Chapter 1
Background
Firms in the United Arab Emirates’ financial market face a number of risks that may have a serious negative impact on their value. According to Virine and Trumper (2007), the main product offered by financial institutions is cash. This is one area that puts financial institutions at great risk due to the nature of this product. Smar (2014) says that the problem of bad debts is increasingly becoming common in the United Arab Emirates. Individuals and entities come for loans but disappear when it is time for the repayment. In the past, recovering such loans would be easier because banks demanded stronger collateral against the loans they gave out. However, major changes have been witnessed in this industry and now it is possible for banks to offer loans without demanding for stronger collaterals.
When the customers fail to pay back the loans given to them, in many cases banks are forced to write them off as bad debts. This erodes the value of such a firm because the transaction will be recorded as a loss. Inflation is another major risk that many firms face. The value of the currency that banks use in the United Arab Emirates keeps changing due to a number of environmental factors. Banks are directly affected by this fluctuation of the currency value (Douglass 200, p. 31). Many other environmental factors may affect the value of a financial institution to varying degrees.
According to Alkeback and Hagelin (2001), many banks have been relying on insurance as a way of offsetting the losses incurred during their operations such as those mentioned above. However, a new form of managing these risks has emerged in the name of hedging. Crockford (2006) defines hedging as a strategy used to offset or limit possible losses incurred due to fluctuation in commodity prices, securities or currencies. It involves taking an equal but opposite positions within the market. A good example can be a situation where a bank is loaning Dh. 50,000 to a client at an interest rate of 16% for one year.
There are two possibilities that may occur within that one year. The value of the currency may increase or decrease depending on the environmental factors in the country. Supposing that the change in value of the currency is estimated to be 10%, it means that this firm can gain or lose 10% of the value of money loaned to the customer depending on the changes experienced. The bank may consider a hedging strategy to cover it just in case the change is negative. In this case, it will go to the bank, take a loan of an equal value to protect it from the possible drop in the currency value. The table below shows changes in value based on the two possible eventualities. We assume that the central bank’s interest rate is 4%.
For the purpose of clarity, the statistical values above can be presented diagrammatically as shown in the graph below.
From the figure above, it is clear that hedging cushions a firm from the negative effect of depreciation in the value of the currency. However, it comes at a cost. The cost of hedging is felt when the value of the currency appreciates instead of depreciating. In cases of appreciation, the commercial bank’s profit is significantly reduced as shown in the figure above. In this context, firm should consider using hedging only when the value of the currency is expected to depreciate. Other forms of hedging that a firm can use to cushion it from depreciation including investing in real estate, buying government bonds, having futuristic contracts, or investing in precious metals (Williamson 2000, p. 610).
Research Problem
According to Abed (2014), the financial market in the United Arab Emirates has experienced a massive growth over the past two decades. However, individual institutions have faced a number of risks, top of which is the fluctuating value of the currency used in the local economy. In order to solve this problem, these financial institutions need a strategy that will ensure that they are not affected by these fluctuations. This will help them operate normally without fearing the possible consequences of the changing value of the currency. According to Adam and Fernando (2006), hedging is one of the best tools that financial institutions can use to solve this problem. Inasmuch as this strategy reduces benefits that could be gained from sudden increase in the value of the currency, it cushions firms from a possible loss in the currency’s value (Flyvbjerg 2003, p. 45). It makes the currency value relatively stable in the market despite the possible fluctuations that may be experienced. In this study, the researcher will look at the hedging effect on the value of a financial institution in the United Arab Emirates. HSBC was chosen as the most appropriate financial institution for the study.
Research questions
When conducting research, Vogt (2007) says that it is important to develop effective research questions that will help in collecting relevant data. The research questions act as a guide to the researcher to ensure that information gathered from both primary and secondary sources are relevant to the study. The following are the research questions that will be used in this study.
- What is the effect of hedging on the value of HSBC in the Middle East?
- How relevant is hedging as a strategy in managing risks associated with fluctuation of the currency value?
The researcher will strive to respond to the above questions through this research project.
Research objectives
The researcher set specific objectives that are to be achieved by the end of this study. The objectives were based on the research questions above.
To determine the effect of hedging on the value of HSBC in the Middle East
To establish relevant is hedging as a strategy in managing risks associated with fluctuation of the currency value
Significant of the Study
Financial institutions in the United Arab Emirates play a very important role in our economy. According to Schwaighofer (2014), these institutions offer a platform for other sectors to conduct trade. They ensure that there is a smooth flow of currency or any other means of payment. Any negative impact on these firms may have a ripple effect on the entire economy. These firms also play a major role in managing inflation within the economy. Their significance makes it necessary to find ways of making them very stable even in the face of a volatile economy. This study is very important because it seeks to find a solution to the many problems that these financial institutions always face (Hubbard 2009, p. 12). Through this study, these financial institutions will know the relevance of hedging as a strategy in managing risks associated with the fluctuating value of the local currencies.
Contributions of the study
This study is based on a field that has attracted attention of many other scholars. The hedging effect on a firm’s value is a topic that many other scholars have looked at in the past (Jorion 2009, p. 17). However, our study is unique because it will specifically focus on the financial institutions in the United Arab Emirates. This study will identify and address gaps in the existing bodies of knowledge in order to improve the current status of research. This report will be very useful to the policy makers in the banking industry because it will inform their decision making process. Future scholars who will be interested in conducting a study in this field will also find this document vital when reviewing their literature.
Summary of chapter one
This chapter has given a detailed background of the hedging effect on a firm’s value in the banking industry. It has given an overview of how the hedging strategy works to cushion firms from possible consequences of a loss in the value of the currency (Klaes 2008, p. 78). Research questions and research problems have also been clearly defined in the chapter. Finally, the chapter has looked at the significance of the study and contributions of this research to various entities and individuals.
Literature Review
Background of HSBC
HSBC is one of the leading financial institutions in the world. Headquartered in London, the United Kingdom, this firm operates in various other countries in Europe, North and South America, Asia Pacific, and Africa (Demsetz 2012, p. 350). HSBC Bank of Middle East was founded in 1889 by the top management of HSBC to capitalise on the emerging markets in this region. Middle East was a potential market that was not served adequately by the existing firms. In the Middle East, the United Arab Emirates has been the regional headquarters for its operations. Most of the regional operations are strategically managed from the regional head office in Dubai.
HSBC faced a number of challenges in the 1980s due to the spirit of nationalism that was growing in the Middle East. Many firms from the West, especially those in the financial sector, faced serious challenges as customers boycotted them in favour of the local firms (Aggarwal 2007, p. 75). The wave of nationalism and anti-American campaigns made it difficult for these firms to operate in this region. However, the firm was able to overcome this challenge. According to Cortada (2011), HSBC is currently one of the leading international banks in this region. The United Arab Emirates has become one of the best markets for this firm. The massive developments experienced in this country and the emergence of Dubai is a major trading hub in the world has enabled many financial institutions to experience growth in the market.
HSBC has faced problem of fluctuating value of the local currency, just like many other financial institutions in this country. In most of the cases, the local customers coming to the bank would borrow money using this currency. When the value of the currency depreciates at the time the customer is paying back the loan, the profitability of the bank gets affected. According to Agrawal and Manelker (2007), the firm has been using various strategies in order to offset such losses in its operations. One of the major strategies that HSBC uses to manage such fluctuations is to diversify its products. Other than the financial market, this firm has invested in various other sectors of economy in the country, including in real estate market (Aabo & Ploeen 2013, p. 45). This has worked well in reducing the perceived loss that is caused by the reduced value of the currency in the market. This is one of the best strategies of hedging that is now gaining popularity among many firms in this region.
According to Connelley (2012), firms are always assured that the value of investment in the real estate will continue to increase despite possible fluctuations in the currency used in a given market. Cortada (2012) says that HSBC is also one of the firms that have been using various approaches of hedging, including taking equal amount of loans to that which has been issued to the customers, especially when the value of the currency is expected to fall. In this study, the researcher will critically analyse various hedging practices used by HSBC in the United Arab Emirates.
Theory to be used in the Research
Risk management is a broad but very important area in the field of management. Adetule (2011) says that firms face a number of risks that may affect their operations in various ways. The best way of managing risks in an organisation is to start by identifying the risks before developing a specific strategy that can be used to address the challenge. According to Dempsey (2014), hedging is one of the tools that are gaining popularity in the banking industry. Many firms in the financial sector are now relying on various hedging strategies in order to cushion themselves from the uncertainties in the market. In order to understand hedging effect from a broad perspective, the researcher will analyse various hedging theories. The following are the specific contemporary corporate hedging theories that will be used in the research project.
Financial theory
Financial theory is one of the widely used theories of hedging (Dorfman 2007, p. 112). This theory explains why it is relevant for corporate to hedge as a way of protecting themselves from various risks that may occur during their normal operational processes. One of the fundamental assumptions of this theory is that corporations are risk-neutral in a perfect market scenario. This is so because of the assumptions that large corporations are held by individuals who buy shares, and therefore, are actually looking for the financial risks in order to benefit from their investment. This theory also assumes that large corporations are highly diversified, making hedging unnecessary because a loss experienced in one industry is likely to be compensated by profits in another sector (Rita & Man 2014, p. 51). The researcher will analyse this theory in order to explain why this theory emphasises of hedging despite these assumptions which justify the need to avoid hedging among corporations such as HSBC.
Agency theory
Agency theory explains the relationship between two parties which can work as a team in order to meet individual interests. The relationship exists between the principal assigns the agent to undertake certain tasks on its behalf at a given fee (Lowe 2015, p. 74). In the context of hedging, agency theory can be interpreted in various ways. For instance, a financial institution such as HSBC can invest in a real estate firm as a way of cushioning itself against possible risks that it may face in the banking sector. HSBC will be acting as a principal while the real estate firm will be acting as an agent. HSBC may not invest directly into the real estate market because of a number of reasons. However, nothing will stop it from relying on an agent to do that work for it at a fee. The profits generated from the real estate market will be shared in a predetermined ratio. It is important note that the agents can be assigned to undertake various roles that they specialise on as a way of allowing the firm to diversify its products.
Stakeholder theory
When it comes to hedging, Oborn (2013) says that stakeholder’s theory should not be ignored. This theory holds that all the stakeholders within a corporation play an important role and should never be ignored when coming up with an important strategy that will affect them. According to McGivern and Fischer (2012), hedging may have far reaching consequences on the performance of a firm. When a firm decides to employ this strategy, it may be necessary to consult the stakeholders and take into consideration their views. Some may have a better opinion about the best hedging approach that can be taken in order to achieve the best result. Sometimes borrowing an equal amount of money from the central bank as that which is given to the customers may not be the best option for a financial institution. When the management decides to take such a decision without consulting the investors, conflict may arise. This may specifically be the case when the value of the currency rises instead of falling as was expected (Miles 2012, p. 87). The rise in the value of the currency would mean that the investment of the stakeholders will increase to equal proportions as the increase in the value of currency. When this is not reflected in their stock because of the percentage reduction caused by hedging, then the shareholders will feel cheated. They may consider selling their shares from such a firm, a move that may cripple it within a very short time.
New institutional economics
The new institutional economic is another concept that will be relevant when explaining hedging effect on the value of HSBC. This concept expands the principles and concepts presented in neoclassical economics. It explains the legal and social norms underlying economic activities. This will help in explaining the fact that whichever approach of hedging a firm decides to take, the legal and social forces can never be ignored (Phillips 2003, p. 90). The strategy must always be socially and legally acceptable.
Summary
This chapter has looked briefly at the background of HSBC in Middle East and how its operations have been affected by a number of factors. It has also looked at the theories of hedging relevant to this research project.
Research Methods
Methodology
In this study, it is important to define the appropriate research methodology that will help in proper data collection and analysis. In this project, the researcher will be investigating the hedging effect on HSBC in the Middle East. This is a topic that has attracted attention of many scholars. For that reason, both primary and secondary sources of data will be used. The secondary sources of data will be obtained from books, journal articles, and reliable online sources. The researcher will use secondary data to inform the study. It will help in forming the background of the research. It will also help in understanding the theories that are used in this field. A review of the relevant literatures will also help in identifying gaps in the existing body of knowledge in this field. This will help in ensuring that the researcher does not produce a report that adds no value to this area of research.
The primary data will be collected from participants sampled to participate in this study. The participants will be employees of HSBC at its Dubai branches and financial experts, especially in the field of hedging. The researcher will use stratified sampling method in order to select individuals who will participate in the study. The two strata will be the employees of HSBC and financial experts. The financial experts will give the insight into this topic, while the employees of HSBC will provide a case-study scenario of how this firm has used hedging to manage various financial risks and how these strategies impacted on the firm. In each stratum, the researcher will use simple random sampling strategy to select individual participants for the study.
Questionnaire questions
The researcher will use a questionnaire to collect primary data from the sampled respondents. The questionnaire will be divided into three. The first part will focus on the demographic factors of the respondents. The second part will be questions for the employees of HSBC while the third part will be questions for the financial experts. The following are the questions that will be used in this research project.
- What is the effect of hedging on the value of HSBC in the Middle East?
- How relevant is hedging as a strategy in managing risks associated with fluctuation of the currency value?
- How often does HSBC use hedging as a way of managing financial risks it faces in the Emirati market?
- How often should HSBC use hedging as a way of managing financial risks it faces in the Emirati market?
- What is the view of the stakeholders of HSBC towards hedging?
- Who should be consulted when a bank is planning to use hedging to manage its risks?
Data analysis Plan
The analysis of collected data will be analysed using both quantitative and qualitative approaches. This will help in explaining the statistical values resulting from the mathematical analysis. SPSS (statistical package for social scientists) will be used in statistical analysis.
Summary
This chapter looks at the method that will be used in this research project. It looks at the sources of data that will be used, sampling methods, research questions, and data analysis plan.
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