency. For example, a firm should hold debt in currency of a foreign country, in which the firm increases a considerable export market. Existing text such as Glaum (1990) suggests economic exposure management should be integrated into the long-range, strategic planning system of the corporation and included with all areas of corporate decision-making.

Tools and techniques for foreign exchange risk management

Nowadays foreign exchange risk could not only control a firm’s quarterly earnings, but

Also decide its survival. A variety of financial implements come into sight as the financial markets require managing the different increasing exposure that firms face. For

Managing foreign exchange risk, there exist internal techniques such as matching

inflows and outflows, inter-company netting of receipts and payments, transfer

pricing agreement, etc, and external hedging tools involve the usage of different

sorts of derivatives including forwards, futures, debt, options and swaps. Each of

these techniques differs to hedge different exchange risk in each company situation.

There have been many studies concerned with the effect from the use of these

Currency derivatives, e.g. recent study as Allayannis and Ofek (2001), Bengt

Pramborg (2002).

Foreign exchange forwards

A forward foreign exchange contract is a contract to exchange one currency for

another with a particular amount, where the exchange rate is fixed on the day of the

contract but the actual exchange takes place on a fixed date in the future. The predetermined exchange rate is also known as the forward exchange rate. The amount of the contract, the value date, the payments method, and the exchange rate are all

mentioned in contract at the time of contract. Forward contracts in major currencies are available on daily basis with maturities of up to 30-, 90-, and 180-day. Two types of forwards contracts are often used: deliverable forwards (face amount of currency is exchanged on settlement date) and non-deliverable forwards (which are settled on a net cash basis).

A currency forward contract is usually used to hedge exchange risks that ranges from short to medium term and whose timing is known for certainty. It is so important for

Firm’s treasurers to deal in the forward market that they can fix the costs of

imports and exports in advance for the payable or receivable amount and hedge the exchange risk. A lot of experimental researches such as Belk et al. (1992), Bodnar et al. (1995), Mallin et al (2000) and Pramborg (2002) pointed out that the most commonly used method is forward exchange contract. With forwards, the firm can be totally hedged. However, some exposures including settlement risk that exchange rate shift in the opposite direction as they predicted, and counter party risk which the other party is unable to perform the contract. Sometimes the high cost of forward contracts prevent

Firms to implement this instrument to fully hedge their exchange exposure. For that reason, futures are more beneficial.

Currency futures

Currency future is another tool to decrease the exposure of foreign exchange instability

It is an exchange-traded agreement specifying a standard amount of a particular currency

to be replaced on a specific future payment date. It is likely to forward contract in a way that they permit a firm to buy or sell definite currency at a fixed price and at a future time.

So far, there are some differences among these two sorts of practices. One of the

futures distinctiveness vary from forward is that futures are standardized both for

amount and payment date (normally March, June, September and December), whereas

Forwards are for any amount and any delivery date upon which the two parties are agreed. One more difference is that forwards are dealt by phone and telex and are completely independent of locality or time while all clearing functions for futures markets are hold by an exchange clearing house. The biggest difference is in terms of

liquidation that futures contracts are settled by balancing of gains and losses for each day,

whereas forward contracts are settled by real delivery whether full delivery of the two

Currencies or net value only at the contract maturity. Giddy and Dufey said “This daily cash compensation attribute mostly eliminates default risk.?

Futures market and forward market both are of most important ways to hedge risk. David

Tien (2002) pointed out “Firms uncomfortable with the uncertainty involved in

receiving a fixed payment in foreign currency can easily hedge the transaction using

either futures or forward contracts.? Some studise as Belk and Glaum (1992) establish

that none of the firms which were talked used currency futures, because the standardized features of exchange traded futures most often do not enable the companies to hedge their positions completely. Mallin et al (2000) also found that only 9 companies out of 231 respondents to their survey used currency futures. Giddy and Dufey conclude that “forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability?. The largest part of big companies use forwards; futures tend to be used whenever exchange risk may be a problem.

Currency options

A foreign exchange option which is dissimilar from currency forward agreements and

currency futures is to give the possessor of the contract the right to buy or sell a definite

amount of a certain currency at a prearranged price (also called strike or exercise

price) until or on a specified date, but he is not bound to do so. The seller of a

currency option has obligation to execute the contract. The right to buy is a call position and the right to sell is a put position. There is option premium required to pay by those who acquire such a right. The holder of a call option can take advantage from a price increases (profit is the difference between the market price and the strike price plus the premium), while can choose not to exercise the right when the price decreases (locked in loss of the option premium). Vice versa is the situation for the holder of a put option. For the advantages of simplicity, elasticity, lower cost than the forwards, and the expected maximum loss—which is up to the premium paid to acquire the right , the currency option has become growing popular as a hedging tool to protect firms against the exchange rate movements. Whenever there is insecurity in the size of cash flows and the timing of cash flows, currency option agreements would be better to conventional hedging instruments such as forward contracts and futures contracts. Grant and Marshall (1997) observed the degree of derivative use and the motives for their use by carried out surveys in 250 large UK companies, found that a extensive use of both forwards and options(respectively 96% and 59%). They pointed that comparing the most important reasons for the use of forwards were company policy, business reasons and risk aversion, A good understanding of instrument, and price were prominent while the primary reasons to use option for company management.

Currency swaps

As a virtually new financial derivative used to hedge foreign exchange exposure,

currency swaps have a rapid advancement. Since its introduction on a global scale is in

the early 1980’s, currency swaps market has turn into one of the leading financial

derivative markets in the world. A currency swap is a foreign exchange agreement

among two parties to exchange a given amount of one currency for another and,

after a particular period of time, to give back the original amounts exchanged. It can be

negotiated for a broad range of maturities up to at least 10 years, and can be regarded

as a series of forward contracts. It is normally used under such circumstances that a firm

functions in one currency but need to borrow in another currency. Currency swaps are

frequently connected with interest rate swaps, as the common cross currency swaps the

cross-currency coupon swap which is to pay fixed and get floating interest

sum meantime buying the currency swap. Another generally used one is cross

currency basis swap which is to pay floating interest in a currency and receive

floating interest in another currency. The benefit of currency swaps is to facilitate

each contracting part to borrow in their relative constructive market, and both

parties can benefit from the swaps by lessening the borrowing costs. The use of swaps

now has developed rapidly in western countries such as Grant and Marshall (1997)

found that the use of swaps and forwards/futures is dominant in UK, Bodnar et al.

(1995) found that swaps govern for interest rate risk management in US.

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