Document Text (Pages 11-20) Back to Document

Foreign Exchange Risk Management in Commercial Banks in Pakistan

by Sabri, Maroof Hussain, MS


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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.
Foreign Exchange Risk can be either Transactional or it can be Translational.
When the exchange rate changes unfavorably it give rise to Transactional Risk, as
the name implies because of transactions in Foreign Currencies, can be hedged
using different techniques. Other one Translational Risk is an accounting risk
arising because of the translation of the assets held in foreign currency or abroad.

Foreign Exchange Risk in Commercial Banks

Commercial banks, actively deal in foreign currencies holding assets and
liabilities in foreign denominated currencies, are continuously exposed to Foreign
Exchange Risk. Foreign Exchange Risk of a commercial bank comes from its
very trade and non-trade services.
Foreign Exchange Trading Activities (Saunders & Cornett, 2003)include:

1. The purchase and sale of foreign currencies to allow customers to partake

in and complete international commercial trade transactions.
2. The purchase and sale of foreign currencies to allow customers (or the

financial institution itself) to take positions in foreign real and financial
investments.
3. The Purchase and sale of foreign currencies for hedging purposes to offset

customer (or FI itself) exposure in any given currency.
4. To purchase and sale of foreign currencies for speculative purposes base

on forecasting or expecting future movements in Foreign Exchange rates.
The above mentioned Trade Activities do not expose a commercial bank to
foreign exchange risk as a result of all of the above. The commercial bank is
exposed to foreign exchange risk only upto the extent to which it has not hedged
or covered its position. Wherever there is any uncertainty that the future exchange
rates will affect the value of financial instruments, there lies the foreign exchange
risk of a commercial bank. Foreign Exchange risk does not lie where the future
exchange rate is predefined by using different instruments and tools by the bank.

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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.

Foreign Currency Exposure of a Commercial Bank

Any unhedged position in a particular currency gives rise to FX risk and such a
position is said to be Open Position in that particular currency. If a bank has sold
more foreign currency than he has purchased, it is said to be Net Short in that
currency, alternatively if it has purchased more foreign currency than it has
purchased than it is in Net Long position. Both of these positions are exposed to
risk as the foreign currency may fall in value as compared to local or home
currency and becomes a reason for substantial loss for the bank if it is in Net Long
position or the foreign currency may rise in value and cause losses if the bank is
Net Short in that currency.
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.

Exchange Rate Volatility

There is a real time fluctuation in floating exchange rate. The Exchange rate
volatility measures the degree to which the exchange rate fluctuates or varies over
a period of time. Exchange rate is said to be more volatile if there are more
frequent ups and downs or less volatile if there are lesser changes in it over a
period of time.

Foreign Exchange Risk Management

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Whenever a commercial bank deals in foreign currency, it is exposed to risk of
exchange rate. When these transactions are done on the behalf of customers, the
risk is also transferred to them and the bank has no exposure. Bank’s assets &
liabilities in foreign currencies or assets and liabilities in other countries give rise
to Foreign exchange risk which has to be managed by the bank.

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:
1. Foreign Currency Assets & Liabilities Matches: A commercial bank matches

its assets and liabilities in foreign currencies to ensure a profitable spread by
dealing in FX. By using this technique the positive profit spread is ensured
regardless of the movements in exchange rate at the respective maturities of
these assets and liabilities, in the investment period. For example, if a bank
has a liability in shape of a deposit for one year in US$ at rate of 3% p.a. and
it has another liability of same type but in PKR @ 10% p.a., it can match its
assets with these liabilities by advancing US$ at rate of 4.5% p.a. and PKR @
15% p.a. Using this the bank has locked into the profit of spread. Bank will
get US$ & PKR to repay the principal and exchange rate will not affect the
cost of exchanging the currencies.
2. Hedging using Derivatives: A commercial bank uses foreign currency

derivatives to hedge foreign exchange risk. Foreign currency derivatives are:
a. Foreign Currency Futures
b. Foreign Currency Swap
c. Foreign Currency Options
d. Foreign Currency Forward Contracts

The most popular amongst all others as mentioned above are FX forward
Contracts. Instead of matching FX asset-liability bank enters into a forward
contract having the same maturity. For example in above examples bank does
not need to advance loans in the same currency rather it uses forward
contracts to insulate FX risk. An important feature of such contracts is that
they do not appear on the balance sheet of the bank instead it appears under
the head of Contingencies & Commitments and hence are off-balance sheet
items.
3. Hedging through Diversification of Foreign Asset-Liability Portfolio:

Commercial Banks try to mitigate the foreign currency risk on its individual
currency by holding Multicurrency Asset-Liability Positions. Holding assets
and liabilities in various foreign currencies does not reduce the risk of the
portfolio of assets and liabilities of a bank alone but also significantly lower
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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.

Central Bank’s Role in Foreign Exchange Risk Management

Central Banks across the globe continuously strive to achieve the financial
stability in their respective economies. Nearly all the central banks issue
guidelines for Risk Management in the commercial banks which they have to
follow. State Bank of Pakistan has also issued a comprehensive set of guidelines
for the management of different types of risk faced by commercial banks
including foreign exchange risk. These guidelines provides the minimum
requirement and procedures to manage risks faced by a commercial bank and
focus on establishing Risk Management Committee & Asset Liability
Management committee by banks, setting limits for the open positions,
measurement & control of risk , independent audit of risk management process
and role board of directors & management.

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.
As per Risk Management Guidelines published by State Bank of Pakistan for
Commercial banks & DFIs, Foreign exchange risk also exposes a bank to Interest
Rate Risk due to the mismatches in the maturity pattern of foreign assets and
liabilities. Even if the maturities of different assets and liabilities are properly
matched, mismatches in the maturities of forward positions taken by bank also
expose it to interest rate risk. Since the banks hold assets and liabilities in foreign
currency, it also poses a serious risk of Counterparty (default) Risk, although in
such case there is no principal is at stake due to the notional principal of the
contracts but still the bank has to enter into different spot and forward positions to
cover such failed transactions. In this case bank faces replacement cost depending
upon the exchange rates at that time. The forex transactions with the parties
situated outside the home country also lead to Time Zone Risk, risk arising
because of difference of settlement time between the markets in two different
time-zones, and Sovereign or Country Risk.

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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:
1. Do the Pakistani commercial banks face foreign exchange risk.

Study the foreign exchange risk exposure of commercial banks in
Pakistan. Whether the Foreign Currency exposure of Commercial
Banks in Pakistan depends on Ownership Status (public sector
commercial bank or local private bank), its type (conventional or
Islamic), its size and exchange rate Volatility? Is there any
difference between the foreign currency exposure of conventional
banks and Islamic banks.
2. How do Pakistani commercial banks manage foreign exchange

risk? What are the different tools & instruments used by the
commercial banks in Pakistan to manage foreign currency risk
faced by them?
Are there any tools used by the commercial banks in

Pakistan?
If yes, what are the tools used by them?
Do all the banks use same tools?
3. What are the currency derivatives which are being used by the

commercial banks in Pakistan? Does the usage of these tools
depend on its ownership status, its type, Size of Bank & Exchange
Rate Volatility?
4. Study the income from dealing in foreign currencies by the

commercial banks in Pakistan? Compare the income from dealing
in foreign currencies of commercial banks in Pakistan between
different ownership categories (public sector commercial banks
and local private banks and types (conventional and Islamic). Does
using different mix of currency derivatives have any effect on the
income of the bank? Does size of bank or exchange rate volatility
have any effect on income from dealing in foreign currencies?

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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.
(Shamsuddin, 2009) mentioned that adoption of flexible exchange rate regime in
1983 along with financial system globalization have exposed Australian Banks to
new risks along with new opportunities. According to him small banks are
immune to changes in interest and exchange rate.
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

Year No. of Commercial Banks
in Pakistan (Excluding

Foreign Banks)
2005 24 20
2006 26 22
2007 30 26
2008 29 25
2009 29 25
Total 138 118
Missed Banks 8
Total Sample Size 110
No. of Commercial Banks

Listed on KSE

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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