The Management Of Foreign Exchange

Published Date: 02 Nov 2017

Abstract

The increased volatility of exchange rates and interest rates, has given rise to increased financial price risks faced by companies. The management of these risks has become paramount for the survival of companies in today’s volatile financial markets. Following an analysis of data collected, we have been able to address our research objectives and questions as to identify the practices adopted by Mauritian banks and to what extent same are being used. We came across the various issues linked with usage of derivatives by banks and assess the future market of derivatives in Mauritian banking sector. We were able to compare our findings with the workings of other researchers in developed countries. However we have seen that in Mauritius, the derivatives markets are just now in the phase of expansion and need further enhancement to be more effective.

Introduction

Mauritius has a relatively well-developed financial system. The country’s highly developed and efficient banking system consists of 18 registered deposit-taking banks. Mauritius is famous as a major offshore banking centre, attracting capital from around the globe.

Sustained changes in the financial and competitive environment of industries, increasing globalization and increasing complexity of financial markets has led to an unprecedented period of currency and interest rate volatility worldwide. Being exposed to the international markets, Mauritius banks had to resort to the innovative foreign exchange and interest rate risks hedging techniques, known as derivatives. In Mauritius the derivatives market is rather developed, market activity is however expected to expand after the Global Board of Trade (GBOT) opened a multi-asset derivatives exchange in late 2010, on which a variety of African commodity and currency derivatives are offered.

The problem and its context

The fear of encountering foreign exchange and interest rates fluctuations and exposing a company to risk is often the deciding factor for a company to stay out of the global market. While hedging instruments such as currency futures, forwards and options have always been available, their relative complexity has hindered widespread adoption by the average investor. Many firms refrain from active management of their foreign exchange and interest rates exposure, as they consider any use of risk management tools, such as forwards, futures and options, as speculative.

Forecasting these fluctuations is important for planning purposes. However, new information surfaces constantly. Therefore, market-based forecasts rarely will come true.

In a corporation, there is no such thing as being perfectly hedged. Not every transaction can be matched, for international trade and production is a complex and uncertain business. Even identifying the correct currency of exposure, the currency of determination, is tricky. Flexibility is called for, and management must necessarily give some discretion, to the corporate treasury department or whichever unit is charged with managing foreign exchange and interest rates risks.

Significance of research

Currently there are few research papers about currency and interest rates exposure management in companies operating in the derivatives markets in Mauritius. The Mauritian derivatives market have constantly been evolving over the recent years and financial institutions are dealing with derivatives products such as swap currency options, futures, forwards and swaps among others. However despite the massive growth of these banks over a long period of time in the local market, their penetration in the global financial market has not been significant. One reason explaining this situation is that Mauritius is situated geographically far from the main markets where these products are traded notably Europe, America and Asia.

Theoretical studies like that of Copeland and Copeland (1999) are usually supported by the findings from developed countries which are the mainstream markets where these products are actively traded. Therefore, the application of such studies might be complicated in developing markets. Researchers that analyze the foreign exchange and interest rates exposure management in companies often use large samples and questionnaires to evaluate the derivate used, and are successful in describing countries with well-developed markets.

For emerging markets like Mauritius such quantitative approaches are extremely rare. Most often the situation with currency exposure management and application of derivatives by financial institutions is reflected in the newspapers. Yet, these articles are not academic papers and serve only as descriptions of the situation.

Literature review

The management of foreign exchange and interest rate risks has received increasing attention. The objectives of risk management include: to minimize foreign exchange losses, to reduce the volatility of cash flows, to protect earnings fluctuations, to increase profitability and to ensure survival of the firm (Fatemi, 2000). Firms are exposed to foreign exchange risk if the results of their projects depend on future exchange rates and if exchange rate changes cannot be fully anticipated. Generally, companies are exposed to transaction, economic and translation risks. According to Clark (1999), the risk manager's choice of the different types of hedging techniques may, however, be influenced by costs, taxes, effects on accounting conventions and regulation. Bodnar and Gentry (1993) note that:

"Although financial research has suggested that it is virtually impossible to outperform the expectations of future rates embedded in the market rates, financial managers have typically found it difficult to avoid letting their own view of the currency market affect their risk-management activities."

Stulz (1996) states two situations in which speculation is rational:

Financially distressed firms near bankruptcy; and

Firms with a comparative advantage in terms of market information.

Research Methodology

The methodology that will be used is that of desk research and Meta analysis. This method will assemble information from a large number of sources, including primary and secondary research, organize and analyze it in such a way as to create an understanding of the research material.

The main data collection technique used will be secondary research or desk research as well as interviews. These methods are chosen both because of the limited time available and of the amount of information already available on the subject matter. Secondary information will include primarily a literature review, which will provide background and theoretical information that can be used in order to form an overall picture of the theory and practice of using derivatives and interest rates structures. Other secondary data will be used to examine the issues at hand for analysis, including materials such as company reports, journal articles and time series, and previously conducted surveys that address the subject matter.

Data will be analysed using the both quantitative and qualitative methods based on the data available for analysis.

Limitations and delimitations

Access to information from banking institutions may be hampered due to confidentiality issues. The study will tackle the use of derivatives products for foreign exchange and interest rates by financial institutions to mitigate risks associated with daily transactions.

Statistical analysis

Quantitative analysis will be exploratory and descriptive, using data summaries in such methods as charts, tables, and descriptive statistics. Qualitative analysis techniques that will be used will include categorization, development and analysis of relationships, and descriptive techniques. This data analysis will be used in order to create an overall view of the data that can be used in order to explore the research questions.

Expected results

It will contribute to the increase in the number of academic studies about the use of derivatives in Mauritian markets. It will also contribute to the business community, as it will analyze the application of derivatives by financial institutions for hedging currency exposure and reveal the causes higher or lower popularity of derivatives. Finally it will apply the theoretical model which was developed based on the practice in developed countries, and test if the results from model application match the empirical findings in reality in Mauritius.

Dissertation structure

Chapter One will be the Introduction and it will start with an overview of the topic. Chapter Two will be the Literature Review and it will give a presentation of the theories relevant for the research problem. Chapter Three, the Methodology, deals with the method chosen for this thesis and how this method will result in resolving our problem statement. Chapter four which is the Analysis of Findings deal with the analysis of data used. Chapter Five, which is the last chapter, will consist of the Discussions, Recommendations and Conclusions.

Timetable and resources

A Gantt chart will be established in order to keep track of the study progress. Financial and material (stationeries) resources will be sufficiently available.

Budget and resources

Having large pool of data to analyse, we will have recourse to software such as SPSS to analyse them. Also we may incur printing costs such as paper & coloured ink for our charts and graphs.