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TABLE OF CONTENTS

LIST OF ABBREVIATIONS...........................................................................................ii CHAPTER ONE: INTRODUCTION..............................................................................1


1.1 Background............................................................................................................1 1.1.1 Derivatives.......................................................................................................2 1.1.2 Foreign Currency Exposure of a Commercial Bank..........................................3 1.1.3 Effect of derivatives on foreign exchange exposure......................................... 1.1.! Commercial Banks in "enya............................................................................# 1.2 $esearch %ro&lem..................................................................................................' 1.3 (&)ectives of the *tudy...........................................................................................+ 1.! ,alue of the *tudy..................................................................................................2.1 .ntroduction........................................................................................................... 1/ 2.2 0heoretical revie1.................................................................................................1/ 2.3 Foreign Exchange $isk 2anagement...................................................................13 2.# Empirical $evie1..................................................................................................1+ 2.# *ummary of 3iterature revie1...............................................................................1-

CHAPTER THREE: RESEARCH METHODOLOGY..............................................20


3.1 .ntroduction........................................................................................................... 2/ 3.2 $esearch Design..................................................................................................2/ 3.3 *tudy %opulation...................................................................................................2/ 3.! Data Collection %rocedures..................................................................................2/ 3. Data 4nalysis and %resentation............................................................................2/

REFERENCES................................................................................................................22 APPENDICES..................................................................................................................26

LIST OF ABBREVIATIONS
CBK Central Bank of Kenya ERV - Exchange rate volatility FOREX Foreign Exchange FX Foreign Exchange IFE International Fisher Effect IFX - Income from foreign currencies as a percentage of total income IRP Interest Rate Parity MST arket !egmentation "heory NA - #et $ssets NFXNA - #et Foreign Currency Exposure Relative to #et $ssets NFX - #et Foreign Currency Exposure NSE #airo%i !ecurities Exchange OS - &'nership !tatus or #ature of &'nership PPP Purchasing Po'er Parity

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CHAPTER ONE: INTRODUCTION


1.1 B !"#$%&'( "he tra(itional role for commercial %anks has %een perceive( to %e the re(uction of transactions costs an( the provision of information) *o'ever+ given the technological+ information+ an( financial innovations of the last (eca(e+ risk sharing an( risk management are increasingly %eing vie'e( as a ma,or source of value creation in %anking) $llen an( !antomero -.//01 argue that these changes have increasingly shifte( %anks a'ay from their tra(itional activities) Instea(+ they suggest that %anks are making increasing use of financial markets to transfer+ transform+ an( re(istri%ute risk) "hus the financial markets2 perception of %ank activities has taken on increasing importance) Especially+ after glo%al financial crisis in 3445+ %anks2 (erivative activities have %ecome increasingly controversial) In fact+ the effect of (erivative use on risk measure an( value is especially important in %anking since %anks (ominate most (erivative markets) *o'ever+ the use of (erivatives contracts %y %anks has increase( in the past t'o (eca(es+ the effect of (erivatives on the risks an( market value of %anks is still unkno'n) 6espite more 'i(ely availa%le (ata on (erivatives usage+ the evi(ence o%taine( from empirical research on its effects is mixe( -Peek an( Rosengren+ .//01) &ne possi%le ans'er to such contra(ictory results is 'hether %anks use (erivatives for tra(ing or he(ging purpose) Previous stu(ies have use( (ata (isclose( %y all kin(s of firms+ inclu(ing non-financial firms an( %anks in(ustries+ %een trying to improve our un(erstan(ing of ho' firms use (erivatives -Bartram+ Bro'n an( Conra(+ 34..1) "he i(entifying assumption in nearly all of this literature has %een that firms+ inclu(ing financial firms+ use (erivatives for he(ging) *o'ever+ Chernenko an( Faulken(er -34..1 have (emonstrate( non-financial firms use (erivatives not only for he(ging %ut also for speculation)

In the practice+ not to mention for financial firms+ %anks2 involvement in the (erivatives market has %een consi(era%ly asymmetric 'ith respect to tra(ing an( he(ging activities an( %anks more likely to speculate 'ith (erivatives - inton et al) 344/1) "herefore+ the primary o%,ective of this stu(y is to empirically investigate 'hether commercial %ank2s purpose -tra(ing or he(ging1 of using (erivatives is significantly relate( to their %ank risk an( value) 1.1.1 D)$i* +i*), $ derivative is a financial instrument 'hose value (epen(s on or is (erive( from the value of some other financial instrument+ calle( the 7un(erlying asset2) "here are a 'i(e range of financial assets that have %een use( as un(erlying+ inclu(ing e8uities or e8uity in(ex+ fixe(-income instruments+ foreign currencies+ commo(ities+ cre(it events an( even other (erivative securities) 6epen(ing on the types of un(erlying assets+ the values of the (erivative contracts can %e (erive( from the correspon(ing e8uity prices+ interest rates+ exchange rates+ commo(ity prices an( the pro%a%ilities of certain cre(it events -$n(erson an( cKay+ 34451)

"here are four main types of (erivatives contracts9 for'ar(s: futures+ options an( s'aps) "hese allo' users to meet the (eman( for cost-effective protection against risks associate( 'ith movements in the prices of the un(erlying) In other 'or(s+ users of (erivatives can he(ge against fluctuations in exchange an( interest rates+ e8uity an( commo(ity prices+ as 'ell as cre(it 'orthiness) !pecifically+ (erivative transactions involve transferring those risks from entities less 'illing or a%le to manage them to those more 'illing or a%le to (o so) 6erivatives transactions are no' common among a 'i(e range of entities+ inclu(ing commercial %anks+ investment %anks+ central %anks+ fun( managers+ insurance companies an( other non-financial corporations -#yste(t+ 344;1)

Participants in (erivatives markets are often classifie( as either <he(gers= or speculators=) *e(gers enter a (erivative contract to protect against a(verse changes in the values of their assets or lia%ilities) !pecifically+ he(gers enter a (erivative transaction such that a fall in the value of their assets 'ill %e compensate( %y an increase in the value of the (erivative contract) By contrast+ speculators attempt to profit from anticipating changes in market prices or rates or cre(it events %y entering a (erivative contract) $ccor(ing to this (efinition+ activities of speculators are inherently more risky an( shoul( 'arrant close monitoring %y financial regulators) *o'ever+ it is (ifficult to (ifferentiate the t'o in practice) $s pointe( out %y >arro' an( "urn%ull -34441+ he(ging+ risk re(uction+ speculation an( risk augmentation are flip si(es of the same coin) *e(ging an( speculating are not the only motivations for tra(ing (erivatives) !ome firms use (erivatives to o%tain %etter financing terms) For example+ %anks often offer more favoura%le financing terms to those firms that have re(uce( their market risks through he(ging activities than to those 'ithout) Fun( managers sometimes use (erivatives to achieve specific asset allocation of their portfolios) For example+ passive fun( managers of specific in(ex-tracking fun(s may nee( to use (erivatives to replicate exposures to some not so li8ui( financial assets -$nsi an( &u(a 344/1) 1.1.2 F%$)i#' C&$$)'!- E./%,&$) %0 C%11)$!i 2 B '"

Commercial %anks+ actively (eal in foreign currencies hol(ing assets an( lia%ilities in foreign (enominate( currencies+ are continuously expose( to Foreign Exchange Risk) Foreign Exchange Risk of a commercial %ank comes from its very tra(e an( non-tra(e services) Foreign exchange tra(ing activities inclu(e the purchase an( sale of foreign currencies to allo' customers to partake in an( complete international commercial tra(e transactions) "hey also involve the purchase an( sale of foreign currencies to allo' customers -or the %ank1 to take positions in foreign real an( financial investments)

&ther forex tra(ing activities may involve the purchase an( sale of foreign currencies for he(ging purposes to offset customer -or the %ank1 exposure in any given currency an( purchase an( sale of foreign currencies for speculative purposes %ase( on forecasting or expecting future movements in foreign exchange rates -!aun(ers ? Cornett+ 344@1) "he a%ove mentione( tra(e activities (o not expose a commercial %ank to foreign exchange risk as a result of all of the a%ove) "he commercial %ank is expose( to foreign exchange risk only up to the extent to 'hich it has not he(ge( or covere( its position) Aherever there is any uncertainty that the future exchange rates 'ill affect the value of financial instruments+ there lies the foreign exchange risk of a commercial %ank) Foreign Exchange risk (oes not lie 'here the future exchange rate is pre(efine( %y using (ifferent instruments an( tools %y the %ank -Barton+ !henkir+ ? Aalker+ 34431) $ny unhe(ge( position in a particular currency gives rise to FB risk an( such a position is sai( to %e &pen Position in that particular currency) If a %ank has sol( more foreign currency than he has purchase(+ it is sai( to %e #et !hort in that currency+ alternatively if it has purchase( more foreign currency than it has purchase( than it is in #et Cong position) Both of these positions are expose( to risk as the foreign currency may fall in value as compare( to local or home currency an( %ecomes a reason for su%stantial loss for the %ank if it is in #et Cong position or the foreign currency may rise in value an( cause losses if the %ank is #et !hort in that currency ) Cong Position is also kno'n as over%ought or #et $sset Position an( !hort Position is also kno'n as #et Cia%ility or &versol( Position) !um of all the #et $sset positions ? #et Cia%ility positions is kno'n as #et &pen Position or #et Foreign Currency Exposure) <#et Foreign Currency Exposure= gives the information a%out the Foreign Exchange Risk that has %een assume( %y the %ank at that point of time) "his figure represents the unhe(ge( position of %ank in all the foreign currencies) $ negative figure sho's #et !hort Position 'hereas positive figure sho's #et &pen Position -!aun(ers ? Cornett+ 344@1)

1.1.3 E00)!+ %0 ()$i* +i*), %' 0%$)i#' ).!4 '#) )./%,&$) Banks use 6erivatives to manage foreign currency exposure) *e(ging allo's the

commercial %anks to manage foreign exchange risk %ut he(ging itself poses a((itional risk to %anks) Dan(hi -344E1 mentione( that currency (erivatives like currency futures+ currency for'ar(s+ currency s'aps an( currency options help in he(ging foreign exchange risk of firms an( other 'ays of he(ging inclu(ing off-setting positions against the un(erlying assets an( money markets are themselves risky) *e(ging an( he(ging right are t'o (ifferent things) If the he(ging is not (one properly in the right 'ay+ it can %ecome a serious source of risk an( can lea( to a serious financial loss to the firm) Foreign exchange risk can %e manage( if the (iversification of portfolio is (one across the assets in (ifferent currencies) Cash flo's of a portfolio can %e affecte( or change( %y the usage of (erivative securities) "he usage of currency (erivatives a((itionally re(uces the risk of 'hole (iversifie( portfolio -$%ken ? !hrikhan(e+ .//01) Currency 6erivatives are not only helpful in he(ging the foreign exchange risk of the firms an( institutes+ ho'ever+ (ue to information efficiency resultant of usage of currency (erivatives makes the currency markets more efficient an( exchange rates less forecast a%le -Ciu+ 34401 Foreign Currency options are the (erivative instruments that give the %uyer of that option the right %ut not the o%ligation to exercise a specific transaction in the currency pair un(erlying the respective (erivative contract) It entitles the %uyer of the option the flexi%ility of exercising settlement of that option or not) In(ee(+ the foreign currency options are one of the %est tools availa%le for he(ging foreign exchange exposures in (ifferent foreign exchange market con(itions+ like volatile market con(itions+ stagnant+ %ullish or %earish -Dan(hi+ 344E1)

1.1.5 C%11)$!i 2 B '", i' K)'"he %anking sector in Kenya is governe( %y the company2s $ct+ the Banking $ct an( the Central %ank $ct an( the various pru(ential gui(elines issue( %y Central Bank of Kenya) "he %anking sector 'as li%eralise( in .//F an( exchange controls lifte() "he Central Bank of Kenya is responsi%le for formulating an( implementing monetary policy (irecte( to achieving sta%ility in the general level of prices an( fosters the li8ui(ity+ solvency an( proper functioning of a sta%le market %ase( financial system 'hile supporting the economic policy of the Dovernment -Central Bank of Kenya+ 34.31) $s at @.st ortgage 6ecem%er 34.3+ the %anking sector comprise( of the Central Bank of Kenya+ as the regulatory authority+ ;; %anking institutions -;@ Commercial %anks an( . finance company1+ 3 representative offices of foreign %anks+ F 6eposit-"aking icrofinance Institutions an( .3E Forex Bureaus) @. of the %anking institutions are locally o'ne( 'hile .@ are foreign o'ne() "he locally o'ne( financial institutions comprise of @ %anks 'ith pu%lic sharehol(ing+ 30 privately o'ne( commercial %anks+ . mortgage finance company 'hile F 6eposit-"aking icrofinance Institutions an( .3E forex %ureaus are privately o'ne( -Central Bank of Kenya+ 34.31) "he foreign o'ne( financial institutions comprise of nine locally incorporate( foreign %anks an( four %ranches of foreign incorporate( %anks) "he sector 'as (ominate( %y local private institutions 'ith 30 institutions accounting for F5)4 percent of the in(ustry2s total assets an( E;G of total financial institutions -Central Bank of Kenya+ 34.31) In 34.3+ a num%er of %anks respon(e( to the gro'ing nee( of convenient straight-through payments using mo%ile solutions) $s a result+ a num%er of %anks continue( to sign up partnerships 'ith money transfer service provi(ers as they improve their %anking-on-themove menus) In only four years of existence of mo%ile phone money transfer services+ four mo%ile operators have enrolle( over .F million customers -Central Bank of Kenya+ 34.31)

1.2 R),) $!4 P$%62)1 Exchange rate movements have %een a %ig concern for investors+ analysts+ managers an( sharehol(ers since the a%olishment of the fixe( exchange rate system of Bretton Aoo(s in ./0.) "his system 'as replace( %y a floating rates system in 'hich the price of currencies is (etermine( %y supply an( (eman( of money) Diven the fre8uent changes of supply an( (eman( influence( %y numerous external factors+ this ne' system is responsi%le for currency fluctuations -$%or+ 344F1) "hese fluctuations expose companies to foreign exchange risk) oreover+ economies are getting more an( more open 'ith international tra(ing constantly increasing an( as a result companies %ecome more expose( to foreign exchange rate fluctuations -$(ler an( 6umas+ ./5;1) Denerally+ companies are expose( to three types of foreign exchange risk9 accounting -translation1 exposure+ transaction -commitment1 exposure an( economic -operational+ competitive or cash flo'1 exposure -Eiteman et al)+ 344E1) 6erivatives can %e use( either to re(uce risks or to speculate) "he siHe an( complexity of (erivatives transactions concern regulators+ aca(emics+ an( commercial %anks) In theory+ (erivatives shoul( allo' companies to manage risk %etter+ %ut that it is not clear 'hether recent innovations have increase( or (ecrease( the inherent sta%ility of the financial system) $ccor(ing to the Kenya Bankers $ssociation -KB$1+ commercial %anks in Kenya are offering a limite( num%er of (erivatives inclu(ing foreign currency-(enominate( for'ar( contracts+ interest rates an( cross-currency s'aps) "he KB$ chairman+ in a recent article in the 7%usiness (aily2 sai( the regulations 'ill offer gui(elines for %anks that are alrea(y involve( in the tra(e) *e note( that the CBK allo'e( some (erivative instruments to %e use( in the %anking in(ustry %ut rapi( changes that are taking place in the financial markets necessitate( closer oversight) *e further note( that as the financial markets in Kenya continue to evolve+ there 'ill %e a nee( for CBK to first un(erstan( the various (erivative pro(ucts an( then provi(e gui(elines to regulate them+ the a%sence of 'hich coul( result in stress in the financial systems -Business (aily+ 34.@1)

$mong the stu(ies (one on this topic inclu(e Cherutoi -344E1+ 'ho (i( a stu(y on extent of commercial %anks exposure to foreign exchange risk an( I%in(i -344E1 'ho con(ucte( a survey of foreign exchange risk management practices %y forex %ureaus in Kenya) umoki -344/1 (i( a stu(y on foreign exchange risk management9 strategies an( %ithi techni8ues use( %y %anks in Kenya to manage foreign exchange risk exposure)

-34..1 (i( a stu(y on the impact of (erivatives in the #airo%i !tock Exchange 'hile Ditogo -34.31+ con(ucte( a stu(y on the relationship %et'een (erivatives an( financial performance of commercial %anks in Kenya) #o stu(y has %een con(ucte( on the effectiveness of (erivatives in managing foreign exchange risk of commercial %anks in Kenya) Diven the importance of commercial %anks in the Kenyan economy an( the volatility of the Kenyan shilling against the 'orl(2s ma,or currencies+ it is necessary that a survey is con(ucte( to fin( out 'hether the %anks are managing shocks cause( %y foreign exchange movements) "he popularity of the use of (erivatives as a tool to re(uce the foreign exchange risk has also prompte( the researcher to assess further 'hether they are an effective metho() "his stu(y 'ill therefore seek to ans'er the follo'ing 8uestions9 i) ii) Ahat are the currency (erivatives 'hich are %eing use( %y the commercial %anks in KenyaJ 6oes the usage of these tools (epen( on its o'nership status+ its type+ !iHe of Bank an( Exchange Rate KolatilityJ 1.3 O67)!+i*), %0 +4) S+&("he stu(y 'ill %e gui(e( %y the follo'ing o%,ectives9 i) ii) "o esta%lish the extent to 'hich commercial %anks in Kenya use (erivatives to manage foreign exchange exposure "o assess the effect of using (erivatives to manage foreign exchange exposure %y commercial %anks in Kenya

1.5 V 2&) %0 +4) S+&("he stu(y is significant in three main 'ays) "he stu(y 'ill a(( to the %o(y of empirical literature on use of (erivatives to (eal 'ith exchange rate exposure of commercial %anks) "he stu(y also seeks to explain the exchange rate risk management %y commercial %anks from the Kenyan perspective an( assesses the effectiveness of using (erivatives to manage exchange rate volatility) "o the commercial %anks management+ this stu(y 'ill she( more light on the effective use of (erivatives to re(uce foreign exchange risk) It 'ill assist them to un(erstan( ho' to manage foreign exchange risk properly) "o the scholars an( researchers+ this stu(y 'ill provi(e a %asis for future stu(ies on the area of foreign exchange rate risk management)

CHAPTER T8O: LITERATURE REVIE8


2.1 I'+$%(&!+i%' "his chapter consi(ers literature relevant to the su%,ect un(er stu(y) "he main issues un(er revie' are: the theoretical revie'+ (erivatives+ foreign exchange risk management an( empirical revie') 2.2 T4)%$)+i! 2 $)*i)9 ovements in exchange rates ten( to %e influence( %y t'o important varia%les: the relative prices of goo(s in t'o countries an( relative interest rates) "his section gives a %rief overvie' of the foreign exchange theories 'hich inclu(e the purchasing po'er parity -PPP1 theory+ international fisher effect+ expectation theory of for'ar( rates an( interest rate parity) 2.2.1 T4) P&$!4 ,i'# /%9)$ / $i+- +4)%$"he Purchasing po'er parity -PPP1 theory propoun(s that un(er a floating exchange regime+ a relative change in purchasing po'er parity for any pair of currency calculate( as a price ratio of tra(e( goo(s 'oul( ten( to %e approximate( %y a change in the e8uili%rium rate of exchange %et'een these t'o currencies -!hapiro ? Ruten%erg+ .//E1) "he relationship %et'een relative interest rates an( foreign exchange rates is explaine( 'ithin the interest rate theory of exchange rate expectations) #ominal interest rate (ifferentials %et'een t'o countries ten( to reflect exchange rate fluctuations) Purchasing po'er parity -PPP1 is an economic theory an( a techni8ue use( to (etermine the relative value of currencies+ estimating the amount of a(,ustment nee(e( on the exchange rate %et'een countries in or(er for the exchange to %e e8uivalent to -or on par 'ith1 each currencyLs purchasing po'er) It asks ho' much money 'oul( %e nee(e( to purchase the same goo(s an( services in t'o countries+ an( uses that to calculate an implicit foreign exchange rate) Ising that PPP rate+ an amount of money thus has the same purchasing po'er in (ifferent countries -Ca'rence+ .//31)

2.2.2 I'+)$' +i%' 2 Fi,4)$ E00)!+ T4)%$#ame( after its proposer+ the I)!) economist Irving Fisher -.5E0-./;01+ the International Fisher Effect -IFE1 theory suggests that foreign currencies 'ith relatively high interest rates 'ill ten( to (epreciate %ecause the high nominal interest rates reflect expecte( rate of inflation - a(ura+ 34.41) $vaila%le evi(ence is mixe( as in the case of PPP theory) In the long-run+ a relationship %et'een interest rate (ifferentials an( su%se8uent changes in spot exchange rate seems to exist %ut 'ith consi(era%le (eviations in the short run) "he international Fisher effect is kno'n not to %e a goo( pre(ictor of short-run changes in spot exchange rates -Cum%y an( &%stfel(+ ./5.1) IFE states that the currency of a nation 'ith a comparatively higher interest rate 'ill (epreciate in value in comparison to the currency of a nation 'ith a comparatively lo'er interest rate) It further implies that the extent of (epreciation 'ill %e e8ual to the (ifference in interest rates in those t'o nations) It is %ase( on the o%servation that the level of real interest rate in an economy is closely linke( to the level of local inflation rate an( is in(epen(ent of a governmentLs monetary policies) "hus+ in general+ the higher the inflation rate+ the lo'er the value of currency -*ill+ 344;1) 2.2.3 E./)!+ +i%' T4)%$- %0 F%$9 $( R +), Expectations theory suggests that the for'ar( rates in current long-term %on(s are closely relate( to the %on( marketLs expectation a%out future short-term interest rates) Expectations theory attempts to explain the term structure of interest rates) "here are three main types of expectations theories9 pure expectations theory+ market segmentation theory an( preferre( ha%itat theory -Ro%ert+ .//5)1

In pure expectations theory+ it is assume( that any maturity of (e%t can su%stitute for any other through the miracle of compoun(ing) For instance+ if you have a vie' as to 'hat the one-year interest rate 'ill %e one year from no' -the forward rate1+ then you can (etermine the current t'o-year interest rate as the compoun(e( sum of the current oneyear rate an( the one-year for'ar()

"he market segmentation theory - !"1 ackno'le(ges that (ifferent maturities of (e%t cannot %e su%stitute( for each other) "his results in separate (eman(-supply relationships for short-term an( long-term (e%t) !ince investors -assume( to %e risk-a(verse1 prefer the less risky short-term maturities+ the (eman( for short-term (e%t is higher than that for long-term (e%t+ an( thus prices of the former are higher+ (riving (o'n their yiel(s) "his helps to explain the normal shape of the yiel( curve+ %ut not the fact that long an( short term rates ten( to change in unison+ since they are suppose( to %e t'o separate an( in(epen(ent markets - ishkin+ .///1)

Preferre( *a%itat "heory is an extension of

!" 'hich posits maturity preferences+ or

ha%itats+ for (e%t investors9 some investors like @-year %on(s: some prefer E-year maturities+ etc) If you 'ant to sell an investor a %on( outsi(e the investor2s preferre( investment horiHon+ you must offer the investor a premium) !ince it is assume( that more investors have short-term ha%itats+ it explains the higher yiel(s on long-term (e%t+ an( is consistent 'ith the ten(ency of short- an( long-term (e%t yiel( curve segments to retain their shape 'hen overall yiel(s change)

Expectations theories are pre(icate( upon the i(ea that investors %elieve for'ar( rates+ as reflecte( -an( some 'oul( say pre(icte(1 %y future contracts are in(icative of future short-term interest rates) In foreign exchange+ a theory that for'ar( exchange rates for (elivery at some future (ate are e8ual to the spot rates for that (ate) "he theory only functions in the a%sence of a risk premium -Frank+ .//01) 2.2.5 I'+)$),+ R +) P $i+- T4)%$Interest Rate Parity -IPR1 theory is use( to analyHe the relationship %et'een at the spot rate an( a correspon(ing for'ar( -future1 rate of currencies) "he IPR theory states interest rate (ifferentials %et'een t'o (ifferent currencies 'ill %e reflecte( in the premium or (iscount for the for'ar( exchange rate on the currency if there no ar%itrage the activity of %uying shares or currency in one financial market an( selling it at a profit in another -Muhang+ 34401)

"he theory further states siHe of the for'ar( premium or (iscount on a foreign currency shoul( %e e8ual to the interest rate (ifferentials %et'een the countries in comparison) If IRP theory hol(s then ar%itrage in not possi%le) #o matter 'hether an investor invests in (omestic country or foreign country+ the rate of return 'ill %e the same as if an investor investe( in the home country 'hen measure( in (omestic currency) If (omestic interest rates are less than foreign interest rates+ foreign currency must tra(e at a for'ar( (iscount to offset any %enefit of higher interest rates in foreign country to prevent ar%itrage ->onathan+ -344F1) If foreign currency (oes not tra(e at a for'ar( (iscount or if the for'ar( (iscount is not large enough to offset the interest rate a(vantage of foreign country+ ar%itrage opportunity exists for (omestic investors) 6omestic investors can %enefit %y investing in the foreign market) If (omestic interest rates are more than foreign interest rates+ foreign currency must tra(e at a for'ar( premium to offset any %enefit of higher interest rates in (omestic country to prevent ar%itrage) *o'ever+ if foreign currency (oes not tra(e at a for'ar( premium or if the for'ar( premium is not large enough to offset the interest rate a(vantage of (omestic country+ ar%itrage opportunity exists for foreign investors an( foreign investors can %enefit %y investing in the (omestic market -Bruce+ 34..1) In recent years the interest rate parity mo(el has sho'n little proof of 'orking) In many cases+ countries 'ith higher interest rates often experience itLs currency appreciate (ue to higher (eman(s an( higher yiel(s an( has nothing to (o 'ith risk-less ar%itrage)

2.3 F%$)i#' E.!4 '#) Ri," M ' #)1)'+


Foreign currency exchange risk is the a((itional riskiness or variance of a firm7s cash flo's that may %e attri%ute( to currency fluctuations -Brigham an( Ehrhar(t+ 344F1) #ormally+ foreign currency risk exists in three forms: translation+ transaction an( economic exposures) Foreign currency risk management involves taking (ecisions 'hich aim at minimiHing or eliminating the negative effects of currency fluctuations on %alance sheet an( income statement values+ a firmLs receipts an( payments arising out of current transactions+ an( on long term future cash flo's of a firm)

Creativity %y managers an( innovations in financial instruments have ma(e availa%le to firms mitigating tools that can %e follo'e( in managing the impact of foreign currency rate fluctuations) "hese tools are commonly kno'n as he(ging techni8ues) $ he(ge is a means of prevention against a possi%le pro%a%le loss) *e(ging is the process of re(ucing exposure an( consists of a num%er of techni8ues inten(e( to offset or minimiHe the exchange risk of loss on the assets or lia%ilities 'hich are (enominate( in a foreign currency) !ome he(ging techni8ues can %e implemente( 'ithin the firm 'ithout involving any market-%ase( financial instruments) "hese are kno'n as internal he(ging techni8ues) $ll other techni8ues necessitate taking recourse to market - %ase( financial instruments) "hese are external he(ging techni8ues) 2.3.1 N)!),,i+- %0 1 ' #i'# 0%$)i#' ).!4 '#) $i," $ key assumption in the concept of foreign exchange risk is that exchange rate changes are not pre(icta%le an( that this is (etermine( %y ho' efficient the markets for foreign exchange are) Research in the area of efficiency of foreign exchange markets has thus far %een a%le to esta%lish only a 'eak form of the efficient market hypothesis conclusively 'hich implies that successive changes in exchange rates cannot %e pre(icte( %y analyHing the historical se8uence of exchange rates -!oenen+ 344F1) *o'ever+ 'hen the efficient markets theory is applie( to the foreign exchange market un(er floating exchange rates there is some evi(ence to suggest that the present prices properly reflect all availa%le information -Di((y an( 6ufey+ 34431) "his implies that exchange rates react to ne' information in an imme(iate an( un%iase( fashion+ so that no one party can make a profit %y this information an( in any case+ information on (irection of the rates arrives ran(omly so exchange rates also fluctuate ran(omly) It implies that foreign exchange risk management cannot %e (one a'ay 'ith %y employing resources to pre(ict exchange rate changes) &nce a firm recogniHes its exposure+ it then has to (eploy resources in managing it in a heuristic 'ay to manage this risk effectively)

2.3.2 S+)/, %0 0%$)i#' ).!4 '#) $i," 1 ' #)1)'+ $fter (etermining its exposure+ the first step for a firm is to (evelop a forecast on the market tren(s an( 'hat the main (irectionNtren( is going to %e on the FB rates) "he perio( for forecasts is typically E months) It is important to %ase the forecasts on vali( assumptions) $long 'ith i(entifying tren(s+ a pro%a%ility shoul( %e estimate( for the forecast coming true as 'ell as ho' much the change 'oul( %e) Base( on the forecast+ a measure of the Kalue at Risk -the actual profit or loss for a move in rates accor(ing to the forecast1 an( the pro%a%ility of this risk shoul( %e ascertaine() "he risk that a transaction 'oul( fail (ue to market-specific pro%lems shoul( %e taken into account) Finally+ the !ystems Risk that can arise (ue to ina(e8uacies such as reporting gaps an( implementation gaps in the firms2 exposure management system shoul( %e estimate() Diven the exposures an( the risk estimates+ the firm has to set its limits for han(ling foreign exchange exposure) "he firm also has to (eci(e 'hether to manage its exposures on a cost centre or profit centre %asis) $ cost centre approach is a (efensive one an( the main aim is ensure that cash flo's of a firm are not a(versely affecte( %eyon( a point) $ profit centre approach on the other han( is a more aggressive approach 'here the firm (eci(es to generate a net profit on its exposure over time) Base( on the limits a firm set for itself to manage exposure+ the firms then (eci(es an appropriate he(ging strategy) "here are various financial instruments availa%le for the firm to choose from9 futures+ for'ar(s+ options an( s'aps an( issue of foreign (e%t) *e(ging strategies an( instruments are explore( in a section) "he firms risk management (ecisions are %ase( on forecasts 'hich are %ut estimates of reasona%ly unpre(icta%le tren(s) It is imperative to have stop loss arrangements in or(er to rescue the firm if the forecasts turn out 'rong) For this+ there shoul( %e certain monitoring systems in place to (etect critical levels in the foreign exchange rates for appropriate measure to %e taken)

Risk management policies are typically su%,ecte( to revie' %ase( on perio(ic reporting) "he reports mainly inclu(e profitN loss status on open contracts after marking to market+ the actual exchangeN interest rate achieve( on each exposure an( profita%ility vis-a-vis the %enchmark an( the expecte( changes in overall exposure (ue to forecaste( exchangeN interest rate movements) "he revie' analyses 'hether the %enchmarks set are vali( an( effective in controlling the exposures+ 'hat the market tren(s are an( finally 'hether the overall strategy is 'orking or nee(s change) 2.5 C4%i!) %0 4)(#i'# i',+$&1)'+, "he literature on the choice of he(ging instruments is very scant) $mong the availa%le stu(ies+ DecHy et al) -.//01 argues that currency s'aps are more cost-effective for he(ging foreign (e%t risk+ 'hile for'ar( contracts are more cost-effective for he(ging foreign operations risk) "his is %ecause foreign currency (e%t payments are long-term an( pre(icta%le+ 'hich fits the long-term nature of currency s'ap contracts) Foreign currency revenues+ on the other han(+ are short-term an( unpre(icta%le+ in line 'ith the short-term nature of for'ar( contracts) $ survey (one %y arshall -34441 also points out that currency s'aps are %etter for

he(ging against translation risk+ 'hile for'ar(s are %etter for he(ging against transaction risk) "his stu(y also provi(es anec(otal evi(ence that pricing policy is the most popular means of he(ging economic exposures) "hese results ho'ever can (iffer for (ifferent currencies (epen(ing in the sensitivity of that currency to various market factors) Regulation in the foreign exchange markets of various countries may also ske' such results)

2.: F !+%$, 00)!+i'# +4) ()!i,i%' +% 4)(#) 0%$)i#' !&$$)'!- $i," Research in the area of (eterminants of he(ging separates the (ecision of a firm to he(ge from that of ho' much to he(ge) "here is conclusive evi(ence to suggest that firms 'ith larger siHe+ R?6 expen(iture an( exposure to exchange rates through foreign sales an( foreign tra(e are more likely to use (erivatives -$llayanis an( &fek+ 344.1) First+ the follo'ing section (escri%es the factors that affect the (ecision to he(ge an( then the factors affecting the (egree of he(ging are consi(ere() Firm siHe acts as a proxy for the cost of he(ging or economies of scale) Risk management involves fixe( costs of setting up of computer systems an( trainingNhiring of personnel in foreign exchange management) oreover+ large firms might %e consi(ere( as more cre(it'orthy counterparties for for'ar( or s'ap transactions+ thus further re(ucing their cost of he(ging) "he %ook value of assets is use( as a measure of firm siHe) $ccor(ing to the risk management literature+ firms 'ith high leverage have greater incentive to engage in he(ging %ecause (oing so re(uces the pro%a%ility+ an( thus the expecte( cost of financial (istress) *ighly levere( firms avoi( foreign (e%t as a means to he(ge an( use (erivatives) Firms 'ith highly li8ui( assets or high profita%ility have less incentive to engage in he(ging %ecause they are expose( to a lo'er pro%a%ility of financial (istress) Ci8ui(ity is measure( %y the 8uick ratio+ i)e) 8uick assets (ivi(e( %y current lia%ilities1) Profita%ility is measure( as EBI" (ivi(e( %y %ook assets) !ales gro'th is a factor (etermining (ecision to he(ge as opportunities are more likely to %e affecte( %y the un(erinvestment pro%lem) For these firms+ he(ging 'ill re(uce the pro%a%ility of having to rely on external financing+ 'hich is costly for information asymmetry reasons+ an( thus ena%le them to en,oy uninterrupte( high gro'th)

"he measure of sales gro'th is o%taine( using the @-year geometric average of yearly sales gro'th rates) $s regar(s the (egree of he(ging $llayanis an( &fek -344.1 conclu(e that the sole (eterminants of the (egree of he(ging are exposure factors -foreign sales an( tra(e1) In other 'or(s+ given that a firm (eci(es to he(ge+ the (ecision of ho' much to he(ge is affecte( solely %y its exposure to foreign currency movements) "his (iscussion highlights ho' risk management systems have to %e altere( accor(ing to characteristics of the firm+ he(ging costs+ nature of operations+ tax consi(erations+ an( regulatory re8uirements) 2.6 E1/i$i! 2 R)*i)9 In an early stu(y+ $(ler an( 6umas -./5;1 present a metho( of estimating the foreign exchange exposure using a single-factor market mo(el to estimate the elasticity of firm e8uity returns to exchange rate changes) >orion -.//.1 estimates exposure using a t'ofactor mo(el that thereafter %ecame the norm for estimating foreign exchange exposure controlling for market risk) For a sample of firms (ra'n from the Fortune F44+ he fin(s that the (egree of exposure varies (irectly 'ith the (egree of foreign involvement) &ther stu(ies have re-confirme( these %asic fin(ings regar(ing the foreign exchange exposure face( %y internationally involve( an( multinational companies+ an( explore( in greater (etail various issues that arise in the proce(ures use( for estimating such exposure issues that are important consi(erations in this stu(y) "he first issue is the nature of the market mo(el use( to estimate corporate foreign exchange exposure) Earlier stu(ies use( a monthly+ contemporaneous horiHon to measure exposure) Beginning 'ith the seminal stu(y %y >orion -.//41+ initial research in this area focuse( on 'hether corporations are expose( to foreign exchange risk -see Bo(nar an( Dentry+ .//@+ Bartov an( Bo(nar+ .//;+ .//F+ an( Cho'+ Cee an( !olt+ .//0a+ %1) $llayannis an( &fek -344.1 an( !imkins an( Caux -.//E1 investigate the effect of financial he(ging on foreign-exchange exposure) ore recently+ PantHalis+ !imkins+ an( Caux -34441 examine the a%ility of operational he(ges to re(uce exposure) *o'ever+ fe' stu(ies thus far have examine( the com%ine( influence of financial he(ges an( operational he(ges on foreign exchange exposure)

Cocally+ Cherutoi -344E1 (i( a stu(y on the extent of commercial %anks exposure to foreign exchange risk) "he results from the stu(y in(icate( that commercial %anks in Kenya are not significantly expose( to foreign exchange rate risk) I%in(i -344E1 con(ucte( a survey of foreign exchange risk management practices %y forex %ureaus in Kenya) "he fin(ings from most forex %ureaus 'ere similar to empirical evi(ence %ut consi(era%ly inconsistent 'ith recommen(ations of aca(emic literature) Forex %ureaus+ regar(less of their siHe+ extensively utiliHe( most of the conventional he(ging instruments) umoki -344/1 (i( a stu(y on foreign exchange risk management9 strategies an( techni8ues use( %y %anks in Kenya to manage foreign exchange risk exposure) "he results of the stu(y sho'e( that the for'ar( contract 'as the most fre8uently use( instrument) "he money market he(ge an( the currency s'ap 'ere also fre8uently use() Parallel loans -Back-to-%ack loan1+ foreign currency (enominate( (e%t an( cross he(ging techni8ues 'ere mo(erately use() Futures contract+ foreign currency option an( lea(ing an( lagging techni8ues 'ere occasionally use() Prepayment 'as the least use( techni8ue) Ditogo -34.31 con(ucte( a stu(y on the relationship %et'een (erivatives an( financial performance of commercial %anks in Kenya) "he stu(y conclu(e( that there exists relationship %et'een (erivatives an( financial performance of commercial %anks in Kenya) 2.6 S&11 $- %0 Li+)$ +&$) $)*i)9 $mong the many aca(emic pu%lications an( articles+ there is still a nota%le gap in this research stu(y that has %een un(ertaken to (ate in the context of FB risk management 'hich has helpe( to gather some valua%le information) "his stu(y therefore serves as a spring%oar( for future researchers to investigate an( 'i(en their scope on the effectiveness of FB risk management tools especially the use of (erivatives) "he stu(y provi(es scholars 'ith useful information on ho' to manage the FB risk) It is also of use to financial managers 'ho have the responsi%ility of managing the risk associate( 'ith foreign exchange exposure not only in commercial %anks %ut also other organiHations that (eal 'ith multiple currencies)

CHAPTER THREE: RESEARCH METHODOLOGY


3.1 I'+$%(&!+i%' "his chapter covers the (esign of the stu(y+ the target population+ (ata collection metho(s+ measurement of varia%les an( (ata analysis techni8ues) 3.2 R),) $!4 D),i#' "his stu(y 'ill a(opt a (escriptive research (esign 'hich generally (escri%es the characteristics of a particular situation+ event or case) It involves %oth 8ualitative an( 8uantitative (ata) $s (efine( %y Dlass ? *opkins -./5;1+ (escriptive research (esign involves gathering (ata that (escri%es events an( then organiHes+ ta%ulates+ (epicts+ an( (escri%es the (ata collection an( often uses visual ai(s such as graphs an( charts to help the rea(er in un(erstan(ing (ata (istri%ution) 3.3 S+&(- P%/&2 +i%' $ccor(ing to the Central Bank of Kenya -34.31 there are ;@ commercial %anks in Kenya) $ census survey stu(y is recommen(e( so as to cover the entire population of these commercial %anks over a five year perio(: 3445 to 34.3 -see appen(ix for full list1) 3.5 D + C%22)!+i%' P$%!)(&$), 6ata 'ill %e collecte( from secon(ary sources only as this is rea(ily availa%le from the commercial %anks financial reports+ Central Bank of Kenya reports an( the #airo%i !ecurities Exchange -#!E1) 3.: D + A' 2-,i, '( P$),)'+ +i%' In analyHing the responses+ the stu(y 'ill use (escriptive statistics such as percentages+ fre8uency (istri%ution+ measures of central ten(encies -mean+ mo(e+ ? me(ian1+ graphs an( pie charts) 6escriptive statistics ena%le the researcher to meaningfully (escri%e a (istri%ution of measurements - ugen(a ? organiHe an( summariHe (ata -Fain .///1) ugen(a+ 344@1 an( also to (escri%e+

"he follo'ing regression mo(el 'ill %e use( to fin( out the relationship %et'een foreign currency exposure an( factors that influence it9 NFXNA; < = >SI?E = >OS = >ERV = @ Ahere9 NFXNA O #FB relative to #et $ssets P ;Population parameter+ intercept !iHe ; !iHe of the %ank &! O &'nership status of the %ank ERK O Exchange rate volatility Q O Regression coefficient

R O Error term
"he error is the (ifference %et'een the calculate( (epen(ent varia%le value an( the actual value) #FB O S$ssetscurrency T Cia%ilitiescurrency T &ff Balance !heet Exposurecurrency #FB#$ O #FBN #$ #et Foreign Currency Exposure is calculate( %y a((ing #et &pen Position in all currencies hel( %y a %ank) !P!! 'ill %e use( to analyHe regression an( partial regression coefficients an( their significance) !ignificance of in(ivi(ual partial regression coefficients 'ill %e checke( using t-tests an( overall significance using F-test) "he values of statistics t an( F shoul( %e significant at a level of significance of less than 4)4F) Regression analysis use( in un(erstan(ing this relationship is %ack'ar( an( the final mo(el 'ith one in(epen(ent varia%le o%taine( after eliminating all the lesser significant in(epen(ent varia%les out of a total of three tells+ if there is any+ the relationship %et'een the most significant varia%le ? the (epen(ent varia%le)

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&'en Dra(uate !chool of

APPENDICES A//)'(i.: Li,+ %0 C%11)$!i 2 B '",


.) $BC Bank -Kenya1 3) Bank of $frica @) Bank of Baro(a ;) Bank of In(ia F) Barclays Bank E) Brighton Kalekye Bank 0) CFC !tan%ic Bank 5) Chase Bank -Kenya1 /) Citi%ank .4)Commercial Bank of $frica ..)Consoli(ate( Bank of Kenya .3)Cooperative Bank of Kenya .@)Cre(it Bank .;)6evelopment Bank of Kenya .F)6iamon( "rust Bank .E)6u%ai Bank Kenya .0)Eco%ank .5)E8uatorial Commercial Bank ./)E8uity Bank

34)Family Bank 3.)Fi(elity Commercial Bank Cimite( 33)Fina Bank 3@)First Community Bank 3;)Diro Commercial Bank 3F)Duar(ian Bank 3E)Dulf $frican Bank 30)*a%i% Bank 35)*a%i% Bank $D Vurich 3/)I? Bank

@4)Imperial Bank Kenya @.)>amii Bora Bank @3)Kenya Commercial Bank @@)K-Rep Bank @;) i((le East Bank Kenya @F)#ational Bank of Kenya @E)#IC Bank @0)&riental Commercial Bank @5)Paramount Iniversal Bank @/)Prime Bank -Kenya1 ;4)!tan(ar( Chartere( Kenya

;.)"rans #ational Bank Kenya ;3)Inite( Bank for $frica


!3. Kictoria Commercial Bank

S%&$!): C)'+$ 2 B '" %0 K)'- A 2012

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