Risk Management of the Foreign Exchange within the Financial Industry and Institutions in the UK - Research Proposal Example

The risk management of the foreign exchange within the financial industry and institutions in the UK Name: Student ID: Course: Institution: Tutor: 1.0 Introduction 1.1 Background to the Research Problem With the ever globalizing economy, trade in the world are carried out with different currencies. In this respects currencies are subjected to the forces of supply and demand, and are traded in the market as a good (Jacque, 1997, p.3). However, financial institutions are vulnerable to unfavourable movement in foreign exchange that might cause loss of money and reduction in profitability. This calls for proper strategic risk management measures so as to counteract these adverse effects. It has been established that the occurrence of financial foreign exchange risk is attributed to mismatch in a financial institution liabilities and assets that are not subjected to fixed exchange rate and mismatches in currency cash flow. Moreover, the risks arise from different sources such as retail cash transactions, investment in foreign companies, investments denominated in foreign currencies and foreign currency retail accounts (Bank of Jamaica, 1996, p.3). In developed economies such as Britain, the amount of risk available in financial service industry are a function of the magnitude of possible exchange rate changes and the duration as well as size of foreign currency exposure. 1.2 Problem Statement To set the tone of the problem that is likely to afflict any financial institution, Nwankwo (1991) cited in Adetayo, Adetayo and Oladejo (2004, p.209) notes the below concerm. Foreign exchange risk is probably the most involved of the banking risks. The risks involved are frequently not limited to losses due to unanticipated exchange rate changes. As each bank has to be in a position to meet its own foreign currency demand on time, there are liquidity risks and there are also interest rate risks; for dealings in the forward foreign exchange market. Since exchange rate movements correlate with movements in relative interest rate, a mismatched currency position and a mismatched inherent position may frequently not be independent. Management of financial institutions need a lot of tools to be able to administer effectively in the day to day running of the financial institutions. This is even more critical when it pertain dealing in foreign exchange. Moreover, with the kind of economic turbulence that was observed during the global recession in 2009 and 2010 there is need to put in measures for managing risks associated with foreign exchange. While most of the financial institutions from UK would prefer to deal with sterling pound, in recent years there has been a phenomenal increase in the numbers of credit worthy foreign clients who insist on doing their transactions with their local currencies. In addition, there are and local clients doing international business and transactions they who also would prefer to bank with the local currencies of those countries they do business in. The risk with this kind of transaction is exposure to potential financial loss due to devaluation of the foreign currency against the sterling pound. While it is indeed true that this kind of transaction can be avoided, in the long run it would be detrimental to the financial institutions and the economy of UK at large since it may result in losing export opportunities and thus, imbalance of trade. In fact, with the more competitive internal business environment and the international one, the financial institutions that adopt this kind of measure is likely to loose out to those who are willing to accommodate their foreign buyers or clients by selling in their local currency. Worse still, this approach could lead to non payment by foreign client or local client who may find it difficult to meet UK’s sterling pound dominated payment obligations as a result of devaluation of their local currency against the UK’s sterling pound. Therefore, this kind of scenario calls for foreign exchange risk management programme that will allow the financial institution to remain competitive in the domestic and global market. One of the fundamental economic phenomena that is important for development and stabilization of a country economy is the foreign exchange services (Jain, 2007). As such, management of the country’s foreign exchange resources has evolved broadly in accordance with the liberalization of financial markets and economies. Generally, foreign exchange in developed economies such as the United Kingdom is managed and held to facilitate international transactions. Therefore, some of the objectives which the management of foreign transactions seeks to achieve include: profitability, liquidity, safety and adequacy of reserves. Coyle (2001) has noted that the main aim of foreign exchange risk management is to ensure that reserves are adequately maintained to cushion against temporary shortfalls in exchange receipts. Such an initiative allows the economy to adopt necessary measures in dealing with external shocks. 1.3 Purposes of the Study Horcher (2011) has explained in his book that financial institutions need to establish prudent and reasonable foreign exchange rate limits, which ensure that the level of exposure to foreign exchange rate risks does not exceed the set limits. Where possible, the limits should at a minimum cover the currencies to which an institution can incur exposure and the level of risk exposure that the institution can reasonably assume. Nidhi (2007) concurs with this argument and states that foreign exchange risk limits should be set in accordance with individual institution’s overall risk profiles as reflected by such factors as credit quality, capital adequacy and investment and interest rate risks. Banks play integral role in the growth and development of a nation’s economy. In their earlier years of existence banks focused more on deposit transactions. However with time banks have ventured into auxiliary services like foreign exchange transaction of both domestic and international payment system (Bank of Jamaica, 1996, p.3). Foreign exchange is normally a trade in foreign convertible currencies so as to meet financial obligation of the foreign world. In normal situations banks do have what is known as foreign exchange reserve which is a quantum of foreign exchange available at any time. At times, in order to meet their customers demand, they request foreign exchange through bidding. This kind of involvement if not well calculated can result into massive loss by the bank (Adetayo, Adetayo and Oladejo, 2004, p.207). Most of the transactions in foreign currency fall under the treasury department of that bank. The core function of this department is to offer value to the customer by enriching their financial services. Due to their wide scope, there might a rise certain kind of flaws that might hamper them in achieving their goals. To counteract these possible flaws, banks engage in measures such as limit on all unmatched foreign exchange positions, diversification of currency portfolio and provision of limits like day time exposure limit, limit per individual transaction individual and limit settlements zones (Adetayo, Adetayo and Oladejo, 2004, p.207). Therefore, the research aims at conducting analysis of how financial institutions in UK manage risks associated with foreign exchange. Moreover, it looks at how these risks arising from foreign exchange can be effectively managed in relation to the current policies put in place with financial institutions. 1.4 Scope and Limitation of the Study The study will be done within (insert your preferred financial institution) Bank in UK. The researcher will look the current policies and programmes put in place so as to counteract any possible flaws as result in trading in foreign exchange. The study will attempt to measure foreign exchange risk variable values like the net spot and forward positions in each currency or pairings of currencies in which the institution is authorised to have exposure, the aggregate net spot and forward positions in all currencies and transactional and translational gains and losses relating to trading and structural foreign exchange activities and exposures (Bank of Jamaica, 1996, p.6). In line with mitigation, the variables values that will be used to measure risk management of foreign exchange is the comprehensive system of limit on all unmatched foreign exchange positions and for diversification of currency portfolio so as to ensure that potential losses from foreseeable exchanges rate are kept to a minimum. Such operation limits include daytime exposure limits, overnight limits, limits for currency, limits per individual transaction and limits settlement zones along with regular reporting and appraisal modalities, independent inspection audits and hedging techniques. 1.5 Research Question 1. During foreign exchange transaction, what are the various exchange risks which the bank is vulnerable to? 2. How can these risks that emerge from foreign exchange transaction be managed? 3. What is the current management risk programme in the bank? 4. What are the best possible practices that the bank can adopt to manage foreign exchange risks? 1.6 Research Hypothesis Alternative Hypothesis Ha: Foreign exchange risks are hindrance to the positive roles foreign exchange plays in the UK’s economy Null Hypothesis H0: Foreign exchange risks are not hindrance to the positive roles foreign exchange plays in the UK’s economy 1.7 Justification and Significance of the Study Financial operations have becomes gradually complex as a result of the multiple risks and uncertainties associated with them. The key obstacles are how to conceptualize model and visualize risks, define and monitor the risks’ impacts, analyze the probability of risk occurrence and mitigate the negative impact of risks (Culp, 2001, p.210). One key component of risk management is business continuity planning. Risks management entails the protection of firm’s valuable components from a threat. Risk assessment is one of the key components in risk management. Risk assessment entails the predetermination of qualitative and quantitative value of risks connected to a situation and a likely threat or hazard. Qualitative approach to risk assessment entails calculations of two components of risks, magnitude of the potential loss and the probability for loss occurring. The assessment in great deal helps firms detect areas of concern so as to prioritize use of resource in order to maximize response and recovery efforts. The process exposes operations that are subject to a single point of failure (Hopkin, 2010, p.48 and 49). With the globalised world and need for expanded export market so that a country can enjoy positive balance of trade, there is eminent need for foreign exchange trade so that business can be conducted with a lot of ease. Banks play a crucial role in the development of UK’s economy. Moreover, one integral function that they aid is the ensuring of availability of foreign monies. This aid in international trade since one is able to do business at the international level with a lot of ease without minding exchange barriers. Commercial banks play an integral role of ensuring that a country maintains its foreign reserves so that the country can meet its financial obligations. However this trade in currency is not without risks. In away or another it can lead not only to loss of profitability by the bank but a reduction of nation’s foreign reserve (Greuning and Bratanovic, 2009, p.267). Thus, there is pertinent need to take great precaution while dealing in foreign exchange trade. This is what the study aims at conducting by taking a case study and analysing how their treasury department operates and offer best possible way for improvement due to the integral role of this service. 1.8 Assumptions of the study It is indeed true that in UK there are various foreign exchange risk management programmes initiated by different central banks and the commercial banks themselves. However, even more needs to be done at the commercial banks level so as to tighten the measures. In addition, since each bank has a different portfolio and capital outlay, it is important to formulate these policies in a domesticated manner that is unique and applicable to that specific institution. 1.9 Definition of terms and variables Foreign exchange risks means vulnerability to or exposure to unfavourable movement in foreign exchange that might cause loss of money and reduction in profitability. On the other hand, management of foreign exchange risks means comprehensive system used to ensure that potential losses from foreseeable exchanges rate are kept to a minimum (Bank of Jamaica, 1996, p.3). Chapter 2: Literature Review Insert literature review Chapter 3: Research Design and Methodology The research design is a term used to describe a number of decisions which need to be taken regarding the collection of data before actual data collection (Nwana, 1981, p.19).The bank to be used for the study is (insert the bank of your choice and branch) and has been operational for (insert years).The principal activities of the bank include the retail and corporate banking which focuses on import and export financing, bills discounting, leases finance and funds transfer and International trade. The study will employ the use of both the primary and secondary sources of information. The primary source will comprise of a structured questionnaires, to draw specific responses from the respondents. The study will rely on instrument administration in this case a questionnaire. The instrument will be divided into two parts: the first section centred on personal data of the respondents while the last section will cover the area of risk management in foreign exchange. The nominal and the ordinal 5-point likert scale will be used. According to Ugochukwu (1994, p. 27), population is the aggregate or totality of the units in the universe. Moreover, Okeke (1995, p.10) defines population as the collection of elements, units or individuals for which information is sought. The population for this study will be restricted to only the staff of the bank. To meet the statistical significant number (statistically significant number is 30), Data would be collected from forty respondents in the population who will be selected through stratified random sampling method (this you can review in relation to representative sampling and total number of population to be studied). Apart from primary source, the data for this study will be gathered through secondary sources. The data gathered will be analysed and interpreted using the simple arithmetic, percentages and inferential statistics. A non-parametric measure based on chi-square statistics will be employed to test the hypothesis and determine if there is any association between foreign exchange trading and risk management issues. References Adetayo, J.O., Adetayo, E. A. D. and Oladejo, B. 2004. Management of foreign exchange risk in a selected commercial bank, in Nigeria. J. Soc. Sci., Vol. 8, Issue No. 3, pp. 207-213. Coyle, B., 2001, Foreign Exchange Markets. New York: Taylor & Francis. Culp, C. L. 2001. Risk management process: business strategy and tactics. New York: John Wiley and Sons. Greuning , H. V. and Bratanovic, S. V. 2009. Analysing banking risk: a framework for assessing corporate governance and risk management. Washington, D.C.: The World Bank. Hopkin, P. 2010. Fundamentals of risk management: understanding, evaluating and implementing effective risk management. London: Kogan Page. Horcher, K. A., 2011. Essentials of Financial Risk Management. New York: John Wiley and Sons. Jacque, L. L. 1997. Management and control of foreign exchange risk. London: Springer. Jain, N., 2007, Foreign Exchange Risk Management. Boston: New Century Publications. Nidhi, J., 2007. Foreign Exchange Risk Management. Atlanta: New Century Publications. Nwana C. 1981. Research Methodology and Statistic for Beginning Research Student. Enugu: Awka, Christian printing and publishing. Okeke, A. O. 1995. Foundation Statistics for Business Decision. Enugu: High mega system Limited. The Bank of Jamaica. 1996. Standards of sound business practices: foreign exchange risk management. Retrieved on april 12th 2012 from: http://www.boj.org.jm/pdf/Standards- Foreign%20Exchange%20Risk%20Management.pdf. Uzochukwu, B. 1994. “Management Problems in Selected Public Utility Organizations in Enugu State” (Unpublished Post Graduate Diploma Research Project ESUT, Enugu). Read More