Foreign Exchange Risks in Financial Institutions

Abstract

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

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

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

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

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

1 Introduction

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

1.1 Background of the study

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

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

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

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

1.2 Research questions

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

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

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

How these organizations measure the exposure of foreign exchange.

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

1.3 Purpose

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

1.4 Disposition

Chapter one: Introduction

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

Chapter two: Literature review

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

Chapter three: Research methodology

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

Chapter four: Empirical findings

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

Chapter five: Comparative Analysis

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

Chapter six: Conclusions and Recommendations

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