Foreign Exchange Risk Management Practices and Financial Performance of Manufacturing Firms in Kenya

Abstract

Risk management is key to the success of any firm in the business environment. Foreign exchange risk is among the risks that firms face in the business environment especially firms that conduct business internationally and therefore this risk needs to be managed. This risk manifests itself in the form of foreign exchange losses due to adverse fluctuations in exchange rates. This study sought to determine the effect of foreign exchange risk management on the financial performance of manufacturing firms in Kenya. It adopted a descriptive research design and targeted 85 top manufacturing firms in Kenya as per Glassdoor as at September 2020. The variables for the study were financial performance and foreign exchange management strategies. Financial performance was measured using the ROA where used financial data was collected for a period of 5 years (2015-2019) while the foreign exchange management strategies considered were the use of forward exchange contracts, currency options, currency futures, swaps, currency invoicing, leads and lags and netting. For operationalization of the foreign exchange risk management strategies, a value of “1” was assigned if a firm confirmed the usage the above strategies and a value of “0” if a firm doesn’t use the above strategies. From the correlation analysis a strong positive correlation between ROA and the use of forward exchange contracts and leads and lags each with a correlation coefficient of 0.61 and 0.71 respectively. From the regression analysis, a significant relationship between ROA and the use of forward exchange contracts, currency options, currency futures, swaps, currency invoicing, leads and lags and netting in foreign exchange risk management was established. The R-squared was 0.6888 while the adjusted R-squared was 0.6320 with a p value of 0.0000 implying a significant relationship between ROA and the 7 hedging strategies where 68.80% of the variations in ROA were explained by the usage of the study hedging strategies. From the regression analysis, the study found out that there is statistically significant association between ROA and the use of forward contracts, currency options, swaps, and leads and lags where each had a p value of 0.001, 0.039, 0.005 and 0.003 respectively. From the study findings, the study recommends to manufacturing firms in Kenya as well other firms exposed to foreign exchange risk to adopt the use of forward exchange contracts, leads and lags, currency options, swaps, currency invoicing and netting in foreign exchange management so as maximize on the gains and minimize on the losses from foreign exchange which greatly impact a firm’s performance. The use of forward exchange contracts will guarantee a firm to buy or sell foreign currency at a fixed exchange rate thus safeguarding against adverse fluctuations in exchange rates. Leads and lags enables a firm to delay or hasten the payment of its payables or collection of its receivables depending on the movement of exchange rates in the market hence averting the effects of adverse fluctuations in exchange rates. Currency options gives a firm the option but not obligation to buy or sell a specified amount of foreign currency at a specified time hence giving a firm the ability to manage its exposure to foreign exchange risk. Swaps enable a firm to exchange its liabilities denominated in foreign currency with another firm that has liabilities denominated in the home currency hence allowing the firm to settle its liabilities in the home currency averting issues to do with foreign exchange. Currency invoicing ensures that foreign exchange risk is kept in check by either invoicing or being invoiced in the home currency or both. Netting ensures that foreign exchange risk exposure is minimized to only the maximum possible netted amount. It also reduces transactions costs. The study also recommends to the government policy making institutions to ensure that there are well functioning financial derivative markets for the effective trading of financial derivatives. This will ensure that firms exposed to foreign exchange risk embrace fully the use of financial derivatives in foreign exchange risk management.