CHAPTER ONE
INTRODUCTION
BACKGROUND OF THE STUDY
Foreign exchange rate risk management is an integral part in every banks decision about foreign currency exposure (Allayannis, Ihrig, and Weston, 2008). Currency risk or hedging strategies entails eliminating or reducing the risk, and it requires understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications (Barton, Shenkir, and Walker, 2011). Selecting the suitable hedging strategy is usually a frightening task because of the complexities concerned in activity accurately current risk exposure and picking the suitable degree of risk exposure that ought to be covered. The need for currency risk management started to arise after the break down of the Bretton Woods system and the end of the U.S. dollar peg to gold in 1973 (Papaioannou, 2008). The issue of currency risk management for financial firms is independent from their core business and is usually dealt by their corporate treasuries. Most multinational firms have also risk committees to oversee the treasury’s strategy in managing the exchange rate (and interest rate) risk (Lam, 2014). This shows the importance that firms put on risk management issues and techniques. Conversely, international investors usually, but not always, manage their foreign exchange rate risk independently from the underlying assets and/or liabilities. Since their currency exposure is related to translation risks on assets and liabilities denominated in foreign currencies, they tend to consider currencies as a separate asset class requiring a currency overlay mandate (Allen, 2014). Exchange rate volatility creates a risky business environment in which there are uncertainties about future profits and payments. These are especially exacerbated in countries where financial instruments for hedging against foreign exchange risk are not developed, which is the case in many developing countries including Kenya (World Bank & MTTI, 2016). Commercial banks play a critical role in economic development of countries. They channel funds from depositors to investors through their financial intermediation role. Beyond the intermediation function, the financial performance of banks has critical implications for economic growth of countries. Good financial performance rewards the shareholders for their investment
