Effect of Banks and Market Specific Characteristics on the Use of Derivatives among Commercial Banks in Kenya
Ng’eno, Shadrack Kipkoech
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Since the global financial turmoil in 2008, which led to the fall down of financial institutions, there is an increased focus on risk management practices in financial institutions globally. Being an essential tool for risk management and investment reasons, the usage of derivatives has grown speedily lately. Interest rate and currency risks represent the key forms of risks faced by the banks due to their volatility. While several empirical studies have been conducted in the developed financial markets on the application of financial derivatives, a lot remain undone on emerging countries like Kenya on the usage of derivatives as a viable instrument of hedging against the financial risks. Consequently, the primary objective of the study was to establish the effect of banks’ in addition to market specific characteristics on the use of derivatives among the licensed banks in Kenya. The banks specific characteristics under study were the size of the bank, and type of bank. The market specific characteristics under the study were the interest rates and exchange rate volatility while the moderating characteristic was the Central bank of Kenya regulations. The research design was descriptive which generally describes the events from the variables under study. The study involved carrying out a census of all commercial banks that have been operational from 2009 to 2014. The researcher found it appropriate to use census method because the population under study was small and easily accessible. A desk review of secondary data was carried out through review of documentary reports of CBK, Nairobi Securities Exchange, Kenya National Bureau of Statistics, IMF, World Bank and the banks’ financial statements through the period 2009 to 2014. A panel regression analysis model was utilized to examine relationship between banks and market specific characteristics and usage of derivatives among the licensed banks in Kenya. The data collected was used with an aim of presenting the research findings in respect to the extent to which banks’ and market characteristics affect the use of derivatives among the commercial banks in Kenya. Stata v13 software was used to produce descriptive statistics such as means and standard deviation. Results from the Panel model, holding other factors constant, indicated that Interest rate volatility, exchange rate volatility, bank size and liquidity positively affects the use of derivatives while bank type negatively affects the use of derivatives among commercial banks in Kenya. The results further found the R2 to be 0.659 meaning that 65.9 percent of the variations in the use of derivatives are explained by the predictor variables. In the presence of a moderator R2 rose to 0.682. The study recommends that the CBK should monitor the exchange rates by coming up with an exchange rate target band beyond which it can intervene to stabilize exchange rates and protect them from the exchange rate volatilities. The study further recommends that the capital markets authority in liaison with the central bank of Kenya should set up a derivative exchange to allow the banks and companies with small size in terms of the assets to participate in the derivatives market. Thirdly, the study recommends that banks should set a proportion of its net profit to use in derivative trade. Finally, the study recommends that the Central Bank of Kenya should come up with a strong regulatory and policy environment to facilitate the development of derivatives market that will help banks manage its financial risks.