Research On Banking Sector

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
Page | 1
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
Page | 2
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.
Page | 3
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.
Page | 4
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 Banks 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
Page | 5
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
Page | 6
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
Page | 7
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
Page | 8
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
Page | 9
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
countrys 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, travelers 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
worlds 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.
Page | 10
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.
Page | 11
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

Page | 12
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. Banks 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
Page | 13
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 Banks 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.
Page | 14
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?
Page | 15
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 firms 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.
Page | 16
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 treasurys
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).
Page | 17
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
Page | 18
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)
Page | 19
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
2005
2006
2007
2008
2009
Total
Missed Banks
Total Sample Size
No. of Commercial Banks

in Pakistan (Excluding
Foreign Banks)
24
26
30
29
29
138
No. of Commercial Banks

Listed on KSE
20
22
26
25
25
118
8
110
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.
Page | 20
Limitation of Scope of Research

i.
Foreign banks are not included in this study; hence, any findings do not
apply to Foreign Banks.
Data
Data used in this study is all of secondary nature. Annual reports of the
commercial banks are the major source of data along with various Statistical
Bulletins & publications by the State bank of Pakistan.
Foreign Currency Exposure of Commercial Banks in Pakistan

Foreign Currency Exposure of Commercial Banks gives an indication of the
foreign exchange risk assumed by bank.
Holding Net Asset or Net Liability in a currency gives rise to foreign currency
exposure into that currency. Banks hold multiple foreign currencies at a time and
sum of all the net positions in all the currencies held by a commercial bank is Net
Foreign Currency Exposure of the bank. This foreign currency exposure varies
from bank to bank and an attempt is made to understand different factors which
influence foreign currency exposure of a commercial bank.
To understand the foreign currency exposure of commercial banks in Pakistan,
below mentioned questions are designed:
1. Whether Commercial Banks in Pakistan take any foreign currency
exposure or not? If YES, does this exposure vary from bank to bank or
there is some fixed rule set to this?
2. Does there exist any relationship between Foreign Currency exposure &
other factors like Ownership Status (Type), Size of Bank and Exchange
Rate Volatility? Which of these factors is most significant?
3. Does Foreign Currency Exposure of Public Sector Commercial Banks
differ from than those of Local Private Banks?
4. Does Foreign Currency Exposure faced by Islamic Commercial banks
vary from those of Conventional commercial banks?
Answers to the above mentioned research questions can be achieved by using
different statistical and econometric techniques. The detailed methodology is
given below:
1. Net Foreign Currency Exposure
The very first research question is to check whether there is any Net Foreign
Currency Exposure assumed by the commercial banks in Pakistan. For this
purpose, Annual Financial Statements of listed commercial banks are studied. As
Page | 21
per the statutory requirements, all the banks operating in Pakistan including
commercial banks have to mention in the NOTES to Financial statements Net
Foreign Currency Exposure in Pakistani Rupees, the calculated net position by
bank, under the heading of Foreign Exchange Risk. Whether this Net Foreign
Currency Exposure varies from bank to bank or there is a set rule for all the
banks? If a bank has zero Net Foreign Currency Exposure, it means it has all of
his assets and liabilities hedged and offset against other currencies or in the same
currency. It can be analyzed either relative to Total Assets or Net Assets of the
bank; however, it is more appropriate to analyze it with its relativeness to Net
Assets. Therefore, a new variable is constructed i.e. Net Foreign Currency
Exposure relative to Net Assets, denoted by NFXNA. Descriptive are studied
for this variable NFXNA i.e. Max, Min, Mean & Standard Deviation.
2. Factors that Affect Foreign Currency Exposure
Does this variable NFXNA depends on different factors like Ownership Status,
Size of Bank & Exchange Rate Volatility and which of these factors is the most
significant one?
Using Linear Regression to Explore Relationship between NFX and Size,
Ownership Status & Exchange Rate Volatility
The below mentioned Regression Model is used to find out the relationship
between Foreign currency exposure and the factors that influence it:
= +
+ + +
Model 1: NFX depends on Size, Ownership & Exchange Rate Volatility
Where
NFXNA
Size
OS
ERV
= NFX relative to Net Assets

= Size of the Bank
= Ownership Status of Bank
= Exchange rate volatility
= Population parameter, intercept
= Population parameter, slope, regression coefficient
Hypothesis Testing:
Using this model below mentioned hypothesis will be tested to check the
significance of the model as a whole along with individual s as well.
Hypothesis 1:
Page | 22
H0: There is no relationship between NFXNA & Size, OS & ERV

H1: There is a relationship between NFXNA & Size, OS & ERV
F-test using Analysis of variance is used to check the overall significance of
regression.
SPSS is used to analyze Regression & Partial Regression coefficients and their
significance is studied from its output. Significance of individual Partial
Regression coefficients will be checked using t-tests & overall significance using
F-test. The vales of statistics t & F should be significant at a level of significance
of less than 0.05.
Regression analysis used in understanding this relationship is backward and the
final model with one independent variable obtained after eliminating all the lesser
significant independent variables out of a total of three tells, if there is any, the
relationship between the most significant variable & the dependent variable.
Independent Variables:
Net Foreign Currency Exposure Relative to Net Assets:
Net Foreign Currency Exposure relative to Net Assets is calculated for the
comparison purpose. Different commercial banks have different Net Assets that
represent the size of bank and obviously different net positions. Net foreign
currency exposure is divided by Net Assets so that a comparison can be done
between different banks. Therefore, it shows Net foreign currency exposure of a
bank relative to its size, otherwise using only NFX in the model will show its
maximum dependence on Net assets of bank and the effect of other factors will be
not taken into account.
Net Foreign Currency Exposure is calculated by using the following formula:
=
+
!"#$%&'()*+
Equation 1:Calculation of NFX
Net Foreign Currency Exposure is calculated by adding Net Open Position in all
Page | 23
currencies held by a bank. All the banks have mentioned this NFX in the Notes to
Financial Statement and hence that is used.
= /
Equation 2: NFXNA Calculation
Dependent Variables:
1. Size of Bank: Size of Bank can be measured either using number of
branches or the Net Assets (Net Assets = Equity). Since there are certain
banks in Pakistan having lower number of branches and their Net Assets
(or Equity) are higher than the Banks having higher number of branches.
Therefore, Size of Bank, for the purpose of understanding the relationship
under study, is measured by Net Assets. A further categorization could
have been done into small, medium and large (as done by the KPMGs
Banking Survey 2009) which has not been done to check the true impact
of bank size on the net foreign currency exposure.
2. Ownership Status: Ownership Status or Nature of Ownership. Usually
there are three categories of banks operating in Pakistan i.e. Public sector
commercial banks, local private banks & foreign banks. As foreign banks
have been excluded, therefore, only two categories are left herewith. As
ownership status is a category variable, therefore, a dummy variable OS is
introduced in this model. Coding for the dummy variable is 0 for Public
Sector Commercial Banks & 1 for Local Private Banks.
3. Exchange Rate Volatility: Exchange Rate Volatility is used as a measure
to understand the fluctuations in the exchange rate. Standard deviations &
percent changes are amongst the several measures used for exchange rate
volatility (Mbutor, 2010). Exchange rate is measured in units of Pak
Rupees Vis--vis US Dollars. An increase in exchange rate shows
depreciation or weakening of Pak rupee whereas a decrease shows
appreciation or strengthening of Pak Rupee against US dollar. Exchange
rate volatility in this model is calculated by taking standard deviation of
changes in daily price fluctuations. While constructing this variable, it is
assumed for this particular objective that using the historical price changes
can be used for the next period and not for the current period. Therefore,
volatility of previous year is related to the current foreign currency
exposure of current year i.e. if and only if the volatility has had any
impact on the Bankss Foreign currency exposure which is unhedged
position in foreign currencies, bank will adjust its exposure in the next
period. For example, if a bank has a policy to adjust its exposure by
Page | 24
deciding whether to hedge or take a speculative position depends upon

volatility of exchange rate; it will take Exchange rate volatility of previous
year into account as historical data is used for the future forecasting.
Multicollinearity Problem
Multicollinearity can distort the results in the model; hence it has to be checked
before running the multiple regression on the model. Multicollinearity is the
existence of strong correlation between independent variables. In this model,
independent variables i.e. Size of bank, Ownership Status & Exchange Rate
Volatility may exhibit correlation with each other. A correlation matrix can be
drawn and the one of the independent variables exhibiting a correlation of 0.5 or
higher has to be dropped.
Relationship between Net Foreign Currency Exposure & Net Assets
Relationship between Net Foreign Currency Exposure & Net Assets can be
studied using Simple Linear Regression as below:
= +
Model 2: Relationship between NFX & Net Assets
Where
NFX = Net Foreign Currency Exposure
NA
= Net Assets
& = Parameters of Model, intercept and slope respectively
In this model, NFX is dependent variable & NA is independent variable.
Hypothesis 2:
H0: There is no relationship between Net Foreign Currency Exposure and Net
Assets of Commercial Banks in Pakistan
H1: There is a relationship between Net Foreign Currency Exposure and Net
Assets of Commercial Banks in Pakistan
F-Test using ANOVA is used to check the significance of this regression. If the
value of F statistic is significant at a level of significant less than 0.05, it shows
that there is a significant relationship between both of these two variables or NFX
depends on Net Assets of bank.
3. Comparison of Net Foreign Currency Exposure of Public Sector &
Private Commercial Banks
Page | 25
Public Sector Commercial Banks & Local private Commercial banks are two
different ownership statuses of banks in Pakistan. It has to be checked whether
there is any difference between these two types as far as their NFXNA is
considered.
For this purpose same variable as constructed previously, Net Foreign Currency
Exposure Relative to Net Assets (NFXNA), is used.
Hypothesis 3:
H0: The mean of NFXNA of Public Sector Commercial Banks is not significantly
different than that of Local Private Banks.
H1: The mean of NFXNA of Public Sector Commercial Banks is significantly
different than that of Local Private Banks
The above written hypothesis is tested using Independent Sample t-Test. For this
purpose, first equality of variances is tested using Levenes Test. If the value of FTest is significant at a significance level less than 0.05, it shows that variances of
both groups are significantly different and if it is not significant, it shows that
variances are not significantly different. Finally t-test is used to check
independence of both groups and in this case if the value of t with the respective
degree of freedom is significant at a significance level of less than 0.05, it shows
that there is a significant difference between Net Foreign Currency Exposure
relative to Net assets of both types of ownerships of banks.
4. Comparison of Net Foreign Currency Exposure of Islamic &

Conventional Commercial Banks
With a continuous growth in the Islamic Banking in Pakistan, it is important to
check whether there is any difference between the Net foreign currency exposures
taken by them is different from than those of conventional commercial banks.
For this purpose same variable as constructed previously, Net Foreign Currency
Exposure Relative to Net Assets (NFXNA), is used.
Hypothesis 4:
H0: The mean of NFXNA of Islamic Banks is not significantly different than that
of Conventional banks.
H1: The mean of NFXNA of Islamic Banks is significantly different than that of
Conventional banks
Page | 26
The above written hypothesis is tested using Independent Sample t-Test. For this
purpose, first equality of variances is tested using Levenes Test. If the value of FTest is significant at a significance level less than 0.05, it shows that variances of
both groups are significantly different and if it is not significant, it shows that
variances are not significantly different. Finally t-test is used to check
independence of both groups and in this case if the value of t with the respective
degree of freedom is significant at a significance level of less than 0.05, it shows
that there is a significant difference between Net Foreign Currency Exposure of
both types of banks.
Page | 27
Different Tools & Instruments Used by Commercial Banks in

Pakistan to Manage Foreign Exchange Risk
All the commercial banks face Foreign Exchange Risk and they have to use
different tools and instruments to manage this type of risk. Now this study has to
explore in a broader spectrum, by taking into account all the Listed Commercial
Banks, different tools and instruments used by the Commercial Banks in Pakistan
for the management of foreign exchange risk.
To accomplish this objective, answers to the below mentioned questions had to be
found out:
5. Whether commercial banks in Pakistan use any tool or instrument to manage
foreign currency risk? If Yes, what are the different tools used by these
commercial banks to manage foreign currency risk?
6. Whether all the commercial banks use the same tools to manage risk or there
exists any difference regarding the usage of these tools? And If usage of these
tools varies from bank to bank, does it depend on Ownership Nature (Private
or Public Sector), Type of Bank (Islamic or Conventional) Size of Bank,
Banks Foreign Currency Exposure and Exchange Rate Volatility?
5. Tools & Instruments Used by Commercial Banks in Pakistan
Financial Statements of commercial banks are studied to find out whether the
commercial banks use any tool or instrument to measure this foreign exchange
risk or not. Such instruments and tools are disclosed in the notes to the financial
statements of all the banks. To address this answer a detailed and thorough study
of financial statements of commercial banks is conducted and a list of the tools
and instruments used by the commercial bank is prepared. A detailed report on
such tools and instruments, with reference to their usage by the commercial banks
in Pakistan, is given in the Findings & Analysis Section. A descriptive analysis is
conducted for this purpose.
6. Factors Influencing Usage of Foreign Exchange Risk Management
Tools
Financial statements and their notes provide the answer to the question that
whether all the commercial banks use the same tools or not. What are the tools
that are commonly used by all the banks and what are the tools which are
particularly used by used by certain banks.
Usage of these tools, particularly currency derivatives, certainly depends on
different factors like size of bank, nature of ownership (Private or Public Sector),
Type of Bank (Conventional or Islamic) Exchange Rate Volatility and its Foreign
Currency Exposure.
Page | 28
A.
B.
C.
D.
E.
Currency Derivatives & Ownership Status of Banks

Currency Derivatives & Type of Bank (Conventional or Islamic)
Currency Derivatives & Size of Bank
Currency Derivatives & Foreign Currency Exposure
Currency Derivatives & Exchange Rate Volatility
These different bank specific (A, B, C & D) & macroeconomic (E) factors
influence the usage of currency derivatives by the bank. These different factors
can be studied using different ways.
For A & B: Usage of currency derivatives by banks, as far as ownership status &
type of bank is concerned (A & B), is studied through descriptive analysis and
further their relationship, currency derivatives as dependent variable, is studied
using binary logistic regression.
For C, D & E: Relationship between Size of Bank, as measured by Net Assets (or
Equity, since equity and net assets are equal so net assets are used), and Selection
of currency derivatives is studied using binomial regression. Similarly,
relationship between currency derivatives and foreign currency exposure &
exchange rate volatility is also studied using binomial regression.
Currency Derivative Usage by Type of Banks
Type of banks here refers to conventional or Islamic banks. With a continuous
growth of Islamic banking across the globe and in Pakistan and the Islamic banks
dealing in multiple currencies at the same time, it is important to check whether
the Islamic banks use currency derivatives or not. For this purpose descriptive
study is done.
Currency Derivative Usage by Ownership Status
To explore the usage of currency derivatives by the commercial banks in Pakistan
with respect to its ownership status, a descriptive study is done.
Relationship between currency derivatives and other factors
Relationship between currency derivatives usage and other factors like Size of
Bank, Ownership status of bank, type of bank, net foreign currency exposure
relative to net assets & exchange rate volatility is studied using Binary Logistic
Regression.
Predictors:
Predictors in Binary Logistic Regression Model are:
I.
Ownership Status of Bank: This is a categorical variable, having two

categories Public Sector commercial bank and local private bank. Since, it
Page | 29
II.
III.
IV.
V.
has only two categories; it is entered as a single dummy variable with

values 0 and 1, 0 for Public sector commercial bank and 1 for Local
private bank.
Type of Bank: Type of bank is also entered as a dummy variable with two
categories Islamic and conventional, 0 for Conventional and 1 for Islamic.
This variable is entered in to the model to check whether changing the
type of bank results in the change in the usage of currency derivatives.
Size of Bank: Size of Bank is measured by the size of equity. Since,
equity is equal to Net Assets; hence, Net assets are used for this purpose.
However, Net Assets as entered in model are measured in billions rather
than in thousands to magnify its effect.
Net Foreign Currency Exposure Relative to Net Assets: This variable, as
used previously, is entered as a continuous variable in this Binary Logistic
Regression. This variable is entered in the model as a percentage.
Exchange Rate Volatility: Current Year Exchange rate volatility is
entered as a continuous variable. However, in this model, it is entered after
multiplying by 100.
Dependent Variable
Dependent variable in this case is Type of Derivatives used. There are three
types of currency derivatives that are being used by Banks in Pakistan i.e. forward
exchange contracts, currency swaps & foreign currency options. As Forwards are
used by all the banks and other types are not common, hence, a dichotomous
variable is constructed to include in the model. This variable has only two
categories, one is the banks which use forward exchange contracts only and other
one is the banks who use swaps and options also other than forwards. Former is
coded with 0 and later with 1.
Binary Logistic Regression Model
As the dependent variable is a discrete categorical variable with two categories, a
dichotomous variable, therefore the most appropriate statistical procedure for
studying it as Binary Logistic Regression. Whether commercial banks in Pakistan
use only forward exchange contracts or use swaps & options along with these
forwards.
The Logistic Model is as below:
Log[p/1-p]=a+b1X1+b2X2+b3X3+b4X4+b5X5
Model 3: Binary Logistic Model for Currency Derivative Usage
Page | 30
Where:
Log[p/1-p]
Logit [p]
=ln[p/1-p]
Constant
slope values (for independent variables 1 to 5)
Independent variables ( 1 to 5)
P can be calculated using the below formula, which is simply another

rearrangement of the above equation:
= a+b1X1+b2X2+b3X3+b4X4+b5X5 / 1+ a+b1X1+b2X2+b3X3+b4X4+b5X5
Model 4: Calculation of P using Binary Logistic Regression for Currency Derivative Usage
Where:
p
odds ratio
The Logits (Log Odds) are the b coefficients (Slope values) of the regression
equation. b coefficients (slope values) can be interpreted as the change in the Log
Odds due to a unit change in the independent variable. b for the Net Assets (in
billions rupees) can be interpreted as the change in Log Odds due to a one billion
change in net assets of a commercial bank. Similarly, the bs for all other
independent variables can be interpreted in the same way.
p here refers to as the Odds ratio, which is very important to interpret in this
model here. Odds ratio estimate the change in odds of the membership in the
target group (which is usage of tools other than forwards in this case) for a unit
increase in the independent variable. For example, changes in odds due to a unit
change in Net Assets, i.e. one billion rupees of net assets. It can be calculated as
the exponential of the regression coefficient, b, of the relative independent
variable.
Using this model, it has to be found out that what role does above mentioned
independent variables play for the selection of tools. Selection of tools means that
whether the banks use only forward exchange contracts or use swaps and options
along with forward exchange contracts. Using SPSS, Binary Logistic Regression
is run using Backward Stepwise based on Likelihood Ratio Test. All the
variables are entered in the model and then using backward stepwise method
based on Likelihood ratio tests, insignificant independent variables are removed
and finally only the significant variables are retained in the model.
Page | 31
Foreign Exchange Risk Management & its Impact on Income

Foreign Exchange Risk Management practices vary from bank to bank and so
does the income of banks. An important objective of this study is to study income
from dealing in foreign currencies and do different factors affect income from
dealing in foreign currencies.
Study the descriptive of Income from dealing in foreign currencies in
both Islamic & Conventional Banks & Comparison Between them
Income from dealing in foreign currencies of commercial banks with respect to its
type i.e. conventional or Islamic is studied using descriptive analysis. For this
purpose, the variable used is Income from Dealing in foreign currencies as a
percentage of total income. Further income from dealing in foreign currencies in
absolute terms is also descriptively analyzed. The actual purpose of using the both
variables in this descriptive analysis is to check descriptive in absolute terms as
well as in relative terms to its overall income.
To compare both these groups independent sample t-test is used and the below
mentioned hypothesis are formed:
H0: There is no significant difference between IFX of conventional banks and
Islamic Banks
H1: There is a significant difference between IFX of conventional banks and
Islamic Banks
Study the descriptive of Income from dealing in foreign currencies in
both Public Sector Commercial Banks and Local Private Banks &
Compare them
Income from dealing in foreign currencies of commercial banks with respect to its
ownership status i.e. whether it is a public sector commercial bank or local private
bank, is studied using descriptive analysis. Both the variables Income from
dealing in foreign currencies in absolute terms and in relative terms to overall
income.
To compare both these groups independent sample t-test is used and the below
mentioned hypothesis are formed:
H0: There is no significant difference between IFX of public sector commercial
banks and local private banks
H1: There is a significant difference between IFX of public sector commercial
banks and Islamic Banks
Page | 32
Income from dealing in foreign currencies and size of bank

It is very important to check whether size of bank have any effect on income from
dealing in foreign currencies. Simple Linear Regression model is used to check
this relationship. Two separate models are constructed to check the effect of size
of bank on income from dealing in foreign currencies. First model check the
effect of size on Income from dealing in foreign currencies in absolute terms (in
rupees) and second one check the effect of size on the Income from dealing in
foreign currencies relative to total income.
Independent Variable: Size of bank, as measured throughout this study using Net
Assets.
Dependent Variable (Model 1): IFXRS, Income from dealing in foreign
currencies (in 000 rupees)
Dependent Variable (Model 2): IFX, Income from dealing in foreign currencies as
a percentage of total income of bank.
Simple linear regression models used to investigate above relationships can be
given as:
=
+ +
Model 5: Model 1 of Relationship between Net Assets & IFXRS
- = + +
Model 6: Model 2 of Relationship between Net Assets & IFX
Hypothesis:
Following are the list of hypothesis constructed
H0: There is no linear relationship between Net Assets & Income from dealing in
foreign currencies in rupees.
H1: There is a linear relationship between Net Assets & Income from dealing in
foreign currencies in rupees.
H0: There is no linear relationship between Net Assets & Income from dealing in
foreign currencies relative to total income.
H1: There is a linear relationship between Net Assets & Income from dealing in
foreign currencies relative to total income
Effects of tools used on Income from Dealing in Foreign Currencies
Page | 33
Another objective of this study is to check whether the use of currency derivatives
have any impact on the income from dealing in foreign currencies of commercial
banks. This can be investigated using Simple Linear Regression.
Independent Variable: In this case independent variable is tools used by
commercial banks. This variable is entered into the simple linear regression model
as a dummy variable. As forwards contracts are used by all the commercial banks
of Pakistan therefore, again here two categories are formed, 0 & 1. 0 for the banks
who use only forward exchange contracts and 1 for the banks who use currency
swaps or foreign currency options or both along with these forwards exchange
contracts.
Dependent Variable: Dependent Variable in this case is Income from dealing in
foreign currencies as a percentage of total income of bank, as obtained from
Income Statement of respective commercial bank. Income from foreign currencies
is mentioned under non markup income head in income statement. This cannot be
directly used in this model due to the differences between the banks in size and
overall income, therefore, income from dealing in foreign currencies is taken as a
percentage of total income of the bank. Total Income here includes total Net
Markup Income and Markup income before deduction of any expenses. Net
markup income means total markup income earned less markup expenses as paid
on deposits. Therefore, using this variable as Income from foreign currencies as a
percentage of total income, denoted by IFX, adjusts for the interbank differences
of characteristics.
Model:
The simple linear regression model as used in this analysis is as below:
=
+ +
Model 7: Relationship between Tools used and IFX
Where
IFX =
of Total income
Income from dealing in foreign currencies as a percentage
Intercept of the model
Slope of the model, regression coefficient
Tools =
variable
Independent variable: tools used entered as a dummy
Page | 34
Error term
Using the above mentioned model, regression coefficient b, an unbiased estimate

of , is calculated and its significance is checked. To check the significance,
ANOVA is used and below mentioned hypothesis is constructed;
H0: There is no linear relationship between IFX & Tools
H1: There is a linear relationship between IFX & Tools
ANOVA is used to check the overall significance of this regression model. R
square explains the extent of relationship as explained by the regression model.
Income from dealing in foreign currencies and Exchange Rate Volatility
Exchange Rate Volatility is a very important phenomenon in the forex market. As
commercial banks deal in foreign currencies, it is very important to check whether
commercial banks are affected by the exchange rate volatility. Simple Linear
Regression model is used to check this relationship. Two separate models are
constructed to check the effect of exchange rate volatility on income from dealing
in foreign currencies. First model check the effect of Exchange Rate Volatility on
Income from dealing in foreign currencies in absolute terms (in rupees) and
second one check the effect of Exchange Rate Volatility on the Income from
dealing in foreign currencies relative to total income.
Independent Variable: Exchange Rate Volatility, for this purpose current year
exchange rate volatility is taken into account.
Dependent Variable (Model 1): IFXRS, Income from dealing in foreign
currencies (in 000 rupees)
Dependent Variable (Model 2): IFX, Income from dealing in foreign currencies as
a percentage of total income of bank.
Simple linear regression models used to investigate above relationships can be
given as:
=
+ +
Model 8: Model 1 of Relationship between ERV& IFXRS
=
+ +
Model 9: Model 2 of Relationship between ERV & IFX
Hypothesis:
Following are the list of hypothesis constructed
Page | 35
H0: There is no linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies in rupees.
H1: There is a linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies in rupees.
H0: There is no linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies relative to total income.
H1: There is a linear relationship between Exchange Rate Volatility & Income
from dealing in foreign currencies relative to total income
Page | 36
Page | 37
Findings & Analysis

Data obtained from Annual reports of commercial banks, statistical bulletins and
other publications by State Bank of Pakistan is analyzed using the above
methodology mentioned in the previous section. Different research methods and a
variety of statistical techniques are used for this purpose.
All the findings are mentioned in this section, along with analysis.
Page | 38
Findings on Net Foreign Currency Exposure of Commercial Banks in

Pakistan
Foreign Currency Exposure of commercial banks in Pakistan is studied and
findings relative to different research questions are below:
1. Net Foreign Currency Exposure
1. Annual reports of Commercial banks showed that majority of commercial
banks assume foreign currency exposure. All the commercial banks
mentioned their Net Foreign Currency Exposure in Notes to their financial
statements.
2. A new variable Net Foreign Currency Exposure Relative to Net Assets
(NFXNA) is constructed and analyzed.
a. Almost majority of the banks have positive figure which shows
that they hold overall Net Asset Position.
b. Few banks have zero as they do not take any exposure and keep
their positions offset and hedged all the time.
c. A few banks even have negative figure, which shows that they
hold overall NET LIABILITY POSITION.
Below is the table showing descriptive of the variable NFXNA:
Descriptive Statistics: Net Foreign Currency Exposure Relative to Net Assets

N
Range
2.18049
Minimum
-1.03309
Maximum
NFXNA
108
1.14740
Valid N (listwise)
108
Table ii: NFXNA, Descriptive Statistics
Mean
.7988934
Std. Deviation
.39340539
Descriptive statistics as mentioned in the above Table ii, clearly show that Net
foreign currency exposure varies from bank to bank. A standard deviation of
0.3934, as obtained from the data of 108 banks for the period 2005-2009, shows
the degree of dispersion in this variable and hence it can be said that Net foreign
currency exposure of banks vary and all the banks do not have the same ratio of
NFXNA.
2. Findings on Factors Affecting Foreign Currency Exposure
To study whether different factors as mentioned in previous section affect the Net
Foreign Currency Exposure of Commercial banks in Pakistan or not. Multiple
Linear Regression is used to check the relationship between Net Foreign
Currency Exposure Relative to Net Assets as a dependent variable and a set of
Page | 39
independent variables i.e. size of bank, ownership status of bank & exchange rate
volatility. To serve the purpose, below mentioned model (Model # 1) is formed:
= +
+ + +
A correlation matrix to check the correlation between independent variables so
that it can be found out if there is any Multicollinearity in the above mentioned
model or not. The correlation matrix is below:
Correlations
Ownership
Exchange
Status
Ownership Status
Pearson Correlation
Size
Size
Pearson Correlation
NFXNA
**
.073
-.056
.000
.448
.565
110
110
110
108
**
.125
.093
.193
.341
Sig. (2-tailed)
N
Rate Volatility
-.343
-.343
Sig. (2-tailed)
.000
110
110
110
108
Exchange Rate
Pearson Correlation
.073
.125
.142
Volatility
Sig. (2-tailed)
.448
.193
110
110
110
108
-.056
.093
.142
Sig. (2-tailed)
.565
.341
.142
108
108
108
NFXNA
Pearson Correlation
.142
108
**. Correlation is significant at the 0.01 level (2-tailed).

Table iii: Correlation between OS, Size & ERV
It is obvious from the above correlation matrix that the correlation between any of
two independent variables is not greater than 0.5 and is far less than this
threshold. Therefore, it can be said on the basis of the above mentioned findings
that there is no problem of Multicollinearity in this model.
After checking for the Multicollinearity and finding that there is no
Multicollinearity, Multiple Linear Regression is run on the data using the above
mentioned dependents and a set of independent variables, using SPSS Statistics
Processer. The output from SPSS is below:
Page | 40
Model Summary
Std. Error of the
Model
R Square
.167
Adjusted R Square
.028
Estimate
.000
.39342807
a. Predictors: (Constant), Size, Exchange Rate Volatility, Ownership Status
ANOVA
Model
1
Sum of Squares
Regression
df
Mean Square
.462
.154
Residual
16.098
104
.155
Total
16.560
107
Sig.
a
.996
.398
a. Predictors: (Constant), Size, Exchange Rate Volatility, Ownership Status

b. Dependent Variable: NFXNA
Coefficients
Standardized
Unstandardized Coefficients
Model
1
B
(Constant)
Ownership Status
Exchange Rate
Std. Error
.784
.125
-.054
.121
.336
9.561E-10
Coefficients
Beta
Sig.
6.266
.000
-.046
-.447
.656
.238
.139
1.414
.160
.000
.060
.580
.563
Volatility
Size
Table iv: Multiple Linear Regression Output of Relationship Between "NFXNA & "Size, OS & ERV"
Above mentioned tables show the output from the SPSS Statistics Processor. To
check whether there is any significant relationship between the dependent variable
and three independent variables is significant, F-Test is used and to check whether
partial regression coefficients are significant or not t-test is used. From the output
tables, the table showing the coefficients, it is evident that the three different
values of t-statistic, for three partial regression coefficients are not significant at
the desired level of significance. Further value of R Square is very small, which
shows that very small variation is explained because of linear relationship. The
value of F, calculated using ANOVA, is also not significant at the desired level of
Page | 41
significance. Since, the value of F-statistic is not significant, the multiple linear
regression is not overall significant.
Since, the regression is not overall significant, there is no relationship between
dependent variable & independent variables, the null hypothesis 1 is
substantiated. Now, based on our results, it can be said that Net Foreign
Currency Exposure Relative to Net Assets of commercial banks in Pakistan does
not depend on Size of Bank, Ownership Status of Bank & Exchange Rate
Volatility.
3. Relationship Between NFX & Net Assets

The below Model 2 is formed to check the relationship between Net Foreign
Currency Exposure and Net Assets of commercial banks in Pakistan.

A scatter diagram of both variables is below:
Figure 1: Scatter Diagram of NFX & Net Assets (Model 2)
Simple linear regression is used in this model and the output from SPSS Statistics
processor is below:
Model Summary
Model
R Square
Adjusted R
Std. Error of the
Square
Estimate
Page | 42
.960
.922
.921
7.06015E6
ANOVA
Model
1
Sum of Squares
df
Mean Square
Regression
6.264E16
6.264E16
Residual
5.333E15
107
4.985E13
Total
6.797E16
108
Sig.
1256.630
.000
a. Predictors: (Constant), Net Assets

b. Dependent Variable: Net Foreign Currency Exposure
Table v: Output for Regression: NFX & NA
Coefficients
Standardized
Model
1
Std. Error
(Constant)
-2420679.816
851025.994
Net Assets
.973
.027
Coefficients
Beta
.960
Sig.
-2.844
.005
35.449
.000
a. Dependent Variable: Net Foreign Currency Exposure
As per the above mentioned output of SPSS for model 2, it is evident that the
value of regression coefficient B is 0.973 with a standard error of 0.027. The
calculated value of t-statistic used to check its significance shows that it is
significant at the desired level of significance rather highly significant. Value of
R-square is very high which shows that there is a very strong relationship between
dependent and independent variables. To check the overall significance of model,
calculated value of F-Statistic is also significant.
In the light of the above results, null hypothesis 2 is rejected and the alternative
hypothesis 2 is accepted which states that there is a relationship between Net
Foreign Currency Exposure and Net Assets of Commercial Banks in Pakistan.
As there is a direct relationship between these two variables, if the Net assets of
the bank are changed, Net FX Exposure will also be changed. Model 2 differs
from the model 1 in that Model 1 takes into account NFXNA and studies its
relationship with Size of Bank which is measured by Net Assets of bank whereas
in model 2, Net Foreign Currency Exposure is related to Net Assets of bank.
Page | 43
4. Comparison of Net FX Exposure of Commercial banks in Private

Sector & Public Sector
While studying the Net Foreign Currency Exposure of Commercial Banks in
Pakistan, next objective is to compare the net foreign currency exposure of Public
Sector Commercial Banks (PSCB) and Local Private Banks (LPB). Results
(Output, using SPSS Statistics Processors) of the independent sample t-test are
below:
Group Statistics
Ownersh
ip Status
NFXNA
Mean
Std. Deviation
Std. Error Mean
PSCB
14
.8557330
.36257606
.09690253
LPB
94
.7904280
.39891236
.04114467
Independent Samples Test
Levene's Test for Equality of

Variances
NFXNA
Equal variances assumed
t-test for Equality of Means
Sig.
.874
.352
Equal variances not
df
.578
106
.620
18.028
assumed
Std. Error
Sig. (2-tailed)
Mean Difference
Difference
Page | 44
NFXNA
.565
.06530500
.11305264
Equal variances not assumed
.543
.06530500
.10527575
Table vi: Results of independent sample t-test to compare NFX of PSCR & LPB
Levenes Test is used to check the Equality of variances, since, the value of F is
not significant, therefore, variances of both groups is not significantly different
and hence equal variances are assumed.
Assuming equal variances, the value of t=0.578 with degree of freedom 106 is not
significant at the desired level of significance. There is no difference between
means NFXNA of Public Sector Commercial Banks & NFXNA of Local Private
Banks. Hence our Null Hypothesis 3 is substantiated.
5. Comparison of Net Foreign Currency Exposure of Islamic Vs
Conventional Banks
Independent sample t-test is used to check if there is a significant difference
between Islamic & Conventional banks as far as there Net Foreign Currency
Exposure is concerned. Below are the results (output from SPSS Statistics
Processor):
Group Statistics
Type
NFXNA
Mean
Std. Deviation
Std. Error Mean
Conventional
92
.7677321
.40961668
.04270549
Islamic
16
.9780714
.21426364
.05356591
Levene's Test for Equality of

Variances
Page | 45
NFXNA
Sig.
12.572
.001
Equal variances not
df
-2.001
106
-3.070
37.623
assumed
Table vii: Results of independent sample t-test to compare NFXNA for Islamic & Conventional Banks
Std. Error
Sig. (2-tailed)
NFXNA
Mean Difference
Difference
.048
-.21033936
.10509514
Equal variances not assumed
.004
-.21033936
.06850595
Table viii: Results of independent sample t-test to compare NFXNA for Islamic & Conventional Banks
Here Levenes test gives the value of F which is significant at p<0.01, therefore
equality (Homogeneity) of variances is not assumed. Using Independent Sample
t-test, value of t is -3.070 with degree of freedom of 37.623. This value of t is
significant as p-value is less than 0.01, therefore, it is established that there is a
significant difference between means of these two groups. Hence, null hypothesis
4 is rejected and alternative hypothesis 5 is accepted stating that there is a
significant difference NFXNA of Islamic Banks and Conventional Banks.
Page | 46
Findings on Usage of Different Tools for Foreign Exchange Risk

Management
Foreign Exchange Risk is managed by all the commercial banks in Pakistan and
the findings related to research objectives as listed in the previous sections are
given below in the same order as they appear previously:
5. Foreign Exchange Risk Management: Tools & Practices
Foreign exchange risk management practices as adopted by commercial banks in
Pakistan can be broadly listed as below:
Foreign Currency Portfolio Diversification

Foreign Currency Assets & Liabilities Matches
Use of Currency Derivatives
Foreign Currency Portfolio Diversification

Almost all commercial banks hold a portfolio of different foreign currencies i.e.
they deal in multiple currencies. Major currencies, in which they deal in and hold
open positions at the same time, are US Dollar (US$), Great British Pound (GBP),
Japanese Yen, Euro, UAE Dirham & Others.
Foreign Currency Assets & Liabilities Matches
Foreign currency assets and liabilities matching is a very common practice by the
commercial banks in Pakistan to hedge against foreign exchange risk. However,
such matches are strictly done within the limits. These limits are set internally by
the banks themselves, mostly by the Asset Liability Committee, as advised by the
State Bank of Pakistan. These limits control foreign currency exposure through
dealer limits, open foreign currency position limits & counterparty exposure
limits. Foreign currency assets and liabilities are also managed within the strict
limits as prescribed by the State bank of Pakistan.
Use of Currency Derivatives
The most important practice of managing foreign exchange risk involves currency
derivatives. Currency Derivatives are tools employed by every commercial bank,
however, selection of derivatives from the available ones vary from bank to bank.
In Pakistan, a descriptive analysis of such tools (currency derivatives), as used by
the commercial banks included in our sample, is given below:
Page | 47
Category
Frequency
Percent Cumulative Percent
Only Forward Exchange Contracts
63
57.3
57.3
Forward Exchange Contracts & Swaps
33
30.0
87.3
Forward Exchange Contracts, Swaps & Options
14
12.7
100.0
110
100.0
Total
Table ix: Descriptives: Currency Derivatives Usage
In the above table, 110 commercial banks included in sample, use different mix of
currency derivatives.
Majority of banks use forward exchange contracts only.

Some use a mix of forward exchange contracts and currency swaps.
Few banks use a mix of forward exchange contracts, currency swaps &
foreign exchange options.
None of the bank uses Futures for the Foreign exchange risk management
The main reason behind the no usage of Futures is lack of futures exchange in
Pakistan. Same is the reason behind the lesser usage of foreign currency options.
FX options are both exchange traded and over the counter. As there is no
exchange for trading of FX options therefore the FX options being traded here by
the commercial banks are usually over-the-counter. Forward exchange contracts
& currency swaps are also over the counter. Forward exchange contracts is the
most common and most important tool used by the commercial banks in Pakistan
as every bank use it whereas the currency swaps are the second popular tool used.
Swaps are usually long term foreign exchange risk management tool. Few banks
also use options, only 12.7% of our sample i.e. listed commercial banks of
Pakistan. As there is no specific exchange for the exchange traded options in
Pakistan, therefore, the option used by few banks are over the counter ones.
6. Currency Derivatives Usage
Currency derivatives are crucial for the management of foreign exchange risk. In
Pakistan, all the commercial banks use currency derivatives. Even if their policy
is not to use Derivatives, they still use forward exchange contracts.
Results show that all the banks whether public sector commercial banks or local
private banks use forward exchange contracts. 110 banks out of sample of 110
banks use forward exchange contracts. However, 33 out of 110 banks use swaps
in addition to forwards and 14 out of a total of 110 banks use foreign currency
options along with forwards and swaps as well. This is evident from the results
Page | 48
mentioned in the above table that public sector commercial banks do not use
foreign currency options at all.
Currency Derivatives Usage by Ownership Status
Currency derivatives are used by both Public Sector Commercial Banks and Local
Private Banks. To what extent these banks use currency derivatives, below are the
results:
Ownership
Public Sector
Local Private
Frequency
Percent
Cumulative Percent
Forwards
64.3
64.3
Forwards & Swaps
35.7
100.0
Total
14
100.0
Forwards
54
56.3
56.3
Forwards & Swaps
28
29.2
85.4
Forwards, Swaps & Options
14
14.6
100.0
Total
96
100.0
Table x: Currency Derivatives Usage by Ownership Status
Descriptive study, to check whether Islamic banks or conventional banks use

currency derivatives or not, is conducted. Findings in this context are mentioned
in a table below:
Currency Derivative Usage by Type of Bank
Cumulative
Type
Frequency
Conventional
Percent
Percent
Forwards
52
55.3
55.3
Forwards & Swaps
28
29.8
85.1
Forwards, Swaps &
14
14.9
100.0
Total
94
100.0
Forwards
11
68.8
68.8
31.3
100.0
16
100.0
Options
Islamic
Valid
Forwards, Swaps
Total
Table xi: Currency Derivative Usage by Type of Bank
Page | 49
Sample contains 110 banks in total, including 16 Islamic and 94 conventional

banks. All the banks, both Islamic and conventional banks, use forward exchange
contracts. Only 5 out of 16 Islamic banks use swaps along with forwards and none
of Islamic bank use foreign exchange options. However commercial banks use all
the three types of currency derivatives i.e. forwards, swaps and options. It is
evident from the above findings that only 14 out of 94 conventional banks use
foreign currency options. Therefore, the most popular tool is forward exchange
contracts and the least popular and used tool is foreign currency options.
Findings on Factors that affect Currency Derivative Usage
Using Binary Logistic Regression it is tried to establish what are the different
variables that affect the selection of tools for a commercial bank. A set of five
independent variables (Size of bank, Ownership Status of Bank, Type of Bank,
Net Foreign Currency Exposure and Exchange rate Volatility) are included in
model to check their relationship with tools selection as a dependent variable. The
objective is to find out the most significant variables which influence dependent
variable. For this purpose, Stepwise Backward method based on the Likelihood
ratio test is used with the help of SPSS.
Backward Stepwise Binary Logistic Regression took place in the following steps,
in order to reach the significant independent variables:
1. In the beginning the model is fitted with only constant and no independent
variable. After this model is again fitted using all of the five independent
variables. Therefore, step 1 involves the model with all the independent
variables in it.
2. In step 2, model is refitted removing independent variable Type of Bank
which proved to be insignificant on the basis of Likelihood Ratio test.
3. In step 3, another independent variable Current year exchange rate
volatility is removed from the model and the number of independent
variables in the model is reduced to three. These independent variables
include Ownership Status of Bank, Size of Bank (as measured by Net
Assets) and Net foreign currency exposure relative to net assets.
Both Type & Current ERV are removed from model based on the Likelihood ratio
test. The summary of results of likelihood ratio test is given below:
Model if Term Removed
Variable
Model Log
Change in -2 Log
Likelihood
Likelihood
Sig. of the
df
Change
Page | 50
Step 1
Step 2
Step 3
OS
-56.634
7.040
.008
TYPE
-53.120
.012
.911
Size (NA)
-73.188
40.147
.000
NFXNA
-54.109
1.990
.158
Current ERV
-53.430
.632
.427
OS
-56.706
7.170
.007
Size (NA)
-73.618
40.996
.000
NFXNA
-54.139
2.038
.153
Current ERV
-53.440
.639
.424
OS
-56.801
6.724
.010
Size (NA)
-73.650
40.420
.000
NFXNA
-54.964
3.049
.081
Table xii: Factors that affect Currency Derivative Usage: Result of Binary Logistic regression
Below is the summary of Logits and Odd Ratios which show that how the binary
logistic regression model is changed from five independent variables to three
independent variables, Step 1 & 2 do not need to be discussed in detail, however,
step 3 needs to be explained in detail as it corresponds to our objective of this
study.
Variables in the Equation

B
Step 1
Step 2
OS(1)
S.E.
Wald
df
Sig.
Exp(B)
-3.257
1.679
3.763
.052
.039
TYPE(1)
-.072
.642
.012
.911
.931
Size (NA)
.086
.021
16.757
.000
1.090
NFXNA
-.008
.006
1.962
.161
.992
Current ERV
-.012
.015
.627
.428
.989
Constant
-.484
.798
.368
.544
.616
-3.262
1.676
3.787
.052
.038
.086
.021
16.818
.000
1.090
NFXNA
-.008
.006
2.013
.156
.992
Current ERV
-.012
.015
.634
.426
.988
Constant
-.552
.525
1.104
.293
.576
OS(1)
Size (NA)
Page | 51
Step 3
OS(1)
-3.053
1.580
3.736
.053
.047
.084
.020
16.779
.000
1.087
NFXNA
-.010
.006
2.997
.083
.990
Constant
-.647
.512
1.595
.207
.523
Size (NA)
a. Variable(s) entered on step 1: OS, TYPE, NA, NFXNA, Current ERV.

Table xiii: Logits & Odds ratio Results of Binary Logistic Regression
The second column, with heading B, shows the values of regression coefficient
during each step. Logits (Log Odds) are the regression coefficients of the model
which show the impact of a unit increase in the independent variable on the
dependent variable i.e. how does a unit increase in independent variables affects
the decision of the commercial bank to select the tools for foreign exchange risk
management. In the last column, Exp (B) i.e. Odds Ratios are mentioned which
shows that how do a unit increase in independent variables changes the odds of
usage of swaps options along with forwards by a commercial bank.
It is important to interpret the odds ratio in step 3 here. If the ownership status of
bank is changed from public sector commercial bank to local private bank, the
odds of using swaps & options are
0.047 times greater than public sector commercial bank. This shows a weak
influence of ownership status on decision of usage of swaps and options. If the
Net Assets of bank are increased by one billion, the odds of usage of swaps and
options are 1.087 times greater. If NFXNA, when expressed as percentage, is
increased by one percent the odds are 0.99 times greater for the usage of swaps
and options.
Cox & Snell R square for the model as in step 3 is 0.321 and Nagelkerke R square
is 0.430. Based on these results, it can be stated that using our model 43% of the
changes in decision to use swaps and option are because of the independent
variables in our model.
Page | 52
Findings on Income from Dealing in Foreign Currencies and its

Relationship with other Factors
Income from dealing in foreign currencies is mentioned separately in the income
statement of commercial banks under the head of Income from dealing in foreign
currencies. Findings related to this income as per the research objectives of this
study are given below:
Findings on Income from dealing in foreign currencies and Type of
commercial banks (Conventional & Islamic)
Below are the findings regarding the variables income from dealing in foreign
currencies in absolute terms and income from dealing in foreign currencies
relative to its total income.
Descriptive Statistics for Convenntional Banks

N
Minimum
Maximum
Mean
Std. Deviation
IFX % of TI
94
-32.01639
33.53655
5.0842763
6.69593911
Income from FX
94
-79327.00
3969057.00
513044.2766
6.98267E5
Descriptive Statistics for Islamic Banks

N
Minimum
Maximum
Mean
Std. Deviation
IFX % of TI
16
.58781
21.15430
6.9507450
4.87415155
Income from FX
16
740.00
1019732.00
337289.6875
3.15040E5
Table xiv: Descriptives for IFX and IFXRS by Type of Bank
Comparison of IFX of Conventional & Islamic Banks

Independent sample t-test is used to test the hypothesis that there is no significant
difference between means of conventional and Islamic banks.
The value of F using Levenes test is insignificant and hence it is assumed that
variances are not different. The value of t is -1.066 which is not significant at
desired level of significance (as it is significant at 0.289) hence Null hypothesis is
accepted that there is no significant difference between the means of IFX of
commercial banks and Islamic banks.
Page | 53
Findings on Income from dealing in foreign currencies and Ownership

Status of commercial bank (PSCB and LPB)
Results of the descriptive statistics for commercial banks with respect to
ownership status are below:
Descriptive Statistics for Public Sector Commercial Banks
N
Minimum
Maximum
Mean
Std. Deviation
IFX % of TI
14
.24369
7.42242
3.2638994
1.96094421
Income from FX
14
3371.00
3969057.00
835056.3571
1.23401E6
Descriptive Statistics Local Private Banks

N
Minimum
Maximum
Mean
Std. Deviation
IFX % of TI
96
-32.01639
33.53655
5.6608261
6.84683360
Income from FX
96
-79327.00
2229809.00
436791.7500
5.18312E5
Table xv: Desxriptive Statistics for IFX and IFXRS by Ownership Status
Comparison of IFX between Public Sector Commercial Bank & Local

Private Banks
To compare the mean IFX of public sector commercial banks & local private
banks, independent sample t-test is used.
The Levenes test is significant and equality of variances is assumed. The
calculated value of t is -1.297 which is significant at 0.1097 level of significance.
Since level of significance is much higher than the desired one, null hypothesis is
accepted which shows that both groups have not significantly different means.
Table xvi: Descriptive Statistics for IFX and IFXRS by Ownership
Table xvii: Descriptive Statistics of IFX and IFXRS by Ownership Status of Bank
Findings on Income from dealing in foreign currencies and Size of Bank

as measured by Net Assets
Using the simple linear regression, following outputs are produced:
Model 1:
Page | 54
Model Summary
Model
.764
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
.584
.581
4.26448E5
a. Predictors: (Constant), Net Assets in Billions
ANOVA
Model
1
Sum of Squares
df
Mean Square
Regression
2.762E13
2.762E13
Residual
1.964E13
108
1.819E11
Total
4.726E13
109
Sig.
a
151.849
.000

b. Dependent Variable: Income from dealing in foreign currencies in 000 Rs.
Coefficients
Standardized
Model
1
B
(Constant)
Net Assets in Billions
Coefficients
Std. Error
106691.287
51070.033
20390.617
1654.717
Beta
.764
Sig.
2.089
.039
12.323
.000
a. Dependent Variable: Income from dealing in foreign currencies in 000 Rs.

Table xviii: Output of Regression: IFXRS on NA
The first model to study the impact of Size of bank, as measured by Net Assets,
on the Income from dealing in foreign currencies show that there is a significant
relationship. The model R square shows that 58.1% of variation is explained by
the relationship. The value of b i.e. 20390.617 is also significant. Since there is a
relationship between independent and dependent variable, therefore, null
hypothesis is rejected and alternative hypothesis is rejected.
Page | 55
Model 2:
Model Summary
Model
.067
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
.004
-.005
6.49309152
ANOVA
Model
1
Sum of Squares
Regression
df
Mean Square
20.397
20.397
Residual
4553.306
108
42.160
Total
4573.703
109
Sig.
a
.484
.488

b. Dependent Variable: Income from dealing in foreign currencies as a percentage of total income
Coefficients
Standardized
Model
1
Std. Error
(Constant)
5.683
.778
Net Assets in Billions
-.018
.025
Coefficients
Beta
-.067
Sig.
7.308
.000
-.696
.488
a. Dependent Variable: Income from dealing in foreign currencies as a percentage of total income
Table xix: Output of Regression: IFX on NA
Results for the model constructed to investigate the relationship between net
assets (size of bank) and income from dealing in foreign currencies as a
percentage of total income indicates that there is no significant relationship
between these two variables. Null hypothesis is accepted in this case.
The difference between results shown by these two models can be interpreted as
increasing the size of bank increases the income from dealing in foreign
currencies in bank. However, if this income from dealing in foreign currencies is
taken as a percentage of total income of bank, net assets does not affect this
income. It can be said on the basis of findings that Size of bank does not help in
earning extra income from dealing in foreign currencies by simply increasing the
size of bank.
Page | 56
Findings on Income from dealing in foreign currencies and Currency

Derivatives used by commercial banks
The simple linear regression, as described in the methodology section is used with
the help of SPSS and below are the relevant outputs as produced by SPSS.
Model Summary
Model
.078
Adjusted R
Std. Error of the
Square
Estimate
R Square
a
.006
-.003
6.48770060
a. Predictors: (Constant), Tools
Coefficients
Standardized
Model
1
Std. Error
Coefficients
Beta
(Constant)
4.920
.817
Tools
1.019
1.250
.078
Sig.
6.020
.000
.815
.417
a. Dependent Variable: IFX % of TI
ANOVA
Model
1
Sum of Squares
Regression
df
Mean Square
27.955
27.955
Residual
4545.748
108
42.090
Total
4573.703
109
Sig.
.664
.417
a. Predictors: (Constant), Tools

b. Dependent Variable: IFX
Table xx: Regression output IFX on Tools
The above mentioned results show that b is not significant. Also the overall
regression is not significant at the 0.10 level of significance. There is a very weak,
almost no relationship between these two variables, as evident from the value of R
square. Since there is no relationship, therefore, null hypothesis substantiates and
it can be said that in Pakistan, income from dealing in foreign currencies is not
affected by using different tools.
Page | 57
Findings on Effect of Exchange Rate Volatility on Income from Dealing

in Foreign Currencies
To examine whether Exchange rate volatility have any effect on the income from
dealing in foreign currencies, two separate models are constructed.
Result of Model with Income from dealing in foreign currencies in rupees
in 000
First model contains income from dealing in foreign currencies in Rs.000 as
dependent variable. Output produced by SPSS is presented below:
Model Summary
Model
.277
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
.077
.068
6.35607E5
a. Predictors: (Constant), Current Year Exchange Rate Volatility

b
ANOVA
Model
1
Sum of Squares
df
Mean Square
Regression
3.624E12
3.624E12
Residual
4.363E13
108
4.040E11
Total
4.726E13
109
Sig.
a
8.971
.003

b. Dependent Variable: Income from dealing in foreign currencies in Rs. 000
a
Coefficients
Standardized
Model
1
B
(Constant)
Current Year
Std. Error
281336.798
91704.883
1036856.895
346183.103
Coefficients
Beta
.277
Sig.
3.068
.003
2.995
.003
ERV
a.
Dependent Variable: Income from dealing in foreign currencies in Rs. 000
Table xxi: Regression Output IFXRS on ERV
Page | 58
Using Income from dealing in foreign currencies in Rs. 000 in the simple linear
regression model showed a weak but significant relationship between the
independent variable and the dependent variable. R square in this model shows
that less than 7% variation is explained due to linear relationship between the
variables. Therefore, null hypothesis is rejected and alternate hypothesis is
accepted.
Result of Model with Income from dealing in foreign currencies relative to
total income
Results of the simple linear regression to check the impact of the Exchange rate
volatility on the income of the bank using income from dealing in foreign
currencies as a percentage of total income are below:
Model Summary
Model
.006
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
.000
-.009
6.50749413

b
ANOVA
Model
1
Sum of Squares
Regression
df
Mean Square
.175
.175
Residual
4573.528
108
42.347
Total
4573.703
109
Sig.
a
.004
.949

b. Dependent Variable: IFX % of TI
Coefficients
Standardized
Model
1
B
(Constant)
Current ERV
Std. Error
5.310
.939
.228
3.544
Coefficients
Beta
.006
Sig.
5.656
.000
.064
.949
Page | 59
Coefficients
Standardized
Model
1
B
(Constant)
Current ERV
Std. Error
5.310
.939
.228
3.544
Coefficients
Beta
.006
Sig.
5.656
.000
.064
.949
a. Dependent Variable: IFX % of TI

Table xxii: Regression Output of IFX on ERV
Results of the simple linear regression show that there is no significant

relationship between the independent variable and the dependent variable used in
this model. Therefore, Null hypothesis is substantiated and it can be said that
exchange rate volatility has no impact on the income of the income of the
commercial banks in Pakistan.
Page | 60
Conclusion
Based on the findings of this study, following conclusions can be drawn regarding
the Foreign currency exposure, ways to manage foreign exchange risk, currency
derivatives usage & income from dealing in foreign currencies of the commercial
banks in Pakistan:
Foreign Currency Exposure of Commercial Banks in Pakistan
Majority of the bank have significant net position in foreign currencies and this
position varies from bank to bank. If net foreign currency exposure of commercial
banks is taken as a percentage of Net Assets, different factors which are
Ownership Status, Exchange Rate Volatility and Size of Bank do not have any
effect on it. Some bank have zero exposure, majority have net foreign currency
exposure equivalent to or around Net Assets. Net foreign currency exposure is
positively related to Net Assets which means that majority of banks have Net
positions moved with the movement in their Net Assets. There is no difference
between the Net positions as taken by Public Sector Commercial Banks and Local
Private Banks whereas there is a significant difference between the net positions
of conventional and Islamic banks.
Foreign Exchange Risk Management by Commercial Banks in Pakistan
Commercial banks in Pakistan use different tools to manage foreign exchange risk
which include foreign currency portfolio diversification, foreign currency assets
and liabilities matches and Use of currency derivatives.
Usage of Currency Derivatives by the Commercial Banks in Pakistan
In Pakistan, commercial banks use three types of currency derivatives i.e. forward
exchange contracts, currency swaps & foreign currency options. All of these
contracts are over the counter. Forward exchange contracts are used by all the
banks whereas currency swaps are second popular tools used by commercial
banks and foreign exchange options are used by only few banks. The usage of
currency derivatives depends on the ownership status of bank, size of banks and
net foreign currency exposure relative to net assets whereas it does not depend on
exchange rate volatility and type of bank.
Income from Dealing in Foreign Currencies
Income from dealing in foreign currencies is not different if the type of bank or
ownership of bank is considered. Similarly size of bank does not play any role in
increasing income from dealing in foreign currencies of banks. Type of currency
derivative used & exchange rate volatility during the year also do not have any
effect on income from dealing in foreign currencies.
Page | 61
Page | 62
References
Abken, P. A., & Shrikhande, M. M. (1997). The role of currency derivatives in
internationally diversified portfolios. Economic Review of Federal Reserve
Bank of Atlanta, Third Quarter 1997.
Allayannis, G., Ihrig, J., & Weston, J. (n.d.). Exchange Rate Hedging: Finacial
Vs. Operational Strategies. American Economic Review Papers &
Proceedings, 91 (2), pp391-395.
Allayannis, George, Ofek, & Eli. (2001). Exchange Rate Exposure, hedging and
the use of foreign currency derivatives. Jounal of International Money and
Finance, 20 (2001) 273-296.
Allen, S. L. (2003). Financial Risk Management: A Practitioners Guide to
Managing Market and Credit Risk. Hoboken, New Jersey: John Wiley and
Sons.
Atindehou, R., & Gueyie, J. (2001). Canadian Chartered Banks' Stock returns and
exchange rate risk. Management Decisions, 39 (4), 285-295.
Barton, T. L., Shenkir, W. G., & Walker, P. L. (2002). making Enterprise Ris
Management Pay Off: How Leading Companies Implement Risk
Management. Brookfield, Connecticut: Fei Research Foundation.
Choi, J. J., Elyasiani, E., & Kopecky, K. J. (1992). The sensitivity of bank stock
returns to market, interest & exchange rate risks. Jounal of Banking and
Finance, 16, 983-1004.
Daugaard, D., & Valentine, T. (1993). Bank Share prices and profit stability.
Working Paper Series (No.31), School of Finance & Economics,
University of Technology. Sydney.
Gandhi, G. S. (2006). Hedging Foreign Exchange Risk - Isn't it also a risk. The
Instt. of Chartered Accountants of India, "The Chartered Accountant",
August 2006, Page 260-264.
Gandhi, G. S. (2006, Novemner). Selecting a Suitable Currency Options Hedging
Strategy for Managing Foreign Exchange Risk. "The Chartered
Accountant". The Instt. of Chartered Accountants of India.
Page | 63
GECZY, C., MINTON, B. A., & SCHRAND, C. (1997, September). Why Firms
Use Currency Derivatives. The Journal of Finance, Vol. 52. No.4, pp.
1323-1354. BlackWell Publishing.
Hue Hawa Au Yong, Faff, R., & Chalmers, K. (2006). Derivative Activities and
Asia Pacific banks' interest rate and exchange rate exposures. Journal of
International Financial Markets, Institutions and Money, Volume 19,
Issue 1, February 2009, Pages 16-32.
Irio, A. D., & Faff, R. (2000). An Analysis of asymmetry in foreign currency
exposure of the Australian equities market. Jounal of Multinational
FInancial Management, 133-159.
Lam, J. (2003). Enterprise Risk Management: From Incentives to Controls.
Hoboken, New Jersey:John Wiley and Sons.
Liu, S. (2007). Currency Derivatives and Exchange Rate Forecastability.
Financial Analysts Journal, volume 63, Number 4, Page 72-78.
Mbutor, M. O. (2010, November). Exchange rate volatility, stock price
fluctuations and lending behavior of banks in Nigeria. Journal of
Economics & International Finance, Vol 2(11),p.p 251-260.
Pakistan, S. B. (n.d.). Risk Management: Guidelines for Commercial Banks &
DFIs. Karachi, Pakistan: State Bank of Pakistan.
Papaioannou, M. (2001). Volatility and Misalignments of EMS and Other
Currencies During 1974-1998. In J. Jay Choi and Jeffrey M. Wrase (eds).
European Monetary Union and Capital Markets, International Finance
Review, 2, Amsterdam:Elsvier Science, pp. 51-96.
Papaioannou, M. G. (2006). EXCHANGE RATE RISK MEASUREMENT AND
MANAGEMENT: ISSUES AND APPROACHES FOR FIRMS. SouthEastern Europe Journal of Economics 2 (2006) 129-146.
Saunders, A., & Cornett, M. M. (2003). Financial Institution Management. New
York, NY, 10020: McGraw-Hill/Irwin.
Shamsuddin, A. F. (2009). Interest rate and foreign exchange exposure of
Australian banks: A note. International Journal of Banking and Finance
2008/09, vol:6, Number 2:2009: 129-138. University of New Castle,
Australia.
Suranovic, S. (2010). International Finance: Theory & Policy. The International
Economics Study Center.
Page | 64
Walter, A. d., & Tewodros, G. G. (2004). The Exchange Rate Exposure of Major
Commercial Banks in South Africa. African Finance Journal, Vol: 6,
Page 21-35.
Page | 65

Research On Banking Sector

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Research On Banking Sector

Uploaded by

Copyright:

Available Formats

Foreign Exchange Risk Management in Commercial Banks

The Thesis committee for Mr. Maroof Hussain Sabri

Foreign Exchange Risk Management in Commercial

Net Foreign Currency Exposure ......................................................... 21

Factors that Affect Foreign Currency Exposure ................................. 22

Tools & Instruments Used by Commercial Banks in Pakistan .......... 28

Net Foreign Currency Exposure ......................................................... 39

Findings on Factors Affecting Foreign Currency Exposure ............. 39

Relationship Between NFX & Net Assets .......................................... 42

Foreign Exchange Risk Management: Tools & Practices .................. 47

Currency Derivatives Usage ............................................................... 48

Findings on Factors that affect Currency Derivative Usage ......................... 50

Findings on Income from dealing in foreign currencies and Type of

Foreign Exchange Market

Foreign Exchange Regimes

Foreign Exchange Risk

Foreign Exchange Risk in Commercial Banks

The abovementioned trade activities are the typical trade activities of a

Foreign Currency Exposure of a Commercial Bank

Exchange Rate Volatility

Foreign Exchange Risk Management

Whenever a commercial bank deals in foreign currency, it is exposed to risk of

Central Banks Role in Foreign Exchange Risk Management

A study conducted on 48 largest US commercial banks (Choi, Elyasiani, &

Banks use Derivatives to manage foreign currency risk. A review of literature on

Methodology & Variables Construction

No. of Commercial Banks

No. of Commercial Banks

Limitation of Scope of Research

Foreign Currency Exposure of Commercial Banks in Pakistan

= NFX relative to Net Assets

H0: There is no relationship between NFXNA & Size, OS & ERV

Equation 1:Calculation of NFX

deciding whether to hedge or take a speculative position depends upon

4. Comparison of Net Foreign Currency Exposure of Islamic &

Different Tools & Instruments Used by Commercial Banks in

Currency Derivatives & Ownership Status of Banks

Ownership Status of Bank: This is a categorical variable, having two

has only two categories; it is entered as a single dummy variable with

slope values (for independent variables 1 to 5)

P can be calculated using the below formula, which is simply another

Foreign Exchange Risk Management & its Impact on Income

Income from dealing in foreign currencies and size of bank

Income from dealing in foreign currencies as a percentage

Intercept of the model

Slope of the model, regression coefficient

Independent variable: tools used entered as a dummy

Using the above mentioned model, regression coefficient b, an unbiased estimate

Findings & Analysis

Findings on Net Foreign Currency Exposure of Commercial Banks in

Descriptive Statistics: Net Foreign Currency Exposure Relative to Net Assets

**. Correlation is significant at the 0.01 level (2-tailed).

a. Predictors: (Constant), Size, Exchange Rate Volatility, Ownership Status

a. Predictors: (Constant), Size, Exchange Rate Volatility, Ownership Status

3. Relationship Between NFX & Net Assets

Figure 1: Scatter Diagram of NFX & Net Assets (Model 2)

Std. Error of the

a. Predictors: (Constant), Net Assets

a. Dependent Variable: Net Foreign Currency Exposure

4. Comparison of Net FX Exposure of Commercial banks in Private

Std. Error Mean

Independent Samples Test

Levene's Test for Equality of