Commercial banks use foreign currencies when holding assets and liabilities in foreign dominated currencies which result into their exposure to Foreign Exchange Risks. These risks come from trade and non-trade services. Some of the foreign exchange risks include buying of currencies to enable customers participate in the international commercial activities. It also includes purchase or sale of international currencies to enable customers participate in real and financial ventures. The other role of foreign exchange trade is the purchase of foreign currencies for purposes based on forecasting or expectations of the future changes in Foreign Exchange rates (Dornbusch & Fisher 2009).

Stock returns are sensitive to both exchange rate and interest rate risk (Ryan & Worthington 2004). This study examines the sensitivity of the stock returns to exchange rate in European countries and more specifically the United Kingdom. Fluctuations in real exchange rates have also been explained by the presence of changes in the financial market that result into a change in nominal exchange rates, which is passed on to the actual exchange rates as a result of sticky prices.

Problem Statement

There are certain gaps that exist in foreign exchange trading which need to be addressed. There are certain concerns that are related to foreign exchange trade which are associated with management of risks. Most people involved in forex trading are not able to understand the market conditions which are significant when there is the need to help customers or mentors. Most investors also overtrade in foreign exchange by going beyond their risks with the hope of getting huge returns. However, they have encountered losses which result into burning down of their accounts. The strength of a domestic currency, in comparison to a foreign currency, determines the performance of the stock in the markets. Investors have always preferred a mixed portfolio for the purpose of mitigating risks associated with the flexible exchange rate regimes.

Purpose of the Study

This study provides vital information regarding investments in the stock market with financial institutions in the United Kingdom. In the environment where information asymmetry is prevalent, this study provides complete information on the exchange rates effects on investment in stock. The study discusses possible measures adopted to mitigate risk associated with foreign exchange in the investment in stock. This information is critical to banks which engage on daily basis on activities that involve exchanges of currencies and hence relevant in guiding the operations of the banks. Though many studies have been conducted, vitalities seem to be taking new dynamic with every wake and hence need for subsequent studies.

Aims and Objectives

The aim of the dissertation is to measure the effect of the foreign exchange rates on the performance and return of the equity of financial institutions in the United Kingdom. The following objectives are introduced:

I. To profile the market factors that determine foreign exchange rate risk.

II. To explore the factors that influence the performance of the stocks of financial institutions in the UK.

III. To empirically evaluate the effect of foreign exchange rate exposure on the stock performance of the financial institutions in the UK.

IV. To determine measures adopted to mitigate risk associated with foreign exchange rate volatility in the stock market.

Research Questions

The study aims at determining the effects of volatility of exchange rates on the returns on stock. In accomplishing this major objective, the study seeks to address the following questions:

I. What are the market factors that determine the foreign exchange rate risk?

II. What are the factors influencing the performance of stocks of financial institutions in the United Kingdom?

III. What is the effect of foreign exchange rate exposure on stock performance in the financial institutions in the United Kingdom?

IV. What are the measures adopted to mitigate risk associated with foreign exchange rate volatility in stock markets?

In this chapter we will discuss the general view on the effects of volatility of exchange rates in the transaction market. The aim of the chapter is to give a review on the performance of stock in different markets in the economy. This forms a basis of understanding on the performance of bank stocks in the United Kingdom.

Industrial organization theory constitutes different strands. This includes banks that expand their operations with the objective of reaching out to their foreign customers. The high concentration of banking institutions in the home market provides an expanded market with increased profit. The theory also covers aspects of the role played by home country and domestic currency in the performance of the banks. Comparative advantage theory advocates for the expansion of banks, which have a comparative advantage in the process of supplying banking services. The argument fronted by the portfolio theory is that the international expansion plays a crucial role in risk diversification. This can also be induced to solve market imperfections within the domestic country (Bollerslev 2003, p. 321).

Specific Literature

There are many commercial banks in the United Kingdom (Friedmann & Sanddorf   2005). These banks include Barclays Bank, HSBC, NatWest and Lloyds, Standard Chartered, Tesco Bank, Harrods Bank and Bank of Scotland among others. These banks face foreign exchange risks since they hold liabilities and assets in foreign currencies. This is because exchange rates keep on fluctuating from one financial period to another financial period, and thus, these commercial banks may incur huge financial losses due to the downward shift of the exchange rates (Goldberg & Kolstand 2007). A commercial bank may incur two types of foreign exchange risks that include translational risks or transactional risks (Gujarati 2003). Translational risk occurs when commercial banks list foreign assets in their statement of financial position. In case the exchange rates change between quarterly financial statements, there is a possibility that there will be a significant variance between its reported financial figures. Transactional risk occurs when there is a difference in the period between when a commercial bank enters into a contract involving a foreign currency and when it actually settles the contract (Guo &  Neely 2006). This is because there may be fluctuations in exchange rates between these two periods.

Banks are not exposed to foreign exchange risks when they trade in the above activity since the foreign exchange risk is transferred to the customer. In addition to this, banks trade in foreign currencies for speculative purposes since they may forecast future movements in foreign exchange rates (Bollerslev 2003). Commercial banks in the United Kingdom also trade in foreign currencies for hedging purposes in order to offset any risk that may have originated from customers trading in foreign currencies. These transactions do not expose a bank to foreign exchange risks since the banks have hedged their risks (Lundbergh and Teräsvirta 2006, p. 9).

Hinich (2008) posits that the methods of managing foreign exchange risks are grouped into the internal and external methods. The internal methods are the methods that the financial management team takes to prevent losses due to foreign exchange risks (Lundbergh & Teräsvirta 2006). In contrast, companies thatform contractual relationships with other companies in order to insure themselves against any potential foreign exchange loss, use the external methods. The author stated that the main internal methods for managing foreign currency risks include leading, matching, netting, balance sheet hedging and pricing policies. Iorio and Faff (2007, p. 34) also supported the view that companies using the external methods mainly deal with long-term cash-flows and they use instruments, such as options on currency futures, currency options, currency swaps and currency futures.

According to Harrison (2008, p. 56), the main internal methods used to manage transactional risks in the United Kingdom include matching and pricing policies. From his study in commercial banks operating in the United Kingdom, Harrison discovered that most banks in this region used at least these two methods for managing foreign exchange rate risk. However, he discovered that some of the banks place more emphasis on the netting method for managing this type of risk. This is because this method allows forming inter-group settlement programs that would make savings in communication expenses. Guo and Neely (2006, p. 34) conducted studies on how commercial banks in the United Kingdom used pricing policies to manage transactional risks and found results that were similar to the results obtained in previous studies. Results from the study conducted by Hansen (2009, p. 45) revealed that most commercial banks in the United Kingdom used forward contracts as a method of managing transaction risk. However, his study revealed that Japan and Singapore used more derivatives to control the foreign exchange risks.

Literature Overview

The above literature by various authors seems to concur on various ways that can be used to mitigate risks emanating from volatilities of exchange rates. These include matching, netting, balance sheet hedging and pricing policies. They also propose that companies should consider using external methods mainly deal with long-term cash-flows and they use instruments, such as options on currency futures, currency options, currency swaps and currency futures. However, these studies do not shed enough light on the specific causes of FOREX volatility and how they have affected performance in financial banks in the UK.

Methodology

In this chapter, the methodological approach adopted for this piece of research is extensively treated. More specifically, this chapter sets out in detail the data employed, the models used, the mode of empirical estimations as well as diagnostic tests which are used to check the validity of results obtained.

Research Design

The aim of the dissertation is to measure the effect of the foreign exchange rates on the performance and return of the equity of financial institutions in the United Kingdom. The study will make use of primary data of the United Kingdom financial markets while 20 banks will consist as respondents for the study. The data will first be collected by developing a data collection guide where data will be recorded before analysing. Questionnaires and interviews will be used to obtain information from the managers and other relevant people in the UK’s financial sectors.

Data Collection

In this research, only primary data will be collected. In collecting the primary data, interviews and questionnaire will be used. Interviews will be conducted with various stakeholders in the banking industry, such as financial analysts, shareholders opinion on the stock performance and opinion of high-frequency traders who trade in stocks. Questionnaires will have structured questions, which will be accurately and carefully selected to meet the objective of the study. Semi-structured questions may also be used to avoid ambiguous responses. In this research, SPSS will be used to evaluate the bank stock sensitivity to changes in the interest rate and changes in the exchange rate volatilities.

Data Analysis and Presentation

With the help of the SPSS, the data obtained will be used to provide regression analysis between the dependent and independent variables. Descriptive analysis will also be used and will be presented in the form of pie charts, graphs and tables. To make recommendation and conclusions from the results obtained, the test of significance will be conducted to establish how various independent variable impacted on the performance and returns of the financial banks in the UK.

The model to be estimated will be,

hijt = βi0 + βij1hxjt + eijt 

where βi,j,1 represents future foreign exchange rate as a result of volatility in foreign exchange market. This coefficient can be used to estimate future bank exchange rate based on future foreign exchange rate.

Project Plan Including Timescale and Resources

I will conduct this study within a period of one month, and the activities will be organized strategically to ensure that the result obtained will be reliable. The study will take approximately one month. In the first weeks, efforts will be to come up with detailed and extensive questionnaires and interview schedules that will help collect adequate information. In the following week, I will obtain all the relevant stationeries and research assistance where necessary. The third week will be used in data collection while the last one will be for data analysis. The expected budget is as follows:

COST ELEMENT

AMOUNT ($)

Research Assistant (2)

200 allowances

Training and Seminar for research assistants (2)

$100

Stationery

$100

Travel (20 trips) @ $ 5

$200

Computer cost

$100

Publication and report cost

$200

Consultancy (from medical experts)

$100

Miscellaneous Expenses

$100

Total

$1,100

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