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Foreign Exchange Risk Management in Commercial Banks in Pakistan

by Sabri, Maroof Hussain, MS

Abstract (Summary)
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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Bibliographical Information:

Advisor:Ramiz Rehman

School:The University of Lahore

School Location:Pakistan

Source Type:Master's Thesis

Keywords:Foreign exchange risk, currency risk, exchange rate risk, commercial banks in Pakistan, foreign currency exposure, currency derivatives

ISBN:

Date of Publication:04/14/2011

Document Text (Pages 1-10)

Foreign Exchange Risk Management in Commercial Banks
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:

Foreign Exchange Risk Management in Commercial
Banks of Pakistan

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

Below is the list of symbols used:

Symbols
NFXNA
NFX
OS
ERV
NEER
NA
PSCR
LPB
IFX

Explanation
Net Foreign Currency Exposure Relative to Net Assets
Net Foreign Currency Exposure
Ownership Status or Nature of Ownership
Exchange rate volatility
Nominal Effective Exchange Rate
Net Assets
Public Sector Commercial Banks
Local Private Banks
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;”

Foreign Exchange Market

Foreign Exchange Market is a market where the currencies are traded and is the
world’s biggest market across the globe. In this market, the price of one unit of a
currency is determined in the units of other currency. Major participants of FX
Market are commercial banks, central banks, governments, interbank brokerage
houses, exchange companies, people travelling abroad or receiving remittances
from other countries & money changers.

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.

Foreign Exchange Regimes

How a country manages is its own country and the FX market in its country is the
exchange rate regime that is being followed by the said country. A country can
follow any of the below mentioned exchange rate regimes:





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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