Professional Documents
Culture Documents
of Pakistan
A Thesis Presented
by
Maroof Hussain Sabri
(Registration Number: MAF 05091057)
to
The Committee on Academic Degrees
in partial fulfillment of the requirements
for a degree with honors
of
MS Accounting & Finance
Business School,
The University of Lahore
April, 2011
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The Thesis committee for Mr. Maroof Hussain Sabri
certifies that this is the approved version of the following
thesis:
APPROVED BY
SUPERVISING COMMITTEE:
Supervisor: ________________________________________
Ramiz Rehman
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Acknowledgements
I extend my sincere gratitude to my supervisor Mr. Ramiz Rehman who has been
very friendly and cooperative throughout the course of this study. Without him,
simply this piece of work would have not been possible. One simple cannot wish
for any better or friendlier supervisor than him. I also thank to Mr. Akram for
assisting in understanding certain techniques during this study.
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Abstract
The purpose of this study is to explore different aspects of foreign exchange risk
management by the commercial banks of Pakistan. As there has been no previous
significant work done on this particular topic, this study tries to explore different
characteristics of Net foreign currency exposure, practices and tools used by
commercial banks in this regard & income from foreign currencies of commercial
banks. Different techniques and statistical procedures are used during this study
including descriptive analysis, simple and multiple linear regression, binary
logistic regression and independent sample t-tests. On the base of findings from
the data of 110 banks listed on the Karachi stock exchange for the period 2005 to
2009 different conclusions are drawn. Commercial banks of Pakistan are exposed
to foreign exchange risk and have a set of practices to manage this risk. Income
from dealing in foreign currencies is also a substantial potion of total income of
banks. Further conclusions are drawn regarding the dependence of Net foreign
currency exposure, tools usage and income impact on other factors like ownership
status, type of bank, size of bank, net assets of banks and exchange rate volatility.
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Table of Contents
Abstract ................................................................................................................... 4
List of Symbols ....................................................................................................... 8
List of Tables .......................................................................................................... 9
List of Models ......................................................................................................... 9
Introduction ........................................................................................................... 10
Foreign Exchange ............................................................................................. 10
Foreign Exchange Market ................................................................................. 10
Exchange Rate .................................................................................................. 10
Foreign Exchange Regimes .............................................................................. 10
Foreign Exchange Risk ..................................................................................... 11
Foreign Exchange Risk in Commercial Banks ................................................. 11
Foreign Currency Exposure of a Commercial Bank ......................................... 12
Exchange Rate Volatility .................................................................................. 12
Foreign Exchange Risk Management ............................................................... 12
Hedging ............................................................................................................. 13
Central Bank’s Role in Foreign Exchange Risk Management ......................... 14
Foreign Exchange Risk & Its Association With Other Types of Risks ............ 14
Research Objectives .......................................................................................... 15
Literature Review.................................................................................................. 16
Methodology & Variables Construction ............................................................... 20
Time Horizon .................................................................................................... 20
Sample............................................................................................................... 20
Limitation of Scope of Research....................................................................... 21
Data ................................................................................................................... 21
Foreign Currency Exposure of Commercial Banks in Pakistan ....................... 21
1. Net Foreign Currency Exposure ......................................................... 21
2. Factors that Affect Foreign Currency Exposure ................................. 22
3. Comparison of Net Foreign Currency Exposure of Public Sector &
Private Commercial Banks ........................................................................... 25
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4. Comparison of Net Foreign Currency Exposure of Islamic &
Conventional Commercial Banks ................................................................. 26
Different Tools & Instruments Used by Commercial Banks in Pakistan to
Manage Foreign Exchange Risk ....................................................................... 28
5. Tools & Instruments Used by Commercial Banks in Pakistan .......... 28
6. Factors Influencing Usage of Foreign Exchange Risk Management
Tools 28
Foreign Exchange Risk Management & its Impact on Income ........................ 32
Study the descriptive of Income from dealing in foreign currencies in both
Islamic & Conventional Banks & Comparison Between them .................... 32
Study the descriptive of Income from dealing in foreign currencies in both
Public Sector Commercial Banks and Local Private Banks & Compare them
....................................................................................................................... 32
Income from dealing in foreign currencies and size of bank ........................ 33
Effects of tools used on Income from Dealing in Foreign Currencies ......... 33
Income from dealing in foreign currencies and Exchange Rate Volatility... 35
Findings & Analysis ............................................................................................. 38
Findings on Net Foreign Currency Exposure of Commercial Banks in Pakistan
........................................................................................................................... 39
1. Net Foreign Currency Exposure ......................................................... 39
2. Findings on “Factors Affecting Foreign Currency Exposure ............. 39
3. Relationship Between NFX & Net Assets .......................................... 42
4. Comparison of Net FX Exposure of Commercial banks in Private
Sector & Public Sector .................................................................................. 44
5. Comparison of Net Foreign Currency Exposure of Islamic Vs
Conventional Banks ...................................................................................... 45
Findings on Usage of Different Tools for Foreign Exchange Risk Management
........................................................................................................................... 47
5. Foreign Exchange Risk Management: Tools & Practices .................. 47
6. Currency Derivatives Usage ............................................................... 48
Findings on Factors that affect Currency Derivative Usage ......................... 50
Findings on Income from Dealing in Foreign Currencies and its Relationship
with other Factors ............................................................................................. 53
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Findings on Income from dealing in foreign currencies and Type of
commercial banks (Conventional & Islamic) ............................................... 53
Comparison of IFX of Conventional & Islamic Banks ................................ 53
Findings on Income from dealing in foreign currencies and Ownership Status
of commercial bank (PSCB and LPB) .......................................................... 54
Comparison of IFX between Public Sector Commercial Bank & Local
Private Banks ................................................................................................ 54
Findings on Income from dealing in foreign currencies and Size of Bank as
measured by Net Assets ................................................................................ 54
Findings on Income from dealing in foreign currencies and Currency
Derivatives used by commercial banks......................................................... 57
Findings on Effect of Exchange Rate Volatility on Income from Dealing in
Foreign Currencies ........................................................................................ 58
Conclusion ............................................................................................................ 61
References ............................................................................................................. 63
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List of Symbols
Symbols Explanation
NFXNA Net Foreign Currency Exposure Relative to Net Assets
NFX Net Foreign Currency Exposure
OS Ownership Status or Nature of Ownership
ERV Exchange rate volatility
NEER Nominal Effective Exchange Rate
NA Net Assets
PSCR Public Sector Commercial Banks
LPB Local Private Banks
IFX Income from foreign currencies as a percentage of total income
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List of Tables
TABLE I: NO. OF COMMERCIAL BANKS, OPERATING IN PAKISTAN & LISTED ON KSE, 2005-2009 ......................20
TABLE II: NFXNA, DESCRIPTIVE STATISTICS ...............................................................................................39
TABLE III: CORRELATION BETWEEN OS, SIZE & ERV ....................................................................................40
TABLE IV: MULTIPLE LINEAR REGRESSION OUTPUT OF RELATIONSHIP BETWEEN "NFXNA & "SIZE, OS & ERV" ....41
TABLE V: OUTPUT FOR REGRESSION: NFX & NA .......................................................................................43
TABLE VI: RESULTS OF INDEPENDENT SAMPLE T-TEST TO COMPARE NFX OF PSCR & LPB ..................................45
TABLE VII: RESULTS OF INDEPENDENT SAMPLE T-TEST TO COMPARE NFXNA FOR ISLAMIC & CONVENTIONAL BANKS
...............................................................................................................................................46
TABLE VIII: RESULTS OF INDEPENDENT SAMPLE T-TEST TO COMPARE NFXNA FOR ISLAMIC & CONVENTIONAL BANKS
...............................................................................................................................................46
TABLE IX: DESCRIPTIVES: CURRENCY DERIVATIVES USAGE ............................................................................48
TABLE X: CURRENCY DERIVATIVES USAGE BY OWNERSHIP STATUS .................................................................49
TABLE XI: CURRENCY DERIVATIVE USAGE BY TYPE OF BANK ..........................................................................49
TABLE XII: FACTORS THAT AFFECT CURRENCY DERIVATIVE USAGE: RESULT OF BINARY LOGISTIC REGRESSION .........51
TABLE XIII: LOGITS & ODDS RATIO RESULTS OF BINARY LOGISTIC REGRESSION .................................................52
TABLE XIV: DESCRIPTIVES FOR IFX AND IFXRS BY TYPE OF BANK ...................................................................53
TABLE XV: DESXRIPTIVE STATISTICS FOR IFX AND IFXRS BY OWNERSHIP STATUS ..............................................54
TABLE XVI: DESCRIPTIVE STATISTICS FOR IFX AND IFXRS BY OWNERSHIP ........................................................54
TABLE XVII: DESCRIPTIVE STATISTICS OF IFX AND IFXRS BY OWNERSHIP STATUS OF BANK .................................54
TABLE XVIII: OUTPUT OF REGRESSION: IFXRS ON NA .................................................................................55
TABLE XIX: OUTPUT OF REGRESSION: IFX ON NA .......................................................................................56
TABLE XX: REGRESSION OUTPUT IFX ON TOOLS ..........................................................................................57
TABLE XXI: REGRESSION OUTPUT IFXRS ON ERV .......................................................................................58
TABLE XXII: REGRESSION OUTPUT OF IFX ON ERV ......................................................................................60
List of Models
MODEL 1: NFX DEPENDS ON SIZE, OWNERSHIP & EXCHANGE RATE VOLATILITY ..............................................22
MODEL 2: RELATIONSHIP BETWEEN NFX & NET ASSETS .............................................................................25
MODEL 3: BINARY LOGISTIC MODEL FOR CURRENCY DERIVATIVE USAGE ........................................................30
MODEL 4: CALCULATION OF P USING BINARY LOGISTIC REGRESSION FOR CURRENCY DERIVATIVE USAGE ..............31
MODEL 5: MODEL 1 OF RELATIONSHIP BETWEEN NET ASSETS & IFXRS .........................................................33
MODEL 6: MODEL 2 OF RELATIONSHIP BETWEEN NET ASSETS & IFX .............................................................33
MODEL 7: RELATIONSHIP BETWEEN TOOLS USED AND IFX ...........................................................................34
MODEL 8: MODEL 1 OF RELATIONSHIP BETWEEN ERV& IFXRS ...................................................................35
MODEL 9: MODEL 2 OF RELATIONSHIP BETWEEN ERV & IFX .......................................................................35
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Introduction
Foreign Exchange
Foreign Exchange (FX) is the conversion of currency of one country to the
currency of other country whereas foreign currency is any currency other than the
country’s own currency. For example, Pakistani Rupee (PKR) is the currency of
Pakistan and US Dollar (US$) is Foreign Currency in Pakistan whereas
conversion of PKR into US$ is Foreign Exchange.
In Pakistan, Foreign Exchange Act, (Section 2), 1947 defines Foreign Exchange
as, “means includes any instrument drawn, accepted, made or issued under clause
(8) of section 17 of the State Bank of Pakistan Act, 1956, all deposits, credits and
balance payable in any foreign currency, and any drafts, traveler’s cheques, letters
of credit and bills of exchange, expressed or drawn in Pakistan currency but
payable in any foreign currency;”
Exchange Rate
Exchange Rate refers to the price paid in one currency to acquire the one unit of
foreign currency or the foreign currency received to sell one unit of currency.
• Fixed
• Freely Floating
• Managed Float
• Pegged
Pakistan has shifted its exchange rate system from Managed Float to Market
Based Floating Exchange Rate System. Here, the commercial banks & authorized
dealers are free to hold and conduct transactions in foreign currencies.
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Foreign Exchange Risk
Foreign Exchange risk arises when a bank holds assets or liabilities in foreign
currencies and impacts the earnings and capital of bank due to the fluctuations in
the exchange rates. No one can predict what the exchange rate will be in the next
period, it can move in either upward or downward direction regardless of what the
estimates and predictions were. This uncertain movement poses a threat to the
earnings and capital of bank, if such a movement is in undesired and
unanticipated direction.
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The abovementioned trade activities are the typical trade activities of a
commercial bank and all of these activities do not involve risk exposure of the
bank. The first 1 & 2 activities are done by the commercial bank on behalf of its
customers and the foreign exchange risk is transferred to the customers as the
bank takes Agency Role in this case. Third activity of bank involves hedging and
there is no risk in this as well as the bank has hedged its risk by pre-determining
the exchange rate with other financial institutions using different financial
instruments. The fourth one involves the risk which may result in the gain or loss
due to unexpected outcome. Ready, spot, forward & swap are the principal FX
related contracts whereas banking products and services in foreign exchange give
rise to non-traded foreign currency exposure.
Long Position is also known as Overbought or Net Asset Position and Short
Position is also known as Net Liability or Oversold Position. Sum of all the Net
Asset positions & Net Liability positions is known as Net Open Position or Net
Foreign Currency Exposure.
“Net Foreign Currency Exposure” gives the information about the Foreign
Exchange Risk that has been assumed by the bank at that point of time. This
figure represents the unhedged position of bank in all the foreign currencies. A
negative figure shows Net Short Position whereas positive figure shows Net Open
Position.
Hedging
Foreign exchange risk is mitigated by using different hedging techniques.
Hedging is a way by using which a bank eliminates or minimizes its risk
exposure. Hedging can be done using different ways:
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the cost of capital. The risk of holding any net open position in a currency is
diversified by holding a position in foreign currency. The main reason for this
is the differential inflation and interest rates in different countries. Almost all
commercial banks hold such type of multicurrency asset-liability portfolios.
Foreign Exchange Risk & Its Association With Other Types of Risks
FX risk is not only the impact of adverse exchange rate movements on the
earnings of the bank due to different open positions held; it impacts the earnings
& capital of bank in different ways.
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Research Objectives
The study focuses on the below mentioned areas and try to get the answers to the
following questions, regarding the foreign exchange risk management in
commercial banks in Pakistan:
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Literature Review
There has been not any significant work done on Foreign Exchange Risk
Management in Commercial Banks in Pakistan before. There is also not any
sufficient literature available on this specific topic. Different work has been done
at different times regarding various topics included in the research objective of
this study. An overview of the existing literature is given here.
The importance of foreign exchange risk management can not be neglected for
any firm or banking organization. Banks face foreign exchange risk management
due to dealing in foreign currencies result of the operations in foreign countries or
dealing with foreign exchange for their own account or for customers account.
Exchange Rate Risk is an integral part of every firm’s decision regarding foreign
currency exposure (Allayannis, Ihrig, & Weston). Currency risk hedging
strategies involve eradicating or reducing currency risk, and need understanding
of both the ways that the exchange rate risk can impact the operations of
economic agents and techniques to deal with the resulting risk implications
(Barton, Shenkir, & Walker, 2002).
Foreign Currency Risk is an important source of risk for the banking industry and
different studies have been done in different parts of the world. (Papaioannou M.
G., 2006) Foreign currency exposure and risk management is very important for
the firm to avoid any vulnerability from exchange rates fluctuation which can
affect the profits and assets values in a negative way. Different traditional types of
foreign exchange risk i.e. translational, transactional and economic risks were
reviewed. Also different ways and strategies for managing foreign currency risk
were analyzed along with advantages and disadvantages of each strategy and
technique. Additionally, best practices widely spread were outlined along with
data on financial derivatives and hedging practices by US firms.
Sources of risks for banking sector have been investigated by many researchers in
different economies. (Daugaard & Valentine, 1993) worked out different sources
of risks and they found out that stock prices of banks have relationship with
different variables like interest rates, exchange rates, banks profitability and
market risk factor. According to them during the period from 1983 to 1991, share
prices of banks responded with the appreciation of the Australian Dollar.
(Irio & Faff, 2000) Studied foreign exchange risk in industries in Australia
including the banking sector. According to them, banking industry as a whole do
effective foreign exchange risk management and therefore, this type of risk is
insignificant in pricing banking companies stocks.
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A study conducted on 48 largest US commercial banks (Choi, Elyasiani, &
Kopecky, 1992) for the period 1975-1987 showed that effects of exchange rate
depend on the Net position of the bank in foreign currencies. According to them,
when banks had positive net position, depreciation of foreign currencies
negatively affected the stock prices of banks before year 1979 and after 1979
banks stock returns responded positively with the depreciation of foreign
currencies as banks had changed from positive to negative net open positions. In a
similar study on Canadian banks (Atindehou & Gueyie, 2001), it is found out for
the Canadian Banks that stock prices responded positively with depreciation of
foreign currencies.
Foreign Exchange Risk is also found out to be one of the major sources of risks in
African Region. (Walter & Tewodros, 2004) investigated the foreign currency
exchange rate exposure of the major commercial banks in South Africa with the
help of augmented market model. According to this study, all the major four
banks in South Africa exhibit the foreign exchange risk and the Net Asset position
in foreign currencies is a weak predictor of foreign exchange risk.
Choosing the suitable hedging strategy is often a difficult task due to the
difficulties involved in measuring precisely current risk exposure and deciding on
the suitable degree of risk exposure that ought to be shielded. The need for
foreign exchange risk management began to arise after the fall of the Bretton
Woods system and at the end of the United States dollar peg to gold in 1973
(Papaioannou M. , 2001) The issue of foreign exchange risk management for
firms in non-financial sector is independent from their principal business and is
usually independently handled with by their corporate treasuries. In most of the
firms there are independent committees who function to oversee the treasury’s
strategy in managing the foreign exchange risk (and interest rate risk) (Lam,
2003). It clearly shows the importance of the fact that firms give a significant
attention to risk management issues and techniques. Contrariwise, international
investors usually use their underlying assets and liabilities to manage foreign
exchange risk. Since the currency exposure of international investor is majorly
related to translation risks on assets and liabilities held in foreign currencies, they
tend to consider foreign currencies as a separate asset class, totally separate from
other assets, requiring a currency overlay mandate (Allen, 2003).
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Banks use Derivatives to manage foreign currency risk. A review of literature on
usage of derivatives and banks’ foreign exchange risk is given here.
There is much of literature which shows that foreign currency management tools
significantly reduce foreign currency exposure. One of such study conducted on it
(Allayannis, George, Ofek, & Eli, 2001), using S & P 500 non financial firms
with the help of multivariate analysis suggested that with the use of foreign
currency derivatives, foreign exchange risk is significantly reduced.
(Hue Hawa Au Yong, Faff, & Chalmers, 2006) Investigated derivative activities
in banks in the Asia Pacific region and tried to discover that level of derivative
usage is linked with the perceptions of market about interest rate and exchange
rates. They did not find any significant relationship between derivative activities
of banks and exposures.
Hedging allows the commercial banks to manage foreign exchange risk but
hedging itself poses additional risk to bank. (Gandhi G. S., 2006) in the paper for
“The Chartered Accountant” for Instt. Of Chartered Accountants of India is
mentioned that currency derivatives like currency futures, currency forwards,
currency swaps and currency options help in hedging foreign exchange risk of
firms and other ways of hedging including off-setting positions against the
underlying assets and money markets are themselves risky. Hedging and hedging
right are two different things. If the hedging is not done properly in the right way,
it itself can become a serious source of risk and have potential to pose a serious
financial loss to the firm.
Fluctuations in the foreign exchange rate force the changes in the portfolio returns
as uncertain future exchange rates translate the returns on investments
denominated in foreign currencies into US dollar returns. Foreign exchange risk
can be managed if the diversification of portfolio is done across the assets in
different currencies. Cash flows of a portfolio can be affected or changed by the
usage of derivative securities. The usage of currency derivatives additionally
reduces the risk of whole diversified portfolio (Abken & Shrikhande, 1997).
Currency Derivatives are not only helpful in hedging the foreign exchange risk of
the firms and institutes, however, due to information efficiency resultant of usage
of currency derivatives makes the currency markets more efficient and exchange
rates less forecast able (Liu, 2007)
“Foreign Currency options” are the derivative instruments that gives the buyer of
that option the right but not the obligation to exercise a specific transaction in the
currency pair underlying the respective derivative contract. It entitles the buyer of
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the option the flexibility of exercising settlement of that option or not. The article
focused on the dynamics of hedging foreign exchange risk with the usage
currency options applications. Indeed, the foreign currency options are one of the
best tools available for hedging foreign exchange exposures in different foreign
exchange market conditions, like volatile market conditions, stagnant, bullish or
bearish. (Gandhi G. S., 2006)
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Methodology & Variables Construction
This section explains a detailed view of Data, Time Period, Sampling, various
statistical techniques and procedures used in the study.
Time Horizon
Time span for this study is five years period from 2005-2009. The main reason for
taking this period into account is that State Bank of Pakistan reportedly allowed
the use of Derivatives, critical for the management of risk management by
commercial banks, by the December, 2004. By allowing such complex
instruments by state bank of Pakistan has enabled commercial banks to have an
equal access to the market. Therefore, this study takes into account the period
from 2005 to 2009.
Sample
Sample data has been used in this study and sample consists of all the
Commercial Banks Listed on Karachi Stock Exchange, Karachi. Only Public
Sector Commercial Banks and Local Private Commercial Banks are listed on
Karachi Stock Exchange. There exists a difference between the number of
commercial banks operating in Pakistan and the number of commercial banks
listed on the Karachi Stock Exchange.
Table i: No. of Commercial Banks, Operating in Pakistan & Listed on KSE, 2005-2009
The banks which are not incorporated in Pakistan and are working here, Foreign
Banks, are not included because of certain limitations. Hence, this study does not
study Foreign Exchange Risk Management by Foreign banks in Pakistan.
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Limitation of Scope of Research
i. Foreign banks are not included in this study; hence, any findings do not
apply to Foreign Banks.
Data
Data used in this study is all of secondary nature. Annual reports of the
commercial banks are the major source of data along with various Statistical
Bulletins & publications by the State bank of Pakistan.
Holding Net Asset or Net Liability in a currency gives rise to foreign currency
exposure into that currency. Banks hold multiple foreign currencies at a time and
sum of all the net positions in all the currencies held by a commercial bank is Net
Foreign Currency Exposure of the bank. This foreign currency exposure varies
from bank to bank and an attempt is made to understand different factors which
influence foreign currency exposure of a commercial bank.
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per the statutory requirements, all the banks operating in Pakistan including
commercial banks have to mention in the NOTES to Financial statements “Net
Foreign Currency Exposure” in Pakistani Rupees, the calculated net position by
bank, under the heading of “Foreign Exchange Risk”. Whether this Net Foreign
Currency Exposure varies from bank to bank or there is a set rule for all the
banks? If a bank has zero Net Foreign Currency Exposure, it means it has all of
his assets and liabilities hedged and offset against other currencies or in the same
currency. It can be analyzed either relative to Total Assets or Net Assets of the
bank; however, it is more appropriate to analyze it with its relativeness to Net
Assets. Therefore, a new variable is constructed i.e. “Net Foreign Currency
Exposure relative to Net Assets”, denoted by “NFXNA”. Descriptive are studied
for this variable “NFXNA” i.e. Max, Min, Mean & Standard Deviation.
= + ௌ௭
+ ைௌ + ாோ
+
Model 1: NFX depends on Size, Ownership & Exchange Rate Volatility
Where
Hypothesis Testing:
Using this model below mentioned hypothesis will be tested to check the
significance of the model as a whole along with individual βs as well.
Hypothesis 1:
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H0: There is no relationship between NFXNA & “Size, OS & ERV”
H1: There is a relationship between NFXNA & “Size, OS & ERV”
SPSS is used to analyze Regression & Partial Regression coefficients and their
significance is studied from its output. Significance of individual Partial
Regression coefficients will be checked using t-tests & overall significance using
F-test. The vales of statistics t & F should be significant at a level of significance
of less than 0.05.
Independent Variables:
Net Foreign Currency Exposure relative to Net Assets is calculated for the
comparison purpose. Different commercial banks have different Net Assets that
represent the size of bank and obviously different net positions. Net foreign
currency exposure is divided by Net Assets so that a comparison can be done
between different banks. Therefore, it shows Net foreign currency exposure of a
bank relative to its size, otherwise using only NFX in the model will show its
maximum dependence on Net assets of bank and the effect of other factors will be
not taken into account.
Net Foreign Currency Exposure is calculated by adding Net Open Position in all
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currencies held by a bank. All the banks have mentioned this NFX in the Notes to
Financial Statement and hence that is used.
= /
Equation 2: NFXNA Calculation
Dependent Variables:
Multicollinearity Problem
Multicollinearity can distort the results in the model; hence it has to be checked
before running the multiple regression on the model. Multicollinearity is the
existence of strong correlation between independent variables. In this model,
independent variables i.e. Size of bank, Ownership Status & Exchange Rate
Volatility may exhibit correlation with each other. A correlation matrix can be
drawn and the one of the independent variables exhibiting a correlation of 0.5 or
higher has to be dropped.
= + ே
Model 2: Relationship between NFX & Net Assets
Where
Hypothesis 2:
H0: There is no relationship between Net Foreign Currency Exposure and Net
Assets of Commercial Banks in Pakistan
H1: There is a relationship between Net Foreign Currency Exposure and Net
Assets of Commercial Banks in Pakistan
F-Test using ANOVA is used to check the significance of this regression. If the
value of F statistic is significant at a level of significant less than 0.05, it shows
that there is a significant relationship between both of these two variables or NFX
depends on Net Assets of bank.
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Public Sector Commercial Banks & Local private Commercial banks are two
different ownership statuses of banks in Pakistan. It has to be checked whether
there is any difference between these two types as far as their NFXNA is
considered.
For this purpose same variable as constructed previously, Net Foreign Currency
Exposure Relative to Net Assets (NFXNA), is used.
Hypothesis 3:
H0: The mean of NFXNA of Public Sector Commercial Banks is not significantly
different than that of Local Private Banks.
H1: The mean of NFXNA of Public Sector Commercial Banks is significantly
different than that of Local Private Banks
The above written hypothesis is tested using Independent Sample t-Test. For this
purpose, first equality of variances is tested using Levene’s Test. If the value of F-
Test is significant at a significance level less than 0.05, it shows that variances of
both groups are significantly different and if it is not significant, it shows that
variances are not significantly different. Finally t-test is used to check
independence of both groups and in this case if the value of t with the respective
degree of freedom is significant at a significance level of less than 0.05, it shows
that there is a significant difference between Net Foreign Currency Exposure
relative to Net assets of both types of ownerships of banks.
For this purpose same variable as constructed previously, Net Foreign Currency
Exposure Relative to Net Assets (NFXNA), is used.
Hypothesis 4:
H0: The mean of NFXNA of Islamic Banks is not significantly different than that
of Conventional banks.
H1: The mean of NFXNA of Islamic Banks is significantly different than that of
Conventional banks
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The above written hypothesis is tested using Independent Sample t-Test. For this
purpose, first equality of variances is tested using Levene’s Test. If the value of F-
Test is significant at a significance level less than 0.05, it shows that variances of
both groups are significantly different and if it is not significant, it shows that
variances are not significantly different. Finally t-test is used to check
independence of both groups and in this case if the value of t with the respective
degree of freedom is significant at a significance level of less than 0.05, it shows
that there is a significant difference between Net Foreign Currency Exposure of
both types of banks.
Page | 27
Different Tools & Instruments Used by Commercial Banks in
Pakistan to Manage Foreign Exchange Risk
All the commercial banks face Foreign Exchange Risk and they have to use
different tools and instruments to manage this type of risk. Now this study has to
explore in a broader spectrum, by taking into account all the Listed Commercial
Banks, different tools and instruments used by the Commercial Banks in Pakistan
for the management of foreign exchange risk.
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A. Currency Derivatives & Ownership Status of Banks
B. Currency Derivatives & Type of Bank (Conventional or Islamic)
C. Currency Derivatives & Size of Bank
D. Currency Derivatives & Foreign Currency Exposure
E. Currency Derivatives & Exchange Rate Volatility
These different bank specific (A, B, C & D) & macroeconomic (E) factors
influence the usage of currency derivatives by the bank. These different factors
can be studied using different ways.
For A & B: Usage of currency derivatives by banks, as far as ownership status &
type of bank is concerned (A & B), is studied through descriptive analysis and
further their relationship, currency derivatives as dependent variable, is studied
using binary logistic regression.
For C, D & E: Relationship between Size of Bank, as measured by Net Assets (or
Equity, since equity and net assets are equal so net assets are used), and Selection
of currency derivatives is studied using binomial regression. Similarly,
relationship between currency derivatives and foreign currency exposure &
exchange rate volatility is also studied using binomial regression.
Predictors:
Page | 29
has only two categories; it is entered as a single dummy variable with
values 0 and 1, 0 for Public sector commercial bank and 1 for Local
private bank.
II. Type of Bank: Type of bank is also entered as a dummy variable with two
categories Islamic and conventional, 0 for Conventional and 1 for Islamic.
This variable is entered in to the model to check whether changing the
type of bank results in the change in the usage of currency derivatives.
III. Size of Bank: Size of Bank is measured by the size of equity. Since,
equity is equal to Net Assets; hence, Net assets are used for this purpose.
However, Net Assets as entered in model are measured in billions rather
than in thousands to magnify its effect.
IV. Net Foreign Currency Exposure Relative to Net Assets: This variable, as
used previously, is entered as a continuous variable in this Binary Logistic
Regression. This variable is entered in the model as a percentage.
V. Exchange Rate Volatility: Current Year Exchange rate volatility is
entered as a continuous variable. However, in this model, it is entered after
multiplying by 100.
Dependent Variable
Dependent variable in this case is “Type of Derivatives used”. There are three
types of currency derivatives that are being used by Banks in Pakistan i.e. forward
exchange contracts, currency swaps & foreign currency options. As Forwards are
used by all the banks and other types are not common, hence, a dichotomous
variable is constructed to include in the model. This variable has only two
categories, one is the banks which use forward exchange contracts only and other
one is the banks who use swaps and options also other than forwards. Former is
coded with 0 and later with 1.
Log[p/1-p]=a+b1X1+b2X2+b3X3+b4X4+b5X5
Model 3: Binary Logistic Model for Currency Derivative Usage
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Where:
a = Constant
X = Independent variables ( 1 to 5)
Model 4: Calculation of P using Binary Logistic Regression for Currency Derivative Usage
Where:
p = odds ratio
The Logits (Log Odds) are the b coefficients (Slope values) of the regression
equation. b coefficients (slope values) can be interpreted as the change in the Log
Odds due to a unit change in the independent variable. b for the Net Assets (in
billions rupees) can be interpreted as the change in Log Odds due to a one billion
change in net assets of a commercial bank. Similarly, the b’s for all other
independent variables can be interpreted in the same way.
p here refers to as the Odds ratio, which is very important to interpret in this
model here. Odds ratio estimate the change in odds of the membership in the
target group (which is usage of tools other than forwards in this case) for a unit
increase in the independent variable. For example, changes in odds due to a unit
change in Net Assets, i.e. one billion rupees of net assets. It can be calculated as
the exponential of the regression coefficient, b, of the relative independent
variable.
Using this model, it has to be found out that what role does above mentioned
independent variables play for the selection of tools. Selection of tools means that
whether the banks use only forward exchange contracts or use swaps and options
along with forward exchange contracts. Using SPSS, Binary Logistic Regression
is run using “Backward Stepwise based on Likelihood Ratio Test”. All the
variables are entered in the model and then using backward stepwise method
based on Likelihood ratio tests, insignificant independent variables are removed
and finally only the significant variables are retained in the model.
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Foreign Exchange Risk Management & its Impact on Income
Foreign Exchange Risk Management practices vary from bank to bank and so
does the income of banks. An important objective of this study is to study income
from dealing in foreign currencies and do different factors affect income from
dealing in foreign currencies.
To compare both these groups independent sample t-test is used and the below
mentioned hypothesis are formed:
To compare both these groups independent sample t-test is used and the below
mentioned hypothesis are formed:
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Income from dealing in foreign currencies and size of bank
It is very important to check whether size of bank have any effect on income from
dealing in foreign currencies. Simple Linear Regression model is used to check
this relationship. Two separate models are constructed to check the effect of size
of bank on income from dealing in foreign currencies. First model check the
effect of size on Income from dealing in foreign currencies in absolute terms (in
rupees) and second one check the effect of size on the Income from dealing in
foreign currencies relative to total income.
Independent Variable: Size of bank, as measured throughout this study using Net
Assets.
Dependent Variable (Model 2): IFX, Income from dealing in foreign currencies as
a percentage of total income of bank.
- = + + ɛ
Model 6: Model 2 of Relationship between Net Assets & IFX
Hypothesis:
H0: There is no linear relationship between Net Assets & Income from dealing in
foreign currencies in rupees.
H1: There is a linear relationship between Net Assets & Income from dealing in
foreign currencies in rupees.
H0: There is no linear relationship between Net Assets & Income from dealing in
foreign currencies relative to total income.
H1: There is a linear relationship between Net Assets & Income from dealing in
foreign currencies relative to total income
Page | 33
Another objective of this study is to check whether the use of currency derivatives
have any impact on the income from dealing in foreign currencies of commercial
banks. This can be investigated using Simple Linear Regression.
Model:
Where
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= Error term
Independent Variable: Exchange Rate Volatility, for this purpose current year
exchange rate volatility is taken into account.
Dependent Variable (Model 2): IFX, Income from dealing in foreign currencies as
a percentage of total income of bank.
=
+ + ɛ
Hypothesis:
Page | 35
H0: There is no linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies in rupees.
H1: There is a linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies in rupees.
H0: There is no linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies relative to total income.
H1: There is a linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies relative to total income
Page | 36
Page | 37
Findings & Analysis
Data obtained from Annual reports of commercial banks, statistical bulletins and
other publications by State Bank of Pakistan is analyzed using the above
methodology mentioned in the previous section. Different research methods and a
variety of statistical techniques are used for this purpose.
All the findings are mentioned in this section, along with analysis.
Page | 38
Findings on Net Foreign Currency Exposure of Commercial Banks in
Pakistan
Foreign Currency Exposure of commercial banks in Pakistan is studied and
findings relative to different research questions are below:
Descriptive statistics as mentioned in the above Table ii, clearly show that Net
foreign currency exposure varies from bank to bank. A standard deviation of
0.3934, as obtained from the data of 108 banks for the period 2005-2009, shows
the degree of dispersion in this variable and hence it can be said that Net foreign
currency exposure of banks vary and all the banks do not have the same ratio of
NFXNA.
Page | 39
independent variables i.e. size of bank, ownership status of bank & exchange rate
volatility. To serve the purpose, below mentioned model (Model # 1) is formed:
= + ௌ௭
+ ைௌ + ாோ
+
Correlations
Ownership Exchange
Status Size Rate Volatility NFXNA
**
Ownership Status Pearson Correlation 1 -.343 .073 -.056
It is obvious from the above correlation matrix that the correlation between any of
two independent variables is not greater than 0.5 and is far less than this
threshold. Therefore, it can be said on the basis of the above mentioned findings
that there is no problem of Multicollinearity in this model.
Page | 40
Model Summary
b
ANOVA
Standardized
Unstandardized Coefficients Coefficients
Above mentioned tables show the output from the SPSS Statistics Processor. To
check whether there is any significant relationship between the dependent variable
and three independent variables is significant, F-Test is used and to check whether
partial regression coefficients are significant or not t-test is used. From the output
tables, the table showing the coefficients, it is evident that the three different
values of t-statistic, for three partial regression coefficients are not significant at
the desired level of significance. Further value of R Square is very small, which
shows that very small variation is explained because of linear relationship. The
value of F, calculated using ANOVA, is also not significant at the desired level of
Page | 41
significance. Since, the value of F-statistic is not significant, the multiple linear
regression is not overall significant.
Simple linear regression is used in this model and the output from SPSS Statistics
processor is below:
Model Summary
Page | 42
a
1 .960 .922 .921 7.06015E6
b
ANOVA
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
In the light of the above results, null hypothesis 2 is rejected and the alternative
hypothesis 2 is accepted which states that there is a relationship between Net
Foreign Currency Exposure and Net Assets of Commercial Banks in Pakistan.
As there is a direct relationship between these two variables, if the Net assets of
the bank are changed, Net FX Exposure will also be changed. Model 2 differs
from the model 1 in that Model 1 takes into account NFXNA and studies its
relationship with Size of Bank which is measured by Net Assets of bank whereas
in model 2, Net Foreign Currency Exposure is related to Net Assets of bank.
Page | 43
4. Comparison of Net FX Exposure of Commercial banks in Private
Sector & Public Sector
While studying the Net Foreign Currency Exposure of Commercial Banks in
Pakistan, next objective is to compare the net foreign currency exposure of Public
Sector Commercial Banks (PSCB) and Local Private Banks (LPB). Results
(Output, using SPSS Statistics Processors) of the independent sample t-test are
below:
Group Statistics
Ownersh
ip Status N Mean Std. Deviation Std. Error Mean
F Sig. t df
Std. Error
Sig. (2-tailed) Mean Difference Difference
Page | 44
NFXNA Equal variances assumed .565 .06530500 .11305264
Table vi: Results of independent sample t-test to compare NFX of PSCR & LPB
Levene’s Test is used to check the Equality of variances, since, the value of F is
not significant, therefore, variances of both groups is not significantly different
and hence equal variances are assumed.
Assuming equal variances, the value of t=0.578 with degree of freedom 106 is not
significant at the desired level of significance. There is no difference between
means NFXNA of Public Sector Commercial Banks & NFXNA of Local Private
Banks. Hence our Null Hypothesis 3 is substantiated.
Group Statistics
Page | 45
F Sig. t df
Table vii: Results of independent sample t-test to compare NFXNA for Islamic & Conventional Banks
Std. Error
Sig. (2-tailed) Mean Difference Difference
Table viii: Results of independent sample t-test to compare NFXNA for Islamic & Conventional Banks
Here Levene’s test gives the value of F which is significant at p<0.01, therefore
equality (Homogeneity) of variances is not assumed. Using Independent Sample
t-test, value of t is -3.070 with degree of freedom of 37.623. This value of t is
significant as p-value is less than 0.01, therefore, it is established that there is a
significant difference between means of these two groups. Hence, null hypothesis
4 is rejected and alternative hypothesis 5 is accepted stating that there is a
significant difference NFXNA of Islamic Banks and Conventional Banks.
Page | 46
Findings on Usage of Different Tools for Foreign Exchange Risk
Management
Foreign Exchange Risk is managed by all the commercial banks in Pakistan and
the findings related to research objectives as listed in the previous sections are
given below in the same order as they appear previously:
Almost all commercial banks hold a portfolio of different foreign currencies i.e.
they deal in multiple currencies. Major currencies, in which they deal in and hold
open positions at the same time, are US Dollar (US$), Great British Pound (GBP),
Japanese Yen, Euro, UAE Dirham & Others.
Foreign currency assets and liabilities matching is a very common practice by the
commercial banks in Pakistan to hedge against foreign exchange risk. However,
such matches are strictly done within the limits. These limits are set internally by
the banks themselves, mostly by the Asset Liability Committee, as advised by the
State Bank of Pakistan. These limits control foreign currency exposure through
dealer limits, open foreign currency position limits & counterparty exposure
limits. Foreign currency assets and liabilities are also managed within the strict
limits as prescribed by the State bank of Pakistan.
The most important practice of managing foreign exchange risk involves currency
derivatives. Currency Derivatives are tools employed by every commercial bank,
however, selection of derivatives from the available ones vary from bank to bank.
Page | 47
Category Frequency Percent Cumulative Percent
In the above table, 110 commercial banks included in sample, use different mix of
currency derivatives.
The main reason behind the no usage of Futures is lack of futures exchange in
Pakistan. Same is the reason behind the lesser usage of foreign currency options.
FX options are both exchange traded and over the counter. As there is no
exchange for trading of FX options therefore the FX options being traded here by
the commercial banks are usually over-the-counter. Forward exchange contracts
& currency swaps are also over the counter. Forward exchange contracts is the
most common and most important tool used by the commercial banks in Pakistan
as every bank use it whereas the currency swaps are the second popular tool used.
Swaps are usually long term foreign exchange risk management tool. Few banks
also use options, only 12.7% of our sample i.e. listed commercial banks of
Pakistan. As there is no specific exchange for the exchange traded options in
Pakistan, therefore, the option used by few banks are over the counter ones.
Results show that all the banks whether public sector commercial banks or local
private banks use forward exchange contracts. 110 banks out of sample of 110
banks use forward exchange contracts. However, 33 out of 110 banks use swaps
in addition to forwards and 14 out of a total of 110 banks use foreign currency
options along with forwards and swaps as well. This is evident from the results
Page | 48
mentioned in the above table that public sector commercial banks do not use
foreign currency options at all.
Total 14 100.0
Total 96 100.0
Total 94 100.0
Total 16 100.0
Table xi: Currency Derivative Usage by Type of Bank
Page | 49
Sample contains 110 banks in total, including 16 Islamic and 94 conventional
banks. All the banks, both Islamic and conventional banks, use forward exchange
contracts. Only 5 out of 16 Islamic banks use swaps along with forwards and none
of Islamic bank use foreign exchange options. However commercial banks use all
the three types of currency derivatives i.e. forwards, swaps and options. It is
evident from the above findings that only 14 out of 94 conventional banks use
foreign currency options. Therefore, the most popular tool is forward exchange
contracts and the least popular and used tool is foreign currency options.
Backward Stepwise Binary Logistic Regression took place in the following steps,
in order to reach the significant independent variables:
1. In the beginning the model is fitted with only constant and no independent
variable. After this model is again fitted using all of the five independent
variables. Therefore, step 1 involves the model with all the independent
variables in it.
2. In step 2, model is refitted removing independent variable “Type of Bank”
which proved to be insignificant on the basis of Likelihood Ratio test.
3. In step 3, another independent variable “Current year exchange rate
volatility” is removed from the model and the number of independent
variables in the model is reduced to three. These independent variables
include Ownership Status of Bank, Size of Bank (as measured by Net
Assets) and Net foreign currency exposure relative to net assets.
Both Type & Current ERV are removed from model based on the Likelihood ratio
test. The summary of results of likelihood ratio test is given below:
Page | 50
Step 1 OS -56.634 7.040 1 .008
Below is the summary of Logits and Odd Ratios which show that how the binary
logistic regression model is changed from five independent variables to three
independent variables, Step 1 & 2 do not need to be discussed in detail, however,
step 3 needs to be explained in detail as it corresponds to our objective of this
study.
Page | 51
a
Step 3 OS(1) -3.053 1.580 3.736 1 .053 .047
The second column, with heading B, shows the values of regression coefficient
during each step. Logits (Log Odds) are the regression coefficients of the model
which show the impact of a unit increase in the independent variable on the
dependent variable i.e. how does a unit increase in independent variables affects
the decision of the commercial bank to select the tools for foreign exchange risk
management. In the last column, Exp (B) i.e. Odds Ratios are mentioned which
shows that how do a unit increase in independent variables changes the odds of
usage of swaps options along with forwards by a commercial bank.
It is important to interpret the odds ratio in step 3 here. If the ownership status of
bank is changed from public sector commercial bank to local private bank, the
odds of using swaps & options are
0.047 times greater than public sector commercial bank. This shows a weak
influence of ownership status on decision of usage of swaps and options. If the
Net Assets of bank are increased by one billion, the odds of usage of swaps and
options are 1.087 times greater. If NFXNA, when expressed as percentage, is
increased by one percent the odds are 0.99 times greater for the usage of swaps
and options.
Cox & Snell R square for the model as in step 3 is 0.321 and Nagelkerke R square
is 0.430. Based on these results, it can be stated that using our model 43% of the
changes in decision to use swaps and option are because of the independent
variables in our model.
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Findings on Income from Dealing in Foreign Currencies and its
Relationship with other Factors
Income from dealing in foreign currencies is mentioned separately in the income
statement of commercial banks under the head of “Income from dealing in foreign
currencies”. Findings related to this income as per the research objectives of this
study are given below:
The value of F using Levene’s test is insignificant and hence it is assumed that
variances are not different. The value of t is -1.066 which is not significant at
desired level of significance (as it is significant at 0.289) hence Null hypothesis is
accepted that there is no significant difference between the means of IFX of
commercial banks and Islamic banks.
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Findings on Income from dealing in foreign currencies and Ownership
Status of commercial bank (PSCB and LPB)
Results of the descriptive statistics for commercial banks with respect to
ownership status are below:
Table xv: Desxriptive Statistics for IFX and IFXRS by Ownership Status
Table xvii: Descriptive Statistics of IFX and IFXRS by Ownership Status of Bank
Model 1:
Page | 54
Model Summary
b
ANOVA
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
The first model to study the impact of Size of bank, as measured by Net Assets,
on the Income from dealing in foreign currencies show that there is a significant
relationship. The model R square shows that 58.1% of variation is explained by
the relationship. The value of b i.e. 20390.617 is also significant. Since there is a
relationship between independent and dependent variable, therefore, null
hypothesis is rejected and alternative hypothesis is rejected.
Page | 55
Model 2:
Model Summary
b
ANOVA
b. Dependent Variable: Income from dealing in foreign currencies as a percentage of total income
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
a. Dependent Variable: Income from dealing in foreign currencies as a percentage of total income
Table xix: Output of Regression: IFX on NA
Results for the model constructed to investigate the relationship between net
assets (size of bank) and income from dealing in foreign currencies as a
percentage of total income indicates that there is no significant relationship
between these two variables. Null hypothesis is accepted in this case.
The difference between results shown by these two models can be interpreted as
increasing the size of bank increases the income from dealing in foreign
currencies in bank. However, if this income from dealing in foreign currencies is
taken as a percentage of total income of bank, net assets does not affect this
income. It can be said on the basis of findings that Size of bank does not help in
earning extra income from dealing in foreign currencies by simply increasing the
size of bank.
Page | 56
Findings on Income from dealing in foreign currencies and Currency
Derivatives used by commercial banks
The simple linear regression, as described in the methodology section is used with
the help of SPSS and below are the relevant outputs as produced by SPSS.
Model Summary
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
b
ANOVA
The above mentioned results show that b is not significant. Also the overall
regression is not significant at the 0.10 level of significance. There is a very weak,
almost no relationship between these two variables, as evident from the value of R
square. Since there is no relationship, therefore, null hypothesis substantiates and
it can be said that in Pakistan, income from dealing in foreign currencies is not
affected by using different tools.
Page | 57
Findings on Effect of Exchange Rate Volatility on Income from Dealing
in Foreign Currencies
To examine whether Exchange rate volatility have any effect on the income from
dealing in foreign currencies, two separate models are constructed.
Model Summary
b
ANOVA
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
Page | 58
Using Income from dealing in foreign currencies in Rs. ‘000 in the simple linear
regression model showed a weak but significant relationship between the
independent variable and the dependent variable. R square in this model shows
that less than 7% variation is explained due to linear relationship between the
variables. Therefore, null hypothesis is rejected and alternate hypothesis is
accepted.
Model Summary
b
ANOVA
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
Page | 59
a
Coefficients
Standardized
Unstandardized Coefficients Coefficients
Page | 60
Conclusion
Based on the findings of this study, following conclusions can be drawn regarding
the Foreign currency exposure, ways to manage foreign exchange risk, currency
derivatives usage & income from dealing in foreign currencies of the commercial
banks in Pakistan:
Page | 61
Page | 62
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