2.3.2 Economic Risks
Economic risk relates to adverse impact on equity/income for both domestic and foreign operations because of sharp, unexpected change in exchange rate.
Economic exchange rate risk is about the effect of long-term movements in exchange rates on businesses' projected future cash flows and, in effect, their total market values. Expectedly, it has been termed the most vital form of exchange risk (Belk and Glaum, 1990; Miller and Reuer, 1998). Whereas economic risk is sometimes considered to being an extension of transaction exchange risk, in that it extends to cash flows that have yet to emerge, it differs from transaction risk in one necessary manner.
In the long run, exchange rates may have a more profound outcome on the future cash flows since they can truly alter the firms' abilities to produce those cash flows by inducing their level of sales, prices and input expenses. Firms' total values are endangered to the extent that the exchange rate linked changes to cash flows are not counterbalance by corresponding changes to the prices of goods (inflation). On the contrary, economic exchange risk is a function of movements in real rates of exchange (Gideon, 2013).
A number of factors, comprising of the international locations of a firm's plants, rivals, key buyers and suppliers, are considered to be significant when measuring a firm's economic exchange rate risk (Lessard, 2007; Miller and Reuer, 2009).
A firm that operates in a different currency area to that of a competitor, for instance, may have to cooperate on the level of sales and product prices in the occasion that favourable movements in exchange rates occur for the competitor who may answer by offering clients discounted prices, something the firm itself is not in a position to do (Lessard, 2007). At the same time, a firm that depends on foreign suppliers may experience the effects of opposing currency movements passed through, if the contractors are in a position to do so without losing out to competition (Miller and Reuer, 2009).
Economic exchange risk is problematic to measure and manage in that it is a function of a multitude of factors. Although the innovative and the urban nature of currency derivatives available today, conventional financial hedging, in which firms forecast future foreign currency cash flows to manage them in the foreign exchange markets, attends little purpose to protect firms from economic risk.
2.3.3 Translation Risks
Translation risk is too tied to assets or earnings derived from offshore enterprise (Glaum, 1990; Grant and Soenen, 1991; Madura, 2003).
Translation exchange risk is the results of the reiteration of financial statements of foreign subsidiaries into parent currency terms for the determinations of alliance. To Madura (2003), the procedure of translation, together with movements in exchange rates, may give outcomes in translation gains or losses in the yearly accounts as firms continue to arrive at a 'balanced' balance sheet; these gains and losses have conservatively been termed translation risk.
With translation risks, foreign currency denominated assets and liabilities are translated at the rate of exchange dominant at the balance sheet date ( thus the 'closing' rate), whereas the profit and loss account is translated either at the average rate of exchange for the financial year or at the closing rate. Share capital is transformed at the pace of exchange prevailing at the date when it was first delivered (significant rate). The occasioning translation gains and losses are reported as a separate constituent of stockholders' equity and bypass the income statement.
Further studies by (Bing et al., 1999; Shen et al., 2001; Wang et al., 2004) have revealed that risk fluctuation is one of the dangers affecting the banking sector. This danger arises from the fluctuation in foreign exchange rates to be on the changing significance to joint ventures.
Chua et al. (2003) indicated that variation of foreign exchange rates is one of the most precarious factors causing budget overrun in most of the countries in the East Asia.
2.4 How exchange rate risk is managed (Hedged)
It is significant to observe that after recognising the diverse patterns of exchange rate risk, strategic measures must be considered in order to hedge these risks. To Papaioannou (2006), he showed that there need to be suitable approaches to manage risks that bear upon the firm. These policies, however, depend on the type of risk that affects the firm and the size of the firm.
Specifically, transaction risk is often managed strategically or tactically to reserve cash flows and net profit, depending on the business's treasury view on the future actions of the currencies involved. Many businesses use tactical hedging to hedge their transaction currency risks in regards to short 'terms receivables and payments. Strategic hedging on the other hired man is used for longer-period transactions. Some firms choose to use passive hedging, which encompasses the maintenance of the same hedging construction and execution over regular hedging periods, irrespective of currency expectations.
Translation risk which is similarly known as balance sheet risk is hedged very irregularly and non-methodically. This is performed in order to keep off the impact of possible abrupt currency shocks on the net assets. This specific risk involves mainly long-term foreign exposures, such as the business valuation of subsidiaries, its debt construction and international investments. However, the long-term nature of these levels and the fact that currency translation affects the balance sheet rather than the income statement of a firm, make hedging of the translation risk less of a priority for management.
Economic risk is mostly put off as a residual risk. Economic risk is hard to measure, as it reflects the likely impact of exchange rate moves on the present value of future cash streams. This may require evaluating the likely shock of an exchange rate deviation from the benchmark rate used to forecast a firm's revenue and cost streams over a fed period. In this event, the impact on each stream may be meted out over product lines and across markets, with the net economic risk becoming small for firms that invest in many foreign markets because of offsetting effects. Similarly, if the exchange rate changes follow inflation differentials (through PPP) and a firm has a subsidiary that faces cost inflation above the general inflation rate, the firm could find its competitiveness eroding and its original value deteriorating as a result of exchange rate adjustments that are not in line with PPP (Froot and Thaler, 1990). Under these conditions, the firm could best put off its economic vulnerability by creating payables (e.g., financing operations) in the currency in which the firm's subsidiary experiences the higher cost inflation (that is, in the currency in which the firm's value is vulnerable).
Complex corporate treasuries, conversely, are developing efficient frontiers of hedging approaches as a more integrated approach to hedge currency risk than buying a simple vanilla hedge to cover certain foreign exchange experience (Kritzman, 1993).
Basically, an effective frontier ensures that cost is hedged against the degree of risk hedged. That is to indicate that a capable frontier regulates the most efficient hedging plan because it is the least expensive among the risk hedged.
For example; a currency view and exposure, hedging optimization models are generally liken to hundred percent (100%) unhedged schemes with hundred percent (100%) hedged by means of plain forwards and option plans in order to get the best one. It is nevertheless suggested that this approach to managing risk provides the least-cost hedging structure for a given risk profile, it critically depends on the corporate treasurer's view of the exchange rate. Such optimization can be employed for the transaction, translation or economic currency risk, provided that the firm supports a specific currency view (that is, a possible exchange rate estimates over a set time point).
2.5 Exchange Rate System in Ghana
Ghana presently runs a floating exchange rate regime with occasional interventions by the central bank. In the year 1983, a payment strategy was employed by the Ghanaian government with the aim of moving away from direct control of the exchange rate market and move towards a reliance on the market undercurrents to fix the exchange rates (Osei, 1996).
In the interest of the country, the government of Ghana in 1990 approved 180 forex bureaus to function in the country (Bhasin, 2004). Consequently, the two-window exchange system was incorporated in 1992 and the market started working an interbank wholesale system (Jebuni, 2006).
Table 1: Foreign Exchange Rate Selling & Buying
Currency BUY SELL
USD
1.8850
1.9300
GBP
3.0160
3.0560
EUR
2.5550
2.5750
JPY
0.0220
0.0235
Source: UT Bank, 2015
Ghana's exchange rate scheme has experienced a singular history of fixed and floating rate schemes. During the former 1970s, fixed exchange rate was largely seen in Ghana. However, by the former 1970s, difficulties in relations with compatibility between the fixed exchange rate and the macroeconomic policy stance emerged as the domestic inflation rate speeded above those of her key trading partners (Salifu, Osei& Adjasi, 2007).
Oduro and Harrigan (2000) noticed that four important features characterized the fixed exchange rate scheme in Ghana. According to them, they include a greatly overvalued official exchange rate; an active parallel market in foreign exchange; capital controls as well as a distribution of foreign currency grounded on import licenses. This epoch was also characterized by risky hesitance on the role of the financial and fiscal authorities to execute large exchange rate adjustments for fear of deteriorating the political instability at that stop.
Ghana exchange rate system became fully liberalized in the 1990s. The local currency, (hence, the Cedi) had still received more or less huge depreciation against the major foreign currencies. These immediate changes in exchange rate movements had obvious implications for firms. As a fashion of reducing such inconsistency, the Bank of Ghana was quite contributory in managing the exchange rate through market forces to ensure stability (Salifu, Osei& Adjasi, 2007).
Summary of foreign exchange risk in Ghana is shown in figure 1 below:
Figure 1: Risks in a Bank
Source: UT Bank, 2015
2.6 Factors that affects foreign Exchange Rate
Exchange rate instability is said to have implications for the financial system of a country especially the stock market. Changes in exchange rates have tenacious impacts, with its effects on prices, wages, interest rates, production levels, and job prospects, and with direct or indirect repercussions for the welfare of almost all economic applicants. For that reason, large and unstable changes in exchange rates show a major concern for macroeconomic steadiness policy. Given the effects that changes in exchange rates can have on economic conditions, policy makers naturally want to understand what can be done to limit exchange rate variability, and with what consequences.
At the national level, it is difficult to say whether depreciation is actually good news or bad news. The stock index consists of several businesses from diverse companies such as seven (7) exporters and importers whose transactions are affected by exchange rate changes in different ways.
In the view of Fortura et al (2007), a robust currency is a mixed blessing. They started that a strong currency is good because: It lowers the prices of imports and makes trips to foreign countries less expensive. Lower prices on foreign goods and helps to keep inflation in check. A strong domestic currency also make investment in foreign financial markets (foreign stocks and bonds) relatively cheaper.
However, on the other side, a strong currency makes domestic exports expensive. Therefore foreigners will buy fewer goods from that country. The net effect of this trade imbalance is a fall in exports and rise in imports (Fortura et al, 2007).
2.7 The Challenges in Managing Foreign Exchange Risks
On that point are some challenges that come about in managing foreign exchange risks. According to Dhanani (2003), since the initiation of foreign exchange risks, two vital frameworks, namely; qualitative and a quantitative framework, have been planned to quantify and manage economic exchange risk.
The qualitative method sees the economic risk as a business risk, in stead of the financial one. This, however affects the strategic and (competitive) profile of businesses (Lessard, 1989; Dhanani and Groves, 2001). This method here challenges the role of operational adjustments such as procurement and marketing mix variations to hedge the risk. These modifications change the currency mix of businesses' revenues and costs and, consequently, accommodate the effects of movements in exchange rates.
For instance, an exporting firm may, source some of its input materials from the international marketplaces in which it trades. That is, the reduction in the level of tax incomes from these markets as a consequence of a homegrown currency reappraisal which will be set off by a uniform reduction in the degree of operating costs. Differently, the firm may change the nature of its product or trading approach or even target fresh, less competitive markets to influence its total level of gross revenue. Further operational strategies comprise of the following: launching new production sites, or moving production within existing websites to avoid the contrary effects of less favorable charges, and production rationalization plans which engage the hostile currency effects.
In contrast, the quantitative framework measures the economic risk associated with statistical regression methods and focuses on the use of fiscal tools to evade the risk (Adler and Dumas, 1984; Kanas, 1996).
2.8 Theoretical Framework
In attempting to explain foreign exchange rate risk management in the Ghanaian banking industry and to achieve the aims of the survey, various hypotheses have been brought forward to connect between exchange rate, domestic and foreign inflation and interest rate. The work will concentrate on theories such as; portfolio theory and Purchasing power parity.
2.8.1 Portfolio Theory
The modern shape of the portfolio theory was propounded by Harry Markowitz in 1952. A major assumption by Markowitz underlying this hypothesis is that the investor in time zero is faced with two conflicting goals; to exploit the likely return and to belittle the danger involved. The primary idea of the portfolio theory is that not all securities answer equally to changes in the marketplace, for example; interest rates, oil prices or events pertaining to supply and requirement. They are regarded as causing a diverse market sensitivity. Important factors to look at when reducing risk are securities returns and their correlations. It is mere to pronounce that if they were not at all correlated, then diversification could remove the danger. On the other hand, if all securities were completely correlated, then diversification could not answer anything to transfer risk.
Yet, according to Harry Markowitz, the potential return of a portfolio is the weighted norm of the expected benefits (returns) of each individual security in the portfolio. For instance, if an investor wanted to only exploit expected return, he or she would simply contain one security, the one which was anticipated to increase the most in value. The conflicting assumption by Markowitz indicates that the investor will diversify by purchasing more than one security, which could cut the hazard of the portfolio (Sharpe, Alexander & Bailey, 1999)
It is inferred by sonic, and McLeavey, (2003) that most securities are linked up, but in the actual sense it is not perfectly correlated. This suggests that diversification could reduce a portfolios risk, but not in its entirety (Markowitz, 1959).
In the international arena for portfolio selection it could both contribute to decrease portfolio volatility due to low connection between global markets, but also to increased opportunities to take in profits if the investor is participating in his or hers portfolio management. The presentation of securities and securities industries to choose from increases and could offer possibilities that the domestic market cannot (Solnik, and McLeavey, 2003).
A basic theory about the portfolio risk is that the higher the number of sureties in the portfolio, the well diversified it is and the lower is the peril that the investor has to endure. In prospect of the hypotheses proposed by Markowitz there is a naturalistic set of portfolios to select from and every investor will pick out his or her best portfolio from a band of others volunteered.
2.8.2 Purchasing Power parity (PPP) Theory
The Purchasing Power parity theory has its origin to the literatures of the Swedish economist Gustav Cassel (1918). The original theory indicates that equal goods in various countries cost the same in the very same states when measured in terms of the same currency.
The purchasing power parity (PPP) theory is one of the important rules in international finance. The PPP theory of the exchange rate considers the relationship between a country's foreign exchange rate and its price tier, as considerably as the relationship between varieties in those variables (Allen & Gandiya, 2004).
In the literature on the explosion of purchasing power parity, lane referred to Purchasing Power Parity (PPP) as the substitution rate between two currencies that would unite the two appropriate national price stages if expressed in a collective currency at that stage; the purchasing power of a constituent of a currency would be equal to both economic systems. The notion of PPP is often consulted to as absolute PPP. Relative PPP, according to an (2000) holds when the pace of depreciation of a currency compared to another agrees with the difference in collective price inflation between the two states in question (LAN, 2001). If the nominal exchange rate is determined simply as the monetary value of one currency in terms of another, then the real exchange rate is the nominal exchange rate set for relative national price point differences. When PPP holds, the real exchange rate is a constant, so that movements in the real exchange rate signify deviations from PPP. Thus, a discourse of the actual exchange rate is equivalent to a discussion of PPP (Sarno & Taylor, 2002).
This theory explains why a country will experience rising prices while its international trading partners do not, when this passes off its exports will become less competitive. Likewise, imports will become more attractive because of their comparatively lower prices. The exchange rate will write as citizens purchase currency of the country with falling prices and sell the currency of the country with rising prices (Gallagher & Andrew, 2000).
CHAPTER THREE