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FOREIGN
EXCHANGE RISK MANAGEMENT IN NIGERIA ECONOMY AND ITS IMPACT ON PROFITS OF BANKS
Management
of risk is one of the essence of the business of banking. The extent to which
risk management is being managed or controlled could either be said to be an
art or science. Indeed a judicious mixture of both could form the subject of an
interesting if inconclusive debate (Richard, 2008). These would however surely
be little argument as to whether or not risk taking and risk management in
banking require the deployment of special skills and judgment for it is in this
field that banking ability of the individual or of the organization is most
critically tested.It is therefore in view of the foregoing that bankers
actually understand the very nature of foreign exchange risks, the methods of
analyzing them. The various types of risks involved and ways of mitigating
these risks. These and other aspect of foreign exchange risks form the various
subsection of this chapter.
2.2 Foreign
Exchange Risk Defined
Before
delving into the mechanics of foreign exchange risk management, it is pertinent
to attempt a definition of the term. Foreign exchange risk or currency risk
exposure as some authors prefers to call risk associated with in fluctuations
in currencies, has been defined severally by different authors. One thing that
is glaring is the lack of consensus on what the term actually connotes.Books on
this subject used a number of expressions lime economic transaction, accounting
transaction, balance sheet exposure but they do not define them in the same way
and very few authors have set out vigorous or formal definitions.Derosa (1991),
foreign exchange risk can be defined as the potential transaction, translation
gains and losses when foreign investments are valued in terms of the investors
home currency”Shapiro (1996) also advanced a simplistic definition when be
defined exchange risk as the variability in the value of the firm that is
caused by uncertain exchange rate changes.Thus, exchange risk is viewed as the
possibility that currency fluctuations can alter expected amounts or
variability of the firms’ future cash flows.Walker (2007) says that” an assets
liability or income stream is exposed to
exchange risk when a currency movement will change, for better of for worse,
its parent currency value” he were on to define accounting exposure as “ the
possibility that these foreign currency.Denominated items which are
consolidated into a company’s published financial statement will show
translation loss (or gain) as a result of currency movement since the previous
balance sheet date” he also defines economic exposure as the possibility that
the parent currency denominated net present value of foreign subsidiary’s cash
flows will be adversely affected by exchange rate movement”Kenyon (1984)
referred to foreign exchange risk as economic currency risk which he defined as
the risk that a sustained real use of a currency against the currencies of
competitors will adversely affect a company’s competitive costs and therefore
its sales, profit margins and market share, which in turn will reduce the
return on the capital and revenue investment previously sunk in its present
commercial activity and the present value of the investment.From the foregoing,
despite the difference in expressions and language used, it can be established
the foreign exchanged risk reference to the uncertainly surrounding variations
in the value of other currencies as compared to a local currency and the effect
of such risks on both the value of the company and its cash flow.
2.3 Why Do
Firms Deal in Foreign exchange?
It has been
argued on many occasions that the simplest way to avoid foreign exchange risk
is not to have the risk in the first place. This means the company/bank will
trade and sell in the currency of cost and by financial all assets by debts in
the same currency However, this is not to be as many organizations today
actively in the foreign exchange market. But why do firms engage in foreign
exchange? This is addressed below.
According to
Mapletoft (1991), there are three main reasons for dealing in foreign exchange.
To sell
receivable or purchase payable, mostly in fulfillment of business commitments opposite customers or
suppliers or financial commitment opposite banks and other institutions e.g
interest flows.
To mange
currencies as part of a comprehensive ongoing currency management position,
where for example maturing forward deals need to be rolled forward to future
period.
To take
positions where distinct views have been taken within the company on the desire
composition of its future flows of currency payable receivable and these views
differ from the company natural or unamended position
While the
first reason being common to all companies and the second more attributable to
the more sophisticated companies, the third reason is the one that most
interests the treasure, the bank and the market.It is therefore to this third
area that most commentators address their attention either to recommend (as
bank) or to bear and perceive a means to increasing understanding (as a
corporate) or to appraise and evaluate (as an analyst) or simple to comment (as
a newspaper). Given the forgoing as reasons to deal in foreign exchange the
motivation to act may differ, particularly for the many levels within the
corporate organization. The board, the management and the dealer for example
may have different views on the corporate decision to act. There are different
constraints impacting on the decision making process, these vary between
companies with some encouraging disciplined activity inherent in an over risk
management strategy.
The above
not withstanding the rationale is mostly characterized by a range of
requirement is involving one or more of the following objective.
To increase
certainly: for example, the sale forward of a
debt at least to ensure a given (say dollar or stealing) equivalent
value, for costing or return on sales, or to safeguard budget exchange rate for
transaction.
To provide
an element of smoothing some what more sophisticated and recognizing the
volatility of exchange rates, this desires is perhaps not to sell or purchase
at necessarily the best rates, but to time the transactions in order to even
exchange gains and losses over time and between budget periods.
To improve
on market rates: the most difficult task since all market participants would
like to achieve this, most difficult task since all market participants would
like to achieve this, but nevertheless the final arbiter of the comparative
success of the treasury operations.
2.4 What
makes currencies fluctuate?
A foreign
exchange rate is a price or a numerical expression of value of the currency of
one country in terms of that of another country at any given time. Having
established the reasons why firms/ banks trade in foreign exchange and the
motives for the transaction, it is pertinent to review those factors which make
currencies fluctuate.
Most
authorities believes that currencies movement are caused by some or all of the
following factors which influence the demand and supply of each currency in the
market .
Relative
price levels and inflation rate
Relative
economic growths
Relative
interest rates, especially in the freely traded money market like the Euro
currency market.
Relative
change in the money supply in the currency areas (countries) concerned
Investment
or portfolio preferences of big international investors like the OPEC
countries.
. Bandwagon
affects (if a currency seems to be on the way up, speculators may exaggerate to
trend by buying in the hope of a quick profit)
Intervention
by central banks
Interest
rate arbitrage.
Any of the
above factors can independently or in conjunction with other factors affect the
value of a particular currency. It is also important to stress the various
causes take different time spans to operate.
2.5
Definition and Types of Foreign Exchange Exposure (Risk)
Exchange
rate risk management is an integral part of every firm’s decision about foreign
currency exposure (Weston 2001). Currency risk hedging strategy entail
eliminating or reducing this risk, and requires understanding of both the ways
that the exchange rate could affect the operations of economic agents and
techniques to deal with the consequent risk implication (Barton and walker,
2002). Selecting the appropriate hedging strategy is often a daunting task due
to the complexities involved in measuring accurately current risk exposure and
deciding on the appropriate degree of risk exposure that ought to be
covered.The issue of currency risk management for banking firms is dependent
from there is business and is usually dealt with by their corporate
treasuries.As mentioned at the beginning of this chapter, when a firm has
assets or liabilities denominated in a foreign currency, profitability will be
influenced by the changes in the value of that currency.
Foreign exchange
Risk therefore refers to the degree to which a company is affected by exchange
rate changes.
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