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Financial Risk Management using Derivatives; A case of selected financial institutions in Uganda Abstract The RAP examines the management of financial risks using derivative instruments in the selected financial institutions in Uganda. Three key research objectives were examined. These included; an examination of the institutions’ objectives for financial risk management, an examination of the determinants of derivative use by the selected commercial banks and an exploration of how commercial banks in Uganda manage various financial risks.

Two (2) key financial risks were considered; interest ate risk and foreign exchange risk. To determine the objectives of financial risk management, a study tool was developed that sought respondents’ views on the major reasons for managing financial risks. To identify the determinants of derivative use among the selected commercial banks, multiple linear regression was used. The volume of derivatives used by the selected banks was considered as a dependent variable and regressed with Bank profitability, Interest Rate Risk Exposure, Bank leverage position, Bank investment growth and Bank size.

The variables tested in the inear regression model were based on the determinants presented in several literature reviews as key rationales for corporate use of derivative instruments. Average derivative volume was 0. 31 ; average bank profitability was 0. 34; average interest rate risk exposure was 0. 14 average leverage was 0. 43; average investment growth of the sampled commercial banks was 0. 38 and the average bank size was approximately UGX. 245Billion. The higher the volume of derivatives used, the lower the bank interest rate risk exposure. The higher the banks’ leverage position, the higher the amount of derivatives used.

The Banking sector also continues to experience a wide disparity between the lending and deposit rates, hich have been caused by the inefficiencies with in the sector. The Industry has also experienced the listing of several companies, including DFCU Bank in 2004, and the cross listing of Jubilee Insurance Company on the Uganda Securities Exchange In 2004, the Bank of Uganda successfully issued 2-, 3-, 5-, and 10-year government bonds with hope to encourage private companies to access the debt markets.

The industry has experienced the issuance of bonds by Standard Chartered Bank and awaits DFCU Limited and Nile Bank Bonds. The East African Development Bank has also been able to trade bonds on the exchange. . 4 Why a topic on financial derivative usage There has been considerable literature on the management of foreign exchange risks and interest rate risks but there are limited literature concerning Ugandan corporations in managing these risks.

Previous empirical works on derivative usage has focused on large companies in advanced markets like the I-JK and USA (Grant and Marshall, 1997). Also, previous empirical works carried out to investigate the management of foreign exchange risk of large multinational companies concentrated on the management of specific exposures such as transaction and translation xposure (Collier and Davies, 1985), (Belk and Glaum, 1990) or economic exposure (Nagashy et al, 1997). There is also limited empirical study relating to interest rate risk management of financial institutions in Uganda.

There is also an increasing number of new financial derivatives being developed to cope with foreign exchange risk and interest rate risk, however there is little empirical study on how different banks in Uganda use these derivatives to manage their exposures. The major objective of this RAP is to examine how some banks in Uganda manage their foreign exchange and interest rate exposure as key financial risks. . Examine the institutions’ objectives for financial risk management. Examine determinants for derivative use by the selected commercial banks.

Examine how commercial banks manage various financial risks. 1. 6 Research approach With a huge interest in the management of financial risks, I embarked on iii. extensive review of related works especially the management of foreign exchange and interest rate risks. Special interest was placed on the applicability of derivative instruments in financial risk management. After extensive review, I was able to identify a possible area for research. As such, I formally contacted the respective financial institutions to establish whether they apply derivatives and if so, how they do it.

It was also of paramount importance to obtain the relevant financial performance data. part 2 Information: Sources and its limitations Information sources for this research study were both primary and secondary. Secondary information is information that was collected for some other purpose and not necessarily the one at hand. Primary information is information collected for the first time and for a particular research study. To examine the management of inancial risks using derivatives, both primary and secondary information were collected. Secondary information was collected from the respective selected commercial banks.

Bank profitability, interest rate exposure and leverage position were already computed from the financial statements of the respective banks. Investment opportunities, the size of the bank and volume of derivatives were manually computed from information on financial statements and other management reports. The major reason for using secondary information for this research was availability of financial statements and fully computed financial ratios. I only needed o locate the source of data and then extract the required information. Also, the costs for the collection of this type of research data were minimal.

Information was readily available. The major foreseeable limitation of this type of research data was the degree of accuracy and reliability attached. It was assumed that management of the respective banks prepared the financial statements and the respective financial ratios in the most ethical way possible and also with full adherence to the recommended International Financial Reporting Standards (IFRS). Concerning the most common derivatives used to manage currency and interest ate risks, primary information was sought using a questionnaire. Respondents were given choices to select what they knew was the most common derivatives.

The most and originality of information. Information that was obtained from the respective financial managers was taken as accurate and could be relied upon. Ethics in data collection When compiling financial ratios, they were collected OR compiled from financial statement data as it was without altering any fgures. Also, management was informed about the objectives of the research and a request was made to access the organizational financial data. Finance managers who provided the data were informed about the degree of confidentiality of the information they were providing.

It was only Oxford Brookes University and perhaps management of the respective banks who could access to the final report. However, it was made clear to the finance managers that no individual name of the bank would appear in the final report because of the confidentiality principle. They were requested to have an open mind in accepting the results and recommendation in the report presented by the researcher. As primary information was collected pertaining to the mostly used derivatives, espondents were informed of the maximum amount of time for an interview and they were at liberty not to provide any responses.

Research variables Derivative Volume: This was measured as the ratio of derivatives to total assets of the bank. Bank Profitability. This was measured by the Return on Assets Ratio (ROA) Interest Rate Risk Exposure. This was measured as Net Interest Margin; the difference of interest income and interest expense relative to assets. This index measures the sensitivity of the Return on Assets to changes in market yields. Leverage position: This was measured by the ratio of the book value of long-term ebt to the book value of assets (Musoke and Suhrus, 2005).

Investment opportunities: These were measured as the ratio of investment expenditures to the book value of assets (Musoke and Suhrus, 2005). Bank size: This was measured by the book value of the company’s total assets (cuyila et al; 2006). Empirical Model To test the hypotheses below, I employed a multiple linear regression model. It was envisaged that there is a linear relationship between derivative volume as a measure of derivative use and the banks’ profitability position, Interest Rate Risk Exposure, Leverage Position, investment growth potential and the bank size.

Derivative volume Bank profitabilitylnterest Rate Risk ExposureBank leverage positionBank investment growthBank size a, b, c, d, e and f are beta coefficients and is the error term Research hypotheses In line with the second research objective, 5 hypotheses were developed. Studies support the expected relationships between the risks and firm’s characteristics. Froot, Scharfstein and Stein (1993) constructed the models of financial risk management.

These models predicted that firms attempted to reduce the risks arising from large costs of potential bankruptcy, or had funding needs for future investment projects in he face of strongly asymmetric information. In many instances, such risk reduction can be achieved by the use of derivative instruments. Developing hypothesis 1 (Bank profitability) Ekuyege et al; (2008) affirm that banks which can manage interest rate risk using derivatives will be less constrained in their lending activities and will thus be able to invest in higher risk/higher yielding assets.

Derivatives can free many banks from the restrictions imposed by traditional internal hedging by allowing the bank to separate its choice of assets or sources of funding from considerations of market risk. A bank ith higher profits would be more likely to have used derivatives because derivatives can be used to hedge loss in income associated with interest rate risk exposure allowing banks to take on more profitable investments. Therefore, derivative use is expected to have a positive relationship with bank profitability.

There is a positive relationship between derivative use and a banks profitability position. Developing hypothesis 2 (Interest Rate Risk Exposure) In theory, banks can benefit from derivative markets because derivatives, like insurance, can be used to hedge against risk. Carefully chosen derivative deals can educe interest rate risk inherent in banking activities because the preexisting interest rate risk can sometimes be offset by a counterbalancing derivative risk.

Therefore, if derivatives are used to hedge against interest rate risk, then the volume of derivatives held by a bank should be negatively related to the current interest rate risk experienced by the bank. There is a negative relationship between derivative use and a banks interest rate risk exposure Developing hypothesis 3 (Bank Leverage Position) Cuyila et al; 2006) found empirical evidence that firms with highly leveraged apital structures are more inclined to hedging by using derivatives.

The probability of a firm to encounter financial distress is directly related to the size of the firm’s fixed claims relative to the value of its assets. Hence, hedging will be more valuable the more indebted the firm, because financial distress can lead to bankruptcy and restructuring or liquidation – situations in which the firm faces direct costs of financial distress. By reducing the variance of a firm’s cash flows or accounting profits, hedging decreases the likelihood, and thus the expected costs, of financial distress. There is a positive relationship between derivative use and a banks leverage position.

Developing hypothesis 4 (Bank Investment growth) and commodity risk, firms can decrease cash flow volatility. By reducing the cash flow volatility, firms can decrease the expected financial distress and agency costs, thereby enhancing the present value of expected future cash flows. In addition, reducing cash flow volatility can improve the probability of having sufficient internal funds for planned investments (Musoke and Suhrus, 2005) eliminating the need to either cut profitable projects or bear the transaction costs of external funding.

The main hypothesis is that, if access to external financing (debt and/or equity) is costly, firms with investment projects requiring funding will hedge their cash flows to avoid a shortfall in own funds, which could precipitate a costly visit to the capital markets. An interesting empirical insight based on this rationale is that firms with substantial investment opportunities that are faced with high costs of raising funds under financial distress will be more motivated to hedge against risk exposure than average firms.

There is a positive relationship between derivative use and a banks investment growth. Developing hypothesis 5 (Bank size) Other empirical studies have linked the frequency of derivative use to company size (Hushalter, 2000), (Nagashy, et al; 1997). In their studies they have argued that larger firms are more likely to hedge and use derivatives. One of the key factors in the corporate risk management rationale pertains to the costs of engaging in risk- management activities. The hedging costs include the direct transaction costs and the agency costs of ensuring that managers transact appropriately.

The assumption underlying this rationale is that there are substantial economies of scale or conomically significant costs related to derivatives use. Indeed, for many banks (particularly smaller ones), the marginal benefits of hedging programs may be exceeded by marginal costs. This fact suggests that there may be sizable set-up costs related to operating a corporate risk-management program. Thus, numerous firms may not hedge at all, even though they are exposed to financial risks, simply because it is not an economically worthwhile activity.

On the basis of empirical results, it can be argued that only large firms with sufficiently large risk exposures are likely to benefit from formal hedging programs. There is a positive relationship between derivative use and a bank size. Information analysis Information collected was entered in SPSS to generate the required charts and regression results. The volume derivatives used, profitability of the bank, interest rate risk exposure, leverage position, investment opportunities and size of the bank were all measured on a ratio scale.

According to (Zikmund, 2002) as long as there is one dependent variable and 2 or more independent variables, the best multivariate analysis technique is linear regression when all the variables are measured on either n interval or ratio scale. part 3 Research results The volume of derivatives was computed as a ratio of derivatives to total assets of the bank. Despite the fact that average ratio of derivatives to total assets is still low; 0. 31, a minimum of 0. 05 and a maximum of 0. 67 indicates that commercial banks in Uganda are gradually embracing the use of derivatives as financial risk management instruments.

Also, there was little dispersion within the volume of derivatives used for the selected commercial banks; standard deviation 0. 18. This gradual acceptance f derivatives as financial risk management instruments within the Ugandan formal financial sector had been noted by (Mugisha, 2008) who said that the continued deregulation of the financial sector, extreme international competition, continued volatilities in foreign exchange rates, interest rates and commodity prices have all resulted in an increase in derivatives.

Bank Profitability was measured by the Return on Assets Ratio (ROA). With a minimum of 0. 19 and a maximum of 0. 67, average profitability was 0. 34. This is recommendable profit performance given the recent financial crisis in which most orporations made gross losses. Again, there was also limited dispersion within the profits for the selected financial institutions represented by a lower standard deviation; 0. 156. Interest Rate Risk Exposure which was measured as a net interest margin; the difference of interest income and interest expense relative to assets.

It had a minimum of 0. 025 and a maximum of 0. 5 with an average exposure of 0. 14. Despite the fact that the net interest margin relative to assets was somehow low, it attracted the use of derivatives and the more derivatives used, the lesser the interest rate risk xposure. It was also discovered that there was little dispersion within the interest rate risk exposure signified by a lower standard deviation; 0. 149. The banks’ leverage position was measured by the ratio of the book value of long- term debt to the book value of assets.

With a minimum of 0. 078 and a maximum of 0. 78, the average leverage position for the selected commercial banks was discovered to be 0. 43. This is a big fgure that certainly attracts the use of derivatives. The banks leverage position also displayed limited dispersion for the selected commercial anks; standard deviation 0. 197. Investment opportunities were also measured as the ratio of investment expenditures to the book value of assets.

With a minimum value of 0. 145 and a maximum value of 0. 61 , the average investment growth in the selected commercial banks was 0. 38. There was also limited dispersion in the investment growth fgures from the selected banks; standard deviation 0. 17. Despite the fact that it was a humble average investment growth fgure, it did attract extensive use of derivatives as banks wished to hedge against risks of their future cash flows.

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