The Effect of Financial Derivatives On The Financial Performance of Commercial Banks in Zambia.

THE EFFECT OF FINANCIAL DERIVATIVES ON THE FINANCIAL
PERFORMANCE OF COMMERCIAL BANKS IN ZAMBIA.
NAME: Memory C. Banda
STUDENT NO: 000-774
COHORT: Bachelor of Banking and Finance
SUPERVISOR: P Kanyinji
A dissertation submitted in Partial Fulfilment of the requirement for the Awards of The
Bachelor Degree in Banking & Finance from Cavendish University of Zambia.
ABSTRACT
The increasing propensity of commercial banks to take part in derivative activities is one of the
notable developments in the present day financial markets. Latterly, the financial innovation
improvements deregulation and development of the financial markets, and banks‟ margins
decreases, due to low-quality loan applicants, motivate the commercial banks to provide
advanced services and products to expand their profits. Profits from traditional banking
activities has been decreasing whilst the competitiveness of markets have been increasing thus
forcing banks to undertake derivative activities. The objective of this study was to establish the
effect of financial derivatives on the financial Performance of commercial banks in Zambia.
The study involved an in depth analysis of Financial derivatives and its effects on the financial
performance of commercial banks and thus descriptive research design was found to be
appropriate. Secondary data about the commercial banks‟ notional amount of derivatives, total
assets, liquidity ratio and Total shareholders’ equity was collected from the Central Bank of
Zambia bank Supervision annual reports (2011-2018) and analysed using multiple regression.
Statistical Package for Social Sciences (SPSS version 18) was used obtain the regression
Output. Return on Assets (ROA) was used as the proxy for financial performance while
financial derivatives, liquidity ratio and shareholders‟ equity ratio were the predictor Variables.
The findings of the study indicated that there is an insignificant relationship between the
financial performances (ROA) of commercial banks in Zambia and financial Derivatives.
Additionally, the negative nature of the relationship means that a unit Change (increase) in
financial derivatives will result to a decrease in financial performance of commercial banks in
Zambia. Consequently, therefore, financial derivatives should be properly used in a manner
that is instrumental to the goal of a sound and safe banking system in Zambia.
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ACKNOWLEDGEMENT
I express my appreciation to my Father and Mother who sponsored me for the study. I also
salute the faculty Dean and Faculty members who provided me with the academic support. I
also want to thank my dissertation supervisor, Dr. Peter Kanyinji who dedicated a lot of Time
and effort to my work. This undertaking would not have been possible without his sincere
comments, criticism, advice, and suggestions. I would also like to thank the Central bank of
Zambia for unconditionally availing me the Information I needed. Special thanks to the entire
teaching fraternity in the school of Business, Cavendish university of Zambia for affording me
the opportunity to acquire the Knowledge required fulfilling this project.
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DEDICATION
This study is dedicated to my parents for their tireless effort and sacrifice to ensure I attain
university education. My siblings for their guidance, encouragement and caring support. The
Almighty God for His unceasing blessings without which it is impossible to accomplish
anything.
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Table of Contents
ABSTRACT................................................................................................................................................ ii
ACKNOWLEDGEMENT ............................................................................................................................ iii
DEDICATION ........................................................................................................................................... iv
Table of Contents .................................................................................................................................... v
CHAPTER ONE ......................................................................................................................................... 1
1.0 INTRODUCTION ................................................................................................................................. 1
1.1 Background of the Study ......................................................................................................... 1
1.1.1 Financial Derivatives .............................................................................................................. 1
1.1.2 Financial Performance ........................................................................................................... 2
1.1.3 Effect of Financial Derivatives on Financial Performance...................................................... 3
1.1.4 Commercial Banks in Zambia ................................................................................................. 4
1.2 Research Problem ......................................................................................................................... 4
1.3 Study Objectives .......................................................................................................................... 5
1.3.1 General Objectives ................................................................................................................. 5
1.3.2 Specific Objectives ................................................................................................................. 5
1.4 Research Questions ................................................................................................................ 5
1.5 Significance of the Study ............................................................................................................... 5
CHAPTER TWO ........................................................................................................................................ 7
2.0 LITERATURE REVIEW ................................................................................................................... 7
2.1 Introduction ............................................................................................................................ 7
2.1 How future contracts affect the financial performance of the banking sector. ......................... 7
2.1.1 Definition of future contracts ................................................................................................ 7
2.1.2 What role do future contract play in the financial sector ..................................................... 7
2.1.3 How future contracts affects the performance of the financial sector ................................. 8
2.2 How forward contracts affects the financial performance of banking sector .............................. 8
2.2.1Definition of forward contracts .............................................................................................. 8
2.2.2 What role do forward contract play in the financial sector................................................... 8
2.2.3 How forward contracts affects the performance of financial sector .................................... 9
2.3 The extent to which options contracts affects the financial performance of banking sector ...... 9
2.3.1 Definition of option in financial management ....................................................................... 9
2.3.2 What role do options play in financial sector ...................................................................... 10
2.2.4 How do options affects the performance of the financial sector. ....................................... 11
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2.4 How swaps contracts affects the financial performance of banking sector. .............................. 11
2.4.1 Definition of SWAPS ............................................................................................................. 11
2.4.2 What role do SWAPS play in the financial sector?............................................................... 11
2.4.3 How do Swaps affect the financial performance of the financial sector? ........................... 12
2.4.4The Financial Intermediary Theory ...................................................................................... 13
2.4 Conceptual Framework ............................................................................................................... 14
Figure 1: Conceptual Framework ...................................................................................................... 14
2.6 Summary of Literature Review ................................................................................................... 16
CHAPTER THREE .................................................................................................................................... 17
RESEARCH METHODOLOGY .................................................................................................................. 17
3.0 Methodology and design ............................................................................................................ 17
3.1 Introduction ................................................................................................................................ 17
3.2 Research Approach ..................................................................................................................... 17
3.3 Research Strategy ....................................................................................................................... 17
3.4 Sampling frame ........................................................................................................................... 17
3.5 Sample size, tools and sampling techniques............................................................................... 19
3.6 Reliability and Validity................................................................................................................. 20
3.6.1 Reliability.............................................................................................................................. 20
3.6.2 Validity of data ..................................................................................................................... 20
3.7 Ethical Consideration .................................................................................................................. 21
CHAPTER FOUR: ANALYSIS AND PRESENTATION OF DATA................................................................... 22
4.1 Introduction .................................................................................................................................... 22
Table 4.1 Future contract have negatively affected the banking sector during the financial crisis . 22
Table 4.2 Speculating and incorrect hedging with future contract have negatively affected the
performance of the banking sector .................................................................................................. 23
Figure 4.2 Speculating and incorrect hedging with future contract have negatively affected the
performance of the banking sector .................................................................................................. 23
Table 4.3 ........................................................................................................................................... 24
Table 4.4 Option contracts have negatively affected the banking sector during financial difficulties
.......................................................................................................................................................... 25
Figure Option contracts have negatively affected the banking sector during financial difficulties . 25
Table 4.5 Banks................................................................................................................................. 26
Figure 4.5 Banks use option contracts to protect their shares which has positively affected the
performance of the banking sector. ................................................................................................. 26
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Table 4.6 Swaps contracts are traded on the over-the-counter market. This means they are subject
credit risk and this affects the performance of the bank negatively. ............................................... 27
Figure 4.6 Swaps contracts are traded on the over-the-counter market. This means they are
subject credit risk and this affects the performance of the bank negatively ................................... 27
Table 4.8 The put option allows the bank to bet that price of the underlying asset will fall which will
affect the bank negatively on their performance ................................................................................. 29
Figure 4.8 .......................................................................................................................................... 29
Table 4.9 Banks use future contracts to lock a certain price of an underlying assets this affect the
financial performance of the bank negatively when the interest rises. ........................................... 30
Figure 4.9 Banks use future contracts to lock a certain price of an underlying assets this affect the
financial performance of the bank negatively when the interest rises. ........................................... 30
Table 4.10 Forward contracts negatively affects the financial performance of the bank when the
other party fails to honour the contract like per agreement ........................................................... 31
Figure 4.10 Forward contracts negatively affects the financial performance of the bank when the
other party fails to honour the contract like per agreement ........................................................... 31
Table 4.11 Derivatives can add value to the bank, as long as the human resource manager of the
bank use restriction and hold a “limited amount.” .......................................................................... 32
Figure 4.11 ....................................................................................................................................... 32
Table 4.12 ......................................................................................................................................... 33
Figure 4.12 ........................................................................................................................................ 33
CHAPTER FIVE ....................................................................................................................................... 34
SUMMARY, CONCLUSION AND RECOMMENDATIONS ......................................................................... 35
5.1 Introduction ................................................................................................................................ 35
5.2 Summary ........................................................................................ Error! Bookmark not defined.
5.3 Conclusion ...................................................................................... Error! Bookmark not defined.
5.4 Limitations of the Study .............................................................................................................. 35
5.5 Recommendations ...................................................................................................................... 36
5.5.1 Policy Recommendations ..................................................................................................... 37
5.5.2 Suggestions for Further Research ........................................... Error! Bookmark not defined.
REFERENCES .......................................................................................................................................... 38
APPENDIX I ............................................................................................... Error! Bookmark not defined.
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CHAPTER ONE
1.0 INTRODUCTION
1.1 Background of the Study
Derivatives go back similarly as Antiquity. Derivatives instruments were initially created to

promote trade and protect the supply of commodities to cover farmers against crop Failures.
Over the years, derivatives were being used as a source of funding and also as a Means to
search for quick profits. In order to protect the supply of commodities and Promote trade, both
in geographical distance and time, the rulers‟ codes as a matter of fact demanded a written
form of buying, selling and other trade related agreements so as to give sellers and buyers the
best conceivable lawful assurance to take part in trade in Ancient Mesopotamia. The primary
reason for this was to minimize the “your word against mine” saying in the event of
disagreements. (Steve and Christian, 2012)The utilization of derivatives instruments by
commercial banks has risen in the previous two decades. In spite of broadly accessible
information on derivative utilization, empirical research evidence on its effects is mixed. One
conceivable reason to such opposing outcomes is whether the banks utilize derivatives for
hedging or trading function. Data unveiled by a wide range of firms, including banking
industries and nonfinancial firms have been used by previous studies in attempting to enhance
our comprehension of how the firms utilize derivatives. Distinguishable assumption in almost
the greater part of all of this literature has been that firms, including financial firms, utilize
derivatives for hedging. Nevertheless, (Faulkender and Chernenko, 2011) indicated that non-
financial firms utilize derivatives for speculation as well as for hedging.
1.1.1 Financial Derivatives
These are financial instruments that derive their values from the values of other Underlying
assets, like, interest rates, equities, commodities, foreign exchange and bonds .E.g. A Treasury
bond futures contract commits the parties to exchange a Treasury bond at future date for a
predetermined price. The futures contract’s value relies on the Underlying Treasury bond’s
value. By the way of illustration, supposing the treasury Bond’s price increases, the futures
contract’s value will also increase because futures Contract’s buyer now qualify to get an asset
with a greater value. The four primary kinds of derivatives instruments are options, forwards,
swaps, and Futures. The users of these instruments are permitted to full fill the need for efficient
Protection against risks caused by the underlying security price changes. That is, those who use
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derivatives are able to protect themselves against uncertainties in interest and Exchange rates,
credit worthiness, as well as commodity and equity prices. Clearly, derivative transactions
include the transferring risks from entities who are unable or less willing to manage them to
entities that are able or more willing to do so. Derivatives Instruments are currently popular
amid a large number of both financial and non-financial Firms (Nystedt, 2004).The traditional
borrowing and lending activities of the commercial banks exposed them to financial market
risk and this is generally the reason why they take part in derivative activities. Financial
derivatives present a cost effective approach to manage these financial market risk without
attracting extra charges to the commercial banks. Banks can use derivatives to hedge liability
and asset positions as the instruments allow them to take position in the derivative market that
is opposite and equal to a planned future or current position in the cash or spot market. Thus,
regardless of the price changes, gains in one market will balance losses in the other.
1.1.2 Financial Performance
This is a test of how properly a firm can utilize the assets from its essential business Operations
to create incomes. Financial performance is typically utilized as the measure of the general
financial health a firm throughout a particular time period. Commercial Banks assume a critical
part in allocating the country’s economic resource as they continuously direct funds from the
depositors to investors. Banks need to be profitable in Order to ensure sustainable
intermediation function. Good financial performance ensures that the shareholders are
rewarded for their investment. This, thus, motivates them to Bring in additional investment and
hence leads to economic growth. Poor banking Performance on the other hand result to banking
crisis and failure which have negative Impact on the economic growth. ( De Young and Rice,
2004) noted that in recent years, commercial banks have taken advantage of deregulation to
make handsome amounts of revenues from non-traditional banking routines like derivatives
usage, securities brokerage, investment banking and mutual funds sales and insurance
underwriting and agency. Interest margins that banks earn by intermediating amongst
borrowers and depositors keep on being the essential profits source for most commercial banks.
The basic goal of commercial banks is profit but they also have other economic and social
goals. There are various ways to ensure the profitability of a bank but according to (Quach,
2005), the profitability of a bank is measured using three ratios. The first ratio is the return on
equity ratio (ROE), which is the amount that the banks earn relative to the total amount of
invested shareholders equity. A high ROE is favourable for a bank as it shows its ability to
generate cash internally. According to (Khrawish, 2011), it shows how efficiently and
effectively a bank is utilizing shareholders‟ funds. The second ratio is the asset return ratio of
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the bank’s net income to its average total asset and it tests the bank’s capacity to create income
by using the assets at its disposal. A high ROA shows the bank is efficiently utilizing its
resources. The third ratio is the net interest margin ratio which measures the amount of interest
lenders are paid and interest income created by banks. Higher bank profitability is associated
with a higher net interest margin. This could however also mean riskier lending practices
associated with Considerable loan loss provision.
1.1.3 Effect of Financial Derivatives on Financial Performance
The increasing propensity of banks to take part in derivative activities is one of the Notable
developments in the present day financial markets. Latterly, the financial Innovation
improvements, deregulation and development of the financial markets, and Banks‟ margins
decreases, due to low-quality loan applicants, motivate the commercial Banks to provide
advanced services and products to expand their gains. Profits from Traditional banking
activities has been decreasing whilst the competitiveness of markets Have been increasing thus
forcing banks to utilize derivative activities. Hasanand (Ebrahim, 2004) found out that the
betterment of the bank’s non-interest earnings was as result of developing new sorts of financial
instruments. OBS activities such as derivatives, commitments and guarantees are at times the
primary revenues sources of the bank. Commercial banks can evade taxes or regulatory costs
and generate high earnings by participating in derivative markets due to the fact that deposit
Insurance premiums and reserve requirements are not enforced on off balance sheet Activities.
Nevertheless, these activities can attract market, credit and operational risks and other risks,
which may influence liquidity and solvency of the commercial banks. Conversely, notable
increase in commercial banks‟ derivatives activities might be due to Increased credit, interest
and foreign exchange rate risk exposures, banks encountered in International and domestic
markets. Financial derivatives provide a means to hedge these Risks without needing to make
comprehensive adjustments to their statement of financial Position. Managing risks by using
financial derivatives is less costly and could substitute for Expensive capital and give banks
the flexibility to achieve their desired risk exposures without changing their original business
objectives. However, financial derivatives also expose investors to additional risks. Entering a
position in derivatives does not need much initial investment, but future cash flows given
fluctuation of the underlying assets could be huge due to the high leverage behind the contracts.
Thus, speculating and Inappropriate hedging with derivatives have the potential to cause severe
financial losses and even bankruptcy.
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1.1.4 Commercial Banks in Zambia
Commercial banks are financial intermediaries that symbolize a vital and robust or healthy part
of the business world as they serve as the global economy’s financial resources mobilization
Points. An efficient, well-functioning, and well-developed banking sector is a critical
Requirement for investment and saving decisions required for fast economic growth. This is
because a system by which the most efficient and profitable projects of a country are
continuously and systematically funded is provided by the banking sector. Commercial Banks
channel the needed funds from surplus spending to deficit spending units in the Economy and
this enables them to execute monetary policy and provide a means for Facilitating payment for
services and goods in the international and domestic trade. The traditional lending and
borrowing activities of the commercial banks expose them to financial market risk and this is
generally the main reason why they participate in the derivative markets. Commercial banks
can evade taxes or regulatory costs and generate high earnings by participating in derivative
markets due to the fact that deposit insurance Premiums and reserve requirements are not
enforced on off balance sheet activities. Nevertheless, off balance sheet activities can attract
market, credit and operational risks and other risks, which may influence liquidity and solvency
of the commercial banks. Conversely, notable increase in commercial banks‟ derivatives
activities might due to increased credit, foreign exchange and interest rate risk exposures,
encountered by the Banks in international and local markets. Financial derivatives provide a
means to hedge these risks without requiring them to make comprehensive adjustments to their
statement of financial position.
1.2 Research Problem

The commercial banks are working on new ways to achieve profits instead of Traditional
methods, and hedging of systemic risks by using financial derivatives because Of the
uncertainty and high insecurity in the global and domestic financial markets. Compared to on-
balance sheet asset-liability management, managing risks by using financial derivatives,
normally known as off-balance sheet activities, gives the commercial banks the flexibility to
reach their preferred risk exposures without changing their original business goals. Derivative
use is also less costly could substitute for expensive capital. However, financial derivatives
also expose investors to additional risks. Entering a position in derivatives does not need much
initial investment, but future cash flows given fluctuation of the underlying assets could be
huge due to the high leverage behind the contracts. Thus, speculating and inappropriate hedging
with Derivatives have the potential to cause severe financial losses and even bankruptcy.
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1.3 Study Objectives
1.3.1 General Objectives
To determine the effects of financial derivatives on the financial performance of commercial

banks in Zambia.
1.3.2 Specific Objectives
i. To assess how future contracts affects the financial performance of the banking sector
in Zambia.
ii. To examine the extent to which options contracts affects the financial performance of
banking sector in Zambia.
iii. To evaluate the extent to which swaps contracts affects the financial performance of To
assess how future contracts affect the financial performance of the banking sector in
Zambia.
iv. To determine how forward contracts affects the financial performance of banking sector
banking sector in Zambia.
1.4 Research Questions

i. How future contracts affects the financial performance of the banking sector in
Zambia?
ii. How the forward contracts are affects the financial performance of the banking sector
in Zambia?
iii. How options contracts affect the financial performance of the banking sector in
Zambia?
iv. What is the extent to which swaps affects the financial performance of the banking in
Zambia?
1.5 Significance of the Study

This research will educate the reader about. The effect of financial derivatives on the financial
performance on commercial banks in Zambia. Findings will supply the regulators with deeper
understanding that can be used to enable best practices and regulatory policy formulation. The
regulators like the Capital Markets Authority, Central Bank of Zambia and Zambian Bankers
Association can use this study’s findings, recommendations and conclusions to enact and
improve Regulation and operation procedures of financial derivatives in Zambia
Scholars will find this study’s findings to be important as it will provide an up to date and top
notch information on how the commercial bank’s financial performance is affected by the use
of financial derivatives. Fellow researchers will also find this study’s Findings to be of
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significance as they will rely on it for further proof and knowledge on how the commercial
bank’s financial performance is affected by the use of financial derivatives.
This study’s findings will benefit investors and potential investors as they will be able to
determine how commercial bank’s financial performance is affected by the utilization of
financial derivatives and thus make better financial decision Management teams of banking
institutions can this study’s findings to understand and Appreciate the necessary environment
for financial derivatives to thrive. The study also sheds light on major criticisms, shortcomings
and risks that are associated with financial Derivatives instruments. In general, commercial
banks practitioners and other participants In the Zambian financial sector can utilize the
findings to better the nature, organization and capital outlay of their present and future financial
derivatives investments. The commercial banks will utilize this study’s findings and
recommendations to allocate resources to the areas that will spur growth of financial derivatives
and deliver greater returns to their shareholders.
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CHAPTER TWO
2.0 LITERATURE REVIEW

2.1 Introduction
This chapter reviews the existing literature related to the subject of the study as described by
different scholars, authors, analyst and researchers. Literature review presents the study with a
clarification of the theoretical rationale of the problem under study and also previous research
finding that relate to the problem at hand. The literature is reviewed from periodicals, published
books, working papers and reports. This chapter explains the theoretical orientation and
empirical framework.
2.1 How future contracts affect the financial performance of the banking sector.
2.1.1 Definition of future contracts
(Kamenchu, 2010) A futures contract is an agreement between two parties a buyer and a seller
to buy or sell something at a future date. Future contracts evolved out of forward contracts and
possess many of the same characteristics. Unlike forward contracts, futures contracts trade on
organized exchanges, called future markets. Future contacts also differ from forward contacts
in that they are subject to a daily settlement procedure. In the daily settlement, investors who
incur losses pay them every day to investors who make profits.
2.1.2 What role do future contract play in the financial sector
Hedging
Banks use futures contracts to hedge their exposure to certain types of risk. For example, an
oil production company may use futures to manage risk associated with fluctuations in the
price of crude oil.
For example, assume an oil company enters into a contract to deliver 5,000 barrels of oil in
six months. The company has exposure to the price of oil going down during that six-month
period. To make up for the risk, the oil company may hedge by selling five contracts of oil in
the month it is to be delivered. Each oil contract is 1,000 barrels. The company may offset or
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make up for all or only a portion of its risk. The futures contracts allow the company to
manage their risk and have more predictable revenue.
Companies that do business internationally may use currency futures to offset their risk in the
fluctuations of currencies against each other. If a company is paid in a different currency than
that of the country where it is headquartered, the company has substantial risk in the
fluctuations of currencies. The company can lock in its exchange rate using currency futures.
Speculation
Other companies, such as hedge funds, may use futures contracts for speculation. Speculation
attempts to profit from movements in the prices of futures contracts. The significant leverage
offered by futures contracts are attractive to many seeking to speculate.
2.1.3 How future contracts affects the performance of the financial sector
Banks use future contracts to lock a guaranteed price for interest rates or exchange rate.
Banks use them to lock in a sales price for their gain. Future contracts guarantee they can buy
or sell the stocks at a fixed price. They plan to transfer possession of the good under contract.
The agreement also allows them to know the revenue or costs involved. For them, the
contracts reduce a significant amount of risk.
2.2 How forward contracts affects the financial performance of banking sector
2.2.1Definition of forward contracts
A forward contract is an agreement between two parties – a buyer and a seller to purchase or
sell something on the current price at specific date in future. Forward contracts, sometimes
called forward commitments, are very common in everyone life. Any type of contractual
agreement that calls for the future purchase of a good or service at a price agreed upon today
and without the right of cancellation is a forward contract (George M, 2018).
2.2.2 What role do forward contract play in the financial sector

 Hedging against Risk
For many people, risk management is the primary motivation for forward contracts. Banks
treasurers use forward contracts to hedge their risk related to foreign currency exchange. For
example, a company based in the U.S. incurs costs in dollars for labor and manufacturing. It
sells to European clients who pay in euros, and the company has a lead time of six months to
supply the goods. In this case, the company is at risk from the uncertain market fluctuation of
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exchange rates. The company uses a forward contract to lock in a sale price for the product in
six months, at today’s exchange rate.
 Can be written for any amount and term
2.2.3 How forward contracts affects the performance of financial sector
Forward rate agreement, no actual lending or borrowing is affected. Only it fixes the rate of
interest for a futures transaction. At the time of maturity, when the customer actually needs
funds, then he has to borrow the funds at the current rate of interest from the market. If the
market rate of interest is higher than the FRA interest then the banker will have to pay to the
other party (customer) the difference in the interest rate. However, if market interest is lesser
than the FRA rate then the customer will have to pay the difference to the banker. This
transaction is known as purchase of FRA from the bank.
Sometimes, a customer (depositor) may also make a FRA contract with the bank for his
deposits for seeking a guaranteed rate of interest on his deposits. If the market rate on his
deposit turns out to be lower than that guaranteed interest rate in the FRA, the bank will
compensate him for the difference, FRA rate minus market interest. Similarly, if the
FRA is lower than the deposit rate then the customer will pay difference to the banker. This
transaction is known as sale of a FRA to the bank. In this way, purchase of FRA protects N
the customer against a rise in interest in case of borrowing from the bank. Similarly, sale of
FRA will protect the customer from deposits point of view. The bank charges different rates
of interest for borrowing and lending, and the spread between these two constitutes bank’s
profit margin. As a result, no other fee is chargeable for FRA contracts.
2.3 The extent to which options contracts affects the financial performance of
banking sector
2.3.1 Definition of option in financial management
According to (Gitogo, 2013) an options contract is an agreement between a buyer and a seller
that gives the buyer the option to trade an underlying asset at a specified price within a certain
period of time. The option buyer has the right but not the obligation to force the option seller
to follow the terms of the agreement at any time before the option expires. The price for the
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underlying asset specified in the option is known as the strike price and is different from the
price that the buyer actually pays for the options contract. Typically, options contracts on stocks
cover 100 shares, although some special contracts have different amounts of stock.
2.3.2 What role do options play in financial sector
Flexibility- With options you can trade any type of potential move in the underlying security.
Think the shares might double within a week - perhaps you believe the shares will hardly move
over the next month - you can even use them to protect your downside. Basically if you have
a view, you can use an option strategy to trade it.
Gain leverage-Leverage means using various financial instruments or borrowed capital, such
as margin, to increase the potential return of an investment.Options can offer incredible
leverage, and returns of 100% or even higher are possible. This leverage can be used
intelligently. For example, options can be used to take a position in a stock using a small down
payment.
Directional choice- Obviously related to flexibility. Options are good tools for trading upward
and downward and even sideways price movements.
Reduce risk -Futures also offer leverage but the potential losses are often open-ended. Many
option strategies allow similar leveraged profit potential but with limited risk
Sell options against shares that you already own - This is called a covered call strategy and it's
a way to earn extra income from shares you already hold
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2.2.4 How do options affects the performance of the financial sector.
Managing risks by using financial derivatives is less costly and could substitute for
Expensive capital and give banks the flexibility to achieve their desired risk exposures
without changing their original business objectives. However, financial derivatives also
expose investors to additional risks. Entering a position in derivatives does not need much
initial investment, but future cash flows given fluctuation of the underlying assets could be
huge due to the high leverage behind the contracts.
2.4 How swaps contracts affects the financial performance of banking sector.
2.4.1 Definition of SWAPS

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula (Gupta, 2007), they can be regarded as collections of
forward contracts. The two commonly used swaps are interest rate swaps and currency
swaps.
Interest rate swaps: These involve swapping only the interest related cash flows between the
parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite directions
2.4.2 What role do SWAPS play in the financial sector?
 Borrowing at Lower Cost:

Swap facilitates borrowings at lower cost. It works on the principle of the theory of
comparative cost as propounded by Ricardo. One borrower exchanges the comparative
advantage possessed by him with the comparative advantage possessed by the other
borrower. The net result is that both the parties are able to get funds at cheaper rates.
 Access to New Financial Markets:

Swap is used to have access to new financial markets for funds by exploring the comparative
advantage possessed by the other party in that market. Thus, the comparative advantage
possessed by parties is fully exploited through swap. Hence, funds can be obtained from the
best possible source at cheaper rates.
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 Hedging of Risk:
Swap can also be used to hedge risk. For instance, a company has issued fixed rate bonds. It
strongly feels that the interest rate will decline in future due to some changes in the economic
scene. So, to get the benefit in future from the fall in interest rate, it has to exchange the fixed
rate obligation with floating rate obligation. That is to say, the company has to enter into
swap agreement with a counterparty, whereby, it has to receive fixed rate interest and pay
floating rate interest. The net result is that the company will have to pay only floating rate of
interest. The fixed rate it has to pay is compensated by the fixed rate it receives from the
counterparty. Thus, risks due to fluctuations in interest rate can be overcome through swap
agreements. Similar, agreements can be entered into for currencies also.
 Tool to correct Asset-Liability Mismatch:

Swap can be profitably used to manage asset-liability mismatch. For example, a bank has
acquired a fixed rate bearing asset on the one hand and a floating rate of interest bearing liability
on the other hand. In case the interest rate goes up, the bank would be much affected because
with the increase in interest rate, the bank has to pay more interest. This is so because, the
interest payment is based on the floating rate. But, the interest receipt will not go up, since, the
receipt is based on the fixed rate. Now, the asset- liability mismatch emerges. This can be
conveniently managed by swap. If the bank feels that the interest rate would go up, it has to
simply swap the fixed rate with the floating rate of interest. It means that the bank should find
a counterparty who is willing to receive a fixed rate interest in exchange for a floating rate.
Now, the receipt of fixed rate of interest by the bank is exactly matched with the payment of
fixed rate interest to swap counterparty. Similarly, the receipt of floating rate of interest from
the swap counterparty is exactly matched with the payment of floating interest rate on
liabilities. Thus, swap is used as a tool
2.4.3 How do Swaps affect the financial performance of the financial sector?
Banks, which need to have their revenue streams match their liabilities. For example, if a
bank is paying a floating rate on its liabilities but receives a fixed payment on the loans it
paid out, it may face significant risks if the floating rate liabilities increase significantly. As a
result, the bank may choose to hedge against this risk by swapping the fixed payments it
receives from their loans for a floating rate payment that is higher than the floating rate
payment it needs to pay out. Effectively, this bank will have guaranteed that its revenue will
be greater than it expenses and therefore will not find itself in a cash flow crunch.
12
Hedge funds, which rely on speculation and can cut some risk without losing too much
potential reward. More specifically, a speculative hedge fund with an expertise in forecasting
future interest rates may be able to make huge profits by engaging in high-volume, high-rate
swaps.
2.4.4The Financial Intermediary Theory
The objective of intermediation theory is to clarify the existence of financial Intermediaries. In

essence, the existence of financial intermediaries is as a result of absence of complete
information at the right time, presence of high cost of transaction and the regulation method.
(Diamond ,1984) developed the financial intermediary theory Which argues that banks should
not take risks that they have no advantage of monitoring Or cannot be able to control.
Permitting the commercial banks to hedge systematic risks can lead to an additional decrease
in the cost of delegation to monitor loan borrowers. Therefore, hedging permits banks to get
excellent profits from diversification by decreasing the cost of delegation that acts as a lending
incentive. (Diamond, 1984) indicated that delegated monitoring do not just presume economies
of scale but also provides a reason why depositors don’t need to monitor the bank itself. He
found out that the bank’s moral hazard problem decreases when the bank’s size increases and
even disappears completely if the bank holds a portfolio of assets that is fully diversified
(including derivatives in their portfolio). Thus, the bank holding a portfolio of assets that is
fully diversified leads the depositors to hold debt contracts that are risk-free and thus they do
not need to continuously monitor the banks.
13
2.4 Conceptual Framework
Independent variables Dependent variable
Banks risk
Interest rate
Future and Risks
forward contracts Foreign
exchange risks
Financial performance of
Options contract Banks commercial Banks
Leverage Return on Assets (ROA)
Swaps Banks
contracts
Liquidity
position
(Kanatas, Deshmukh and Greenbaum ,1983) indicated that commercial banks that utilize
derivative can face less uncertainty in interest rates and thus increase their lending activities
which then lead to higher returns compared to the fixed fee for service activities return. This is
possible if the interest rate risk can be controlled using derivatives.
Figure 1: Conceptual Framework

Total profitability of commercial banks would therefore be higher relative to the banks in which
derivatives are not used to control for interest rates uncertainty. Moser, Brewer, Saunders and
Jackson conducted a study and found out that for savings and loan institutions, a negative
correlation exists between risk and derivative activities. They found that there was a substantial
increase in fixed-rate mortgage portfolios of savings and loans (S&Ls) and thus indicating that
derivatives are utilized by the financial institutions for the purpose of hedging, which therefore
clarify the decrease in the risk volatility due to increase in derivative usage.
Rosen and Gorton (1995) found out that the net income changes as a result of to the interest
rate changes is partly neutralized by the opposite changes in net incomes from hedging interest
rate risk by using swaps, and therefore derivatives assist in managing most of the uncontrollable
risks at commercial banks. (Moser and Zhao, 2009) indicated that both the off- and on-balance
sheet risk management methods of banks efficiently and effectively decrease the interest rate
sensitivity of bank stocks. (Choi and Elyasiani, 1996)and (James and Flannery, 1984) found
out that derivative reduce large bank’s interest and foreign exchange risk if the risk is measured
14
as stock returns sensitivity to foreign exchange risk and interest rate risk respectively.
(Hartarska and Shen,2013) indicated that during the 2008 financial crisis derivatives assisted
agricultural banks boost their profitability and lower their sensitivity to credit risk and interest
risk. Other studies indicated that commercial banks risks increases when they use derivatives.
(Hirtle,1997) and (Elyasiani and Choi, 1997), found out that large dealer BHCs stock returns
were more sensitive to uncertainties in interest rate than the other BHCs and that the interest
rate sensitivity of stock returns is increased by interest rate derivatives. (Angbazo,1997) found
out that while off-balance sheet activities increased banks‟ exposure to on balance sheet
liquidity risk and interest rate risk these activities also enhance profitability of the bank by
permitting activities otherwise restricted with equity or debt financing. The results about how
bank performance is affected by derivatives are mixed and this probably because it is not easy
to differentiate in practice hedging and speculating derivative activities and that above studies
focused on large banks which have considerable speculating derivative activities and market
making that permit them to lessen, if not evade, non-hedging derivative activities disruptions.
(Kamenchu, 2013) stated that trade liberation and legal framework are the major factors
hindering and slowing down the adoption the use of derivatives in Kenya. According to
(Njoroge, 2013) Kenyan companies commonly use swaps and forward contracts. The
companies utilize swaps when they are planning to exchange cash flows in the future while
forward contracts are used to hedge against their imports and exports. Nzuki2010) indicated
that Kenyan oil companies commonly utilize a hybrid of derivatives, predominantly forward
contracts and futures market. As they appear to think about the price volatility of crude oil.
(Gitogo, 2013) indicated that a relationship exist between the commercial banks „financial
performance and financial derivatives and although his study focused only on a time frame of
1 year. My study tends to fill the gap by focusing on a time frame of 5 years (2011-2015) so as
to get more reliable findings.
(Mumoki, 2009) indicated that the most frequently used instrument was the forward contract.
The money market hedge and the currency swap were also frequently used. Parallel loans
(Back-to-back loan), foreign currency denominated debt and cross hedging techniques were
moderately used. Futures contract, foreign currency option and leading and lagging techniques
were occasionally used. Prepayment was the least used technique.
(Nasurutia, 2013) found out that there was a significant relationship foreign exchangeexposure
and derivative usage. And that given the negative nature of the relationship it means that a unit
change derivative usage will significantly influence a decrease in foreign exchange exposure.
15
Consequently, therefore, derivative usage is effective in management of foreign exchange
exposure.
2.6 Summary of Literature Review
A number of both international and local studies have been carried out on different features of
derivatives financial performance and hedging of commercial banks. Locally though, there is
a rarity on studies that explore the relationship of the two. The results about how bank
performance is affected by derivatives are mixed and this probably because it is not easy to
differentiate in practice hedging and speculating derivative activities and that above studies
focused on large banks which have considerable speculating derivative activities and market
making that permit them to lessen, if not evade, non-hedging derivative activities disruptions.
Some of the previous studies indicate that derivatives act as a complement to banks‟ lending
activities (Diamond, 1984) while others find that derivatives find that derivatives increase
commercial banks‟ riskiness (Gorton and Rosen 1995). Literature on how commercial bank’s
financial performance is affected by derivatives is limited even though inappropriate derivative
activities usually result to trading losses large enough to lead to bankruptcy and financial
difficulty. My study tries to fill these gaps in the existing literature and present empirical
evidence on how the commercial banks‟ financial performance is affected by derivatives.
16
CHAPTER THREE
RESEARCH METHODOLOGY
3.0 Methodology and design
3.1 Introduction
The methodology chapter discusses the research strategy and design, sampling frame, sample
size and tools for data collection. According to (Boot, A. W. A., &Marinč, M, 2008). , the
research methodology gives a researcher a direction to manage the research process with
various constructs.
3.2 Research Approach
The research approach used in the study was quantitative which is ideal when you collect
quantitative data (Boot, A. W. A., & Marinč, M, 2008) Although quantitative data analysis
involves different and appropriate quantitative analysis models such as testing relationships,
the data analysis in this study involved descriptive statistics which provided information in
form of frequency distribution tables, and in some cases figures in form of bar charts.
3.3 Research Strategy
The study used a survey method to collect data. Surveys are used in quantitative research
(Kothari, 2004) to collect data from respondents in a randomized manner. The respondents
included commercial banks, financial markets, and the ministry of finance.
3.4 Sampling frame

The sampling frame comprised of the following; 13 staff from ministry of finance randomly
selected, 7 commercial banks, the financial markets with 117 giving, and ministry of finance
with 17 giving an overall total sampling frame of 167. However, in calculating the sample size
the researcher used Newman (2000) formula which states that, if a research is using a target
population which is less than 1000, the researcher requires a 30% degree of accuracy. The
calculation of sample size is given below:
Financial performance 30/100 x13 = 3.9
17
Commercial banks 30/100 x7 = 2.1
Financial market 30/100 x 117 = 35.1
Ministry of Finance 30/100x 17 = 5.1
Therefore, this implies that the sample size for the study was 46.2 respondents and the
researcher took an equivalent of 46 respondents
Summary of sampling frame

Sampling Frame Justification for sample sampling frame
Financial markets
These permit the transfer of funds
(purchasing power) from one agent to
another for either investment or
consumption purposes and they also allow
risk transfer from who undertake
investments to those who provide funds for
those investments.
Financial performance This is a test of how properly a firm can

utilize the assets from its essential business
Operations to create incomes. Financial
performance is typically utilized as the
measure of the general financial health a firm
throughout a particular time period.
Ministry of Finance These provide the budget. It is central
ministry which also monitors how resources
are used through the auditor general office
Commercial banks Commercial banks are financial
intermediaries that symbolize a vital and
robust or healthy part of the business world
18
as they serve as the global economy’s
financial resources mobilization Points.
Source: Author, 2017
3.5 Sample size, tools and sampling techniques
The table below shows the sample size, tools and the sampling techniques used to collect data
SAMPLE SAMPLE Tools SAMPLING TECHNIQUE

SIZE
Commercial 2 Guided The technique used was purposive sampling to
banks Interviews facilitate collection of correct information. The
researcher interviewed the Human resource
managing director of Finance and collected data
on policy of the stock market and its regulation
framework
Financial 4 Questionnaire Technique use for collection of data was a survey
performance method. There are many issues of shares on the
stock market, and these were selected randomly.
Random sampling provides an opportunity for all
participant of being selected
Financial 35 Questionnaire These were selected randomly. The respondents
markets were captured during their consultations on the
type of shares issued on the primary market
Ministry of 5 Questionnaire Selected randomly for information whether they
finance used financial analysis tools to make investment
decisions
Total sample 46
19
3.6 Reliability and Validity
3.6.1 Reliability
Since the study was done through a survey, and the study was quantitative research where data
collection was done through surveys and was analyzed and reported using statistical tools of
its reliability, accuracy, and validity or the strength. Accuracy becomes more reliable when
there is repeated measure of the same thing to get the same results.(Boot, A. W. A., & Marinč,
M, 2008). This means that the researcher was asking for clarification and following-up when
unsure of certain facts. The researchers was verifying facts and information with other
informants and verify facts between multiple sources to ensure accuracy. Although these steps
seem not relevant, they are critical to ensure that the work was credible, authentic and rich with
facts. The researcher also ensured thoroughness of the information so that it offers a level of
reliability, consistency and accuracy that would not otherwise be present.
3.6.2 Validity of data

In a search to ensure validity, a transaction process was applied consisting of techniques by
which misunderstandings were adjusted. Informants were engaged in making sure their
realities correspond with the interpretations brought forth by the researcher. The researchers’
construction of realities were inevitably realigned with reconstructions, and interpretations
and in doing so, the researcher sought to construct ‘what these objects, events, and behaviors
meant to the people engaged in and with them. The researcher also used member checking
techniques for the reason of reassuring the credibility of constructions of the participant, as
well as triangulation to verify facts through multiple data sources to overcome the deficiencies
that flow from one investigation or one method. Transformational validity was another aspect
20
which emphasized a higher degree of self-reflexivity. The researcher critically examined
meanings that were taken for granted and created 'analytic practices' in which meanings are
both deconstructed and reconstructed in a way that makes initial connotations more fruitful.
3.7 Ethical Consideration

The researcher carried out this research in a position of trust. The University has placed trust
in the researcher and complied in an honest and ethical manner throughout the research. And
the confidentiality of any information that was supplied to the researcher, particularly if it is of
a sensitive nature is intended for academic work and not for publication.
21
CHAPTER FOUR: ANALYSIS AND PRESENTATION OF DATA
4.1 Introduction
Data was analysed with the use of descriptive statistics. This involved the use of closed
questionnaire for data collection and generation of frequency distribution tables and figures in
some cases to amplify the detail.
Table 4.1 Future contract have negatively affected the banking sector during the
financial crisis.
Frequency Percent Cumulative Percent
Strongly disagree 4 8 8
Disagree 6 12 20
Valid Agree 15 30 50
Strongly agree 25 50 100
Total 50 100
Missing System 0 0
Total 50 100
Source: Field study 2017
Figure 4.1 Future contract have negatively affected the banking sector during the
financial crisis.
120
100
80
60
40
20
0
Strongly Disagree Agree Strongly agree Total System
disagree
Valid Missing Total
Source: Table 4.1
Table and figure 1 shows the study findings on whether future contracts have negatively
affected the banking sector during the financial crisis. Out of 50 Respondents who were
involved in the study 4 (8%) indicated strongly disagree, 6 (12%) indicated disagree and
15(30%) indicated agree and 25(50%) indicated strongly agree. Since Majority 50% of the
respondents indicated strongly agrees, it means that future contracts negatively affects the
banks during financial crisis.
22
Table 4.2 Speculating and incorrect hedging with future contract have negatively
affected the performance of the banking sector
Disagree 8 16 18
Total 50 100
Missing System 0 0
Total 50 100
Figure 4.2 Speculating and incorrect hedging with future contract have
negatively affected the performance of the banking sector
120
100
80
60
40
20
0
disagree
Valid Missing Total
Source: Table 4.2
Table and figure 2 shows the whether speculating and incorrect hedging with future contract
have negatively affected the performance of banks. Out of 50 Respondents who were involved
in the study 1 (2%) indicated strongly disagree, 8 (16%) indicated disagree, 10 (20%) indicated
agree and 31(62%) indicated strongly agree. Since Majority at 62% of the respondents
indicated strongly agree, it means that incorrect hedging and speculating with future contracts
negatively affects the performance of banks.
23
Table 4.3 Forward contracts issue have affected the banking sector negatively on
their performance.
Disagree 16 32 84
Agree 5 10 94
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.4 Forward contracts issue have affected the banking sector negatively
on their performance.
120
100
80
60
40
20
0
disagree
Valid Missing Total
Source: Table 4.3
Table and figure 3 above shows whether the forward contracts issue have affected the
banking sector negatively on their performance. Out of 50 Respondents who were involved in
the study, 26 (52%) indicated strongly disagree, 16 (32%) indicated disagree, 5 (10%)
indicated agree and 3 (6%) indicated strongly agree. Since Majority 52% of the respondents
indicated strongly disagrees, it means that when issuing out forward contracts the
performance of the is not affected.
24
Table 4.5 Option contracts have negatively affected the banking sector during
financial difficulties.
Disagree 15 30 34
Agree 3 6 40
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.4 Option contracts have negatively affected the banking sector during
financial difficulties.
120
100
80
60
40
20
0
Strongly disagree Disagree Agree Strongly agree Total System
Valid Missing Total
Table and figure 4 shows the discussion on whether options contracts have negatively affect
the banking sector during financial difficulties. Out of 50 Respondents who were involved in
the study 2 (4%) indicated strongly disagree, 15 (30%) indicated disagree, 3(6%) indicated
agree and 30 (60%) indicated strongly agree. Since Majority 60% of the respondents indicated
strongly agree, it means that during financial difficulties options contracts negatively affects
banks.
25
Table 4.5 Banks use option contracts to protect their shares which has positively
affected the performance of the banking sector.
Disagree 3 6 10
Agree 5 10 20
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.3 Banks use option contracts to protect their shares which has positively
affected the performance of the banking sector.
120
100
80
60
40
20
0
Strongly Disagree Agree Strongly Total System
disagree agree
Valid Missing Total
Source: Table 4.5
Table and figure 5 shows the study whether the bank use options contracts to protect their
shares which has positively affects its performance. Out of Respondents who were involved in
the study 2 (4%) indicated strongly disagree, 3 (6%) indicated disagree, 5 (10%) indicated
26
agree and 40(80%) indicated strongly agree. Since Majority 80% of the respondents indicated
strongly agree, its means that banks use options contracts to protect their shares which has
positively affects its performance.
Table 4.6 Swaps contracts are traded on the over-the-counter market. This
means they are subject credit risk and this affects the performance of the bank
negatively.
Disagree 3 6 10
Agree 18 36 46
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.6 Swaps contracts are traded on the over-the-counter market. This
means they are subject credit risk and this affects the performance of the bank
negatively.
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: table 4.6
27
Table and figure 4.6 shows the study whether of 50 Respondents who were involved in the
study 2 (4%) indicated strongly disagree, 3 (6%) indicated disagree,18 (36%) indicated agree
and 27 (54%) indicated strongly agree. Since Majority 54% of the respondents indicated
strongly disagree, it means that the local authority do not have enough infrastructure to run the
decentralized functions.
Table 4.7 The probability that option contracts will payoff depends on volatility
of the underlying asset price of the bank.
Disagree 3 6 10
Agree 20 40 50
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.4 The probability that option contracts will payoff depends on volatility
of the underlying asset price of the bank.
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.7
Table and figure 4.7 shows the study findings whether the probability that option contracts will
payoff depending on volatility of the underlying asset price of the bank. Out of 50 Respondents
28
who were involved in the study 2(4%) indicated strongly disagree, 3 (6%) indicated disagree,
20(40%) indicated agree and 25 (50%) indicated strongly agree. Since Majority 50% of the
respondents indicated strongly agree, this means that probability that option contract will
payoff depends on the volatility of the underlying asset price of the bank.
Table 4.7 The put option allows the bank to bet that price of the underlying asset
will fall which will affect the bank negatively on their performance
Disagree 6 12 18
Agree 10 20 38
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.5 The put option allows the bank to bet that price of the underlying asset will fall
which will affect the bank negatively on their performance.
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.8
Table and figure 4.8 shows the study findings whether the put option allows the bank to bet on
the price of the underlying asset will fall which will affect the bank negatively on their
performance. Out of 50 Respondents who were involved in the study 3(6%) indicated strongly
29
disagree, 6 (12%) indicated disagree, 10 (20%) indicated agree and 31(62%) indicated strongly
agree. Since Majority 62% of the respondents indicated strongly agree, it means that put option
contract allows the bank to bet the price of the underlying asset will fall and this negatively
affect its performance.
Table 4.8 Banks use future contracts to lock a certain price of an underlying
assets this affect the financial performance of the bank negatively when the
interest rises.
Disagree 5 10 10
Agree 15 30 40
Valid Total 50 100
Missing System 0 0
Total 50 100
Figure 4.6 Banks use future contracts to lock a certain price of an underlying
assets this affect the financial performance of the bank negatively when the
interest rises.
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.9
Table and figure 4.9 show whether banks use future contracts to lock certain price of the
30
underlying assets this affects the financial performance of the bank negatively when interest
rate rises. Out of 50 Respondents who were involved in the study 0 (0%) indicated strongly
disagree, 5(10%) indicated disagree, 15 (30%) indicated agree and 30 (60%) indicated strongly
agree. Since Majority 60% of the respondents indicated strongly agree, this means banks uses
future contracts to lock certain price of the underlying asset this affects the financial
performance of the bank negatively when the interest rate.
Table 4.9 Forward contracts negatively affects the financial performance of the
bank when the other party fails to honour the contract like per agreement .
Strongly
0 0 0
disagree
Disagree 0 0 0
Valid Agree 5 10 10
Strongly
45 90 100
agree
Total 50 100
Missing System 0 0
Total 50 100
Figure 4.7 Forward contracts negatively affects the financial performance of the
bank when the other party fails to honour the contract like per agreement.
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.10
Table and figure 4.10 shows whether forward contracts negatively affects the financial
31
performance of the bank when the other party fails to honour the contract like per agreement.
Out of 50 Respondents who were involved in the study 0 (0%) indicated strongly disagree, 0
(0%) indicated disagree, 5 (10%) indicated agree and 45 (90%) indicated strongly agree. Since
Majority 90% of the respondents indicated strongly agree, this means that forward contracts
negatively affects the financial performance of the bank when the other party fails to honour
the contract like per agreement.
Table 4.10 Derivatives can add value to the bank, as long as the human resource
manager of the bank use restriction and hold a “limited amount.”
Strongly
2 4 4
disagree
Disagree 3 6 10
Strongly
25 50 100
agree
Total 50 100
Missing System 0 0
Total 50 100
Source: field study 2017
Figure 4.8 Derivatives can add value to the bank, as long as the human resource
manager of the bank use restriction and hold a “limited amount.”
120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.11
Table 4.11 shows whether derivatives can add value to the bank, as long as the human resource
32
manager of the bank use restriction and hold a limited amount. Out of 50 Respondents who
were involved in the study 2 (4%) indicated strongly disagree, 3 (6%) indicated disagree, 20
(40%) indicated agree and 25 (50%) indicated strongly agree. Since Majority 50% of the
respondents indicated strongly agree, this means that derivatives can add value to the bank, as
long as the human resource manager of the bank use restriction and hold a limited amount.
Table 4.11 The regulations and monitor derivatives consequently providing a

conducive environment for the market to succeed.
Strongly
0 0 0
disagree
Disagree 5 10 10
Strongly
27 54 100
agree
Total 50 100
Missing System 0 0
Total 50 100
Figure 4.9 The regulations and monitor derivatives consequently providing a

120
100
80
60
40
20
0
disagree agree
Valid Missing Total
Source: Table 4.12
33
The table 4.12 shows whether the regulations and monitor derivatives consequently providing
a conducive environment for the market to succeed. Out of 50 Respondents who were involved
in the study 0 (0%) indicated strongly disagree, 5(10%) indicated disagree, 18 (36%) indicated
agree and 27 (54%) indicated strongly agree. Since Majority 54% of the respondents indicated
strongly agree, this means that regulation and monitor derivatives consequently providing a
34
CHAPTER FIVE
CONCLUSION AND RECOMMENDATIONS

5.1 Introduction
This chapter draws a conclusion from the research findings. It brings together literature review,
finding of the research and gives research conclusion.
The study’s results indicated that there was an important relationship between financial
derivatives and the Zambia commercial banks financial performance. Additionally, given the
positive nature of the relationship it means that a unit change (increase) in financial derivatives
will result to an increase in financial performance of commercial banks in Zambia.
Consequently, therefore, financial derivatives should be properly utilized in a manner that is
influential to the goal of a sound and safe banking system in Zambia. The relationship between
financial derivative and commercial banks was in addition found to be important at as indicated
by the ROA This key finding is reliable with the literature and is in particular consonance with
(Choi and Elyasiani1997 and Flannery and James 1984); among others. Some of the previous
studies indicate that’s derivatives act as a balance to banks‟ lending activities (Diamond, 1984)
while others find that utilizing derivatives decrease the commercial banks ‟riskiness (Gorton
and Rosen, 1995).
The results about how bank performance is affected by derivatives are mixed and this probably
because it is not easy to differentiate in practice hedging and speculating derivative activities
and that above studies focused on large banks which have considerable speculating derivative
activities and market making that permit them to reduce, if not avoid, non-hedging derivative
activities interferences.
5.2 Limitations of the Study

The data used in assessing the relationship between the study variables was aggregated data
provided by the industry regulator BOZ. Such data could not allow an analysis at the bank
level, making it difficult to ascertain the manner in which the variables changed from bank to
bank as a result of the different characteristics of each bank. In addition, such an aggregation
left year to year comparison as the feasible approach rather than undertaking the analysis on a
bank to bank basis which could have led to a more healthy result regarding significance of the
underlying relationship The study period chosen covered only 5 years, which may not be
35
adequate for generalization of the findings to a longer time period. Further, there was marked
variation in this same period in the banking industry resulting from differences in the regulatory
regime from year to year, number of banking institutions, macroeconomic and competitive
circumstances alongside others. These differences were not accounted for, and could thus serve
to limit the assumption of homogeneity among all the years selected for the study.
Despite the strong correlation and high coefficient of determination, the relationship between
the study variables was found to be an insignificant one considering the fact that the model
examined the effects of the various variables on the ROA while holding others constant, the
coefficients themselves may not be significant as such thus, the effects of the independent
variables may become significant when taken in combination and not singly. Many factors
apart from those modelled in this relationship exert an impact on the ROA, some of which may
have a greater impact than those identified while the model only included the three (financial
derivatives, liquidity ratio and the shareholder equity ratio).
The focus of this study was on the three financial derivatives used by the commercial banks in
Zambia which are forwards swaps and options. The study looked at the effect of the three
financial derivatives as one variable and failed to study the effect of each financial derivative
separately. Forwards, swaps and options were combined to be one variable in this study.
Financial derivatives affect the large banks and the small banks differently due to difference in
capital structure, asset base, financial performance amount of risks taken and many more. In
contrast to large banks, small banks hold more liquid assets have more traditional capital
structures and are more thoughtful to risky investments. This study did not separate the large
and the small banks and looked at all the 19 commercial banks in Zambia.
5.3 Recommendations
The study recommends that derivative accounting, valuation procedures and derivative
educational programs be established and included to explain Zambia’s derivative market. This
would enable the finance offices to understand each and every hedging practice advantages and
disadvantages as currently most commercial banks do not have a steady policy on derivative
utilization and financial risks management is merely left on the notions and plans of managers
and therefore making investors incur action costs.
Clearly, the banking system’s soundness is an issue of essential concern to society. The study
therefore recommends that regulators carefully and continuously monitor the banks’ derivative
activities to assure that the increasingly popular instruments are used in a manner that is
instrumental to the goal of a sound and safe and banking system.
36
5.4 Policy Recommendations
This study recommends that sound risk management process such as ensuring that Procedures
and policies that outline clearly the lines of responsibility for managing risk. This study also
recommends that commercial banks put in place acceptable risk measuring systems and
appropriately create structured limits on risk taking.
37
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The Effect of Financial Derivatives On The Financial Performance of Commercial Banks in Zambia.

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THE EFFECT OF FINANCIAL DERIVATIVES ON THE FINANCIAL

PERFORMANCE OF COMMERCIAL BANKS IN ZAMBIA.

NAME: Memory C. Banda

STUDENT NO: 000-774

COHORT: Bachelor of Banking and Finance

1.1 Background of the Study

Derivatives go back similarly as Antiquity. Derivatives instruments were initially created to

1.2 Research Problem

To determine the effects of financial derivatives on the financial performance of commercial

1.4 Research Questions

1.5 Significance of the Study

2.0 LITERATURE REVIEW

2.1.2 What role do future contract play in the financial sector

2.2.2 What role do forward contract play in the financial sector

 Can be written for any amount and term

2.2.3 How forward contracts affects the performance of financial sector

2.3.2 What role do options play in financial sector

2.4.1 Definition of SWAPS

2.4.2 What role do SWAPS play in the financial sector?

 Borrowing at Lower Cost:

 Access to New Financial Markets:

 Tool to correct Asset-Liability Mismatch:

2.4.4The Financial Intermediary Theory

The objective of intermediation theory is to clarify the existence of financial Intermediaries. In

Independent variables Dependent variable

Figure 1: Conceptual Framework

2.6 Summary of Literature Review

3.0 Methodology and design

3.2 Research Approach

3.3 Research Strategy

3.4 Sampling frame

Financial market 30/100 x 117 = 35.1

Ministry of Finance 30/100x 17 = 5.1

researcher took an equivalent of 46 respondents

Summary of sampling frame

Financial performance This is a test of how properly a firm can

Source: Author, 2017

3.5 Sample size, tools and sampling techniques

SAMPLE SAMPLE Tools SAMPLING TECHNIQUE

reliability, consistency and accuracy that would not otherwise be present.

3.6.2 Validity of data

construction of realities were inevitably realigned with reconstructions, and interpretations

3.7 Ethical Consideration

Frequency Percent Cumulative Percent

Source: Table 4.1

Frequency Percent Cumulative Percent

Source: Table 4.2

Frequency Percent Cumulative Percent

Source: Table 4.3

Source: Field study 2017

Frequency Percent Cumulative Percent

Frequency Percent Cumulative Percent

Frequency Percent Cumulative Percent

Source: Table 4.5

Frequency Percent Cumulative Percent

Frequency Percent Cumulative Percent

Source: table 4.6

Frequency Percent Cumulative Percent

Source: Table 4.7

Frequency Percent Cumulative Percent

Source: Table 4.8

affect its performance.

Frequency Percent Cumulative Percent