ABSTRACT
This study examined Financial Derivatives and Financial Performance of listed Commercial Banks in Nigeria. A period of seven (7) years (2013 to 2019) was covered and ex-post facto research design was adopted. The study employed all fourteen (14) listed commercial banks in Nigeria as at 31st December, 2019. Return on Assets (ROA), Return on Equity (ROE), Earnings per Share (EPS) and Return on Capital Employed (ROCE) were used as measures of performance while Financial Derivative Assets (FDA), Financial Derivative Liabilities (FDL), Financial Derivative Trading Income (FDTI) and Financial Derivative Disclosure (FDD) were measures of financial derivatives as well as firm age, firm growth and leverage as controls for the regression model. However, to test the hypotheses of the study, multiple regression analyses technique was employed using E-view, version 11. Results revealed that FDA and FDTI has a positive significant (5%) effect on Earnings per share, FDL and FDD has a negative significant effect on return on assets while FDA, FDL, FDTI and FDD have no significant effect on return on equity and return on capital employed. The study concludes that FDL and FDD have a significant effect on return on assets of listed commercial banks in Nigeria while FDA and FDTI have a significant effect on earnings per share of listed commercial banks in Nigeria. The study therefore recommends that corporate managers especially those within the banking sector should engage or drive policies that will promote the use of derivatives. This will engender the banks holdings of derivative assets and derivative trading income to increase their earnings that will in the long run enhance the performance of Commercial Banks in Nigeria. Financial Regulators should organize conferences and symposia for commercial banks in order to enhance their knowledge base on the effective use of financial market derivatives.
TABLE OF CONTENTS
Title Page i
Declaration ii
Certification iii
Dedication iv
Acknowledgment v
List of
Tables viii
List of
Figures ix
List of
Appendices x Abstract xi
CHAPTER 1:
INTRODUCTION 1
1.1 Background to the Study 1
1.2 Statement of Problem 3
1.3 Objectives of the Study 5
1.4 Research Questions 5
1.5 Research Hypotheses 6
1.6 Significance of
the Study 6
1.7 Scope of the
Study
7
1.8 Operational
Definition of Terms 8
CHAPTER 2: REVIEW
OF RELATED LITERATURE 9
2.1 Conceptual
Framework 9
2.1.1 Concept of
financial derivatives 9
2.1.2 Firm performance 11
2.1.3 Financial
derivative assets 12
2.1.4 Financial
derivative liabilities 12
2.1.5 Financial
derivative of trading income 13
2.1.6 Financial
derivative disclosure 13
2.1.7 Firm age 14
2.1.8 Firm growth 15
2.1.9 Firm leverage
15
2.1.10 Financial
derivatives and performance 16
2.1.11 Financial
derivative assets and performance 18
2.1.12 Financial
derivative liabilities and performance 19
2.1.13 Financial
derivative of trading income and performance 19
2.1.14 Financial
derivative disclosure and performance 20
2.1.15 Financial
instruments: recognition, classification and measurement 23
2.1.16 Types of
derivatives 23
2.1.17 The uses of
financial derivatives 26
2.1.18 Financial
derivatives and financial market (global perspective) 28
2.1.19 Financial
derivatives development in Nigeria: sterilized fact 30
2.2 Theoretical Framework 32 .
2.2.1 The Modern
Portfolio Theory of Investment 32
2.2.2 Financial
economic theory 33
2.2.3 New
institutional economic theory 34
2.2.4 Arbitrage theory 34
2.3 Empirical
Review 35
2.3.1 Summary of empirical
review 45
2.4 Gap in
Literature 50
CHAPTER 3: METHODOLOGY
51
3.1 Research
Design 51
3.2 Area of the
Study 51
3.3 Population of
the Study 52
3.4 Sampling and
Sampling techniques 52
3.5 Method of Data Collection 52
3.6 Method of Data Analysis 52
3.7 Model Specification
53
3.8 Operationalization of Variables 54
CHAPTER 4: DATA
PRESENTATION AND ANALYSIS 55
4.1 Data
Presentation 55
4.1.1 Descriptive statistics
55
4.2 Data Validity Test 58
4.2.1 Unit root test 58
4.2.2 Cointegration test 59
4.3 Test of Research Hypotheses 60
4.4 Discussion and Interpretation of Results 69
CHAPTER 5: CONCLUSION
AND RECOMMENDATIONS 72
5.1 Summary of
Findings 72
5.2 Conclusion 72
5.3
Recommendations 73
5.4 Contribution
to Knowledge 74
5.5 Suggestions for Further Studies 75
REFERENCES 76
APPENDICES 85
LIST
OF TABLES
2.1: Summary of Empirical Review
3.1: Operationalization of Variables and
Justification.
4.1: Descriptive Statistics.
4.2: Correlation Analysis
4.3: Unit Root Test.
4.4: Co-integration Tests
4.5: Test of Research Hypothesis
LIST
OF FIGURES
1. Grammatically Representation of
Conception Framework.
LIST
OF APPENDICES
I: Operational Definition of
Terms
II: Analyzed Data
III:
Descriptive
Statistics
IV: Correlation
Analysis Test
V: Unit
Root Test
VI: Cointegration
Test
VII: Regression
Analysis
CHAPTER 1
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
Prices
rise and fall according to market whims in the realm of economics and finance,
and due to constant price volatility, uncertainty becomes a thought-provoking
feature that can make or break returns-on-investment. Derivatives have arisen
as financial tools for engineering contracts with fixed values and timelines
that have shown to be answers to a variety of economic problems. A derivative,
in its most basic form, is an agreement between two parties to carry out some
type of financial transaction at a certain time and at a predetermined price.
In general, this renders derivatives futuristic. Financial derivatives are
effective risk management instruments for reducing market risk exposure. They let manufacturers and consumers to lock
in pricing while ensuring that supply and demand remain consistent. Investors
and businesses can utilize them to protect themselves from negative events by
reducing the impact of changes in macroeconomic variables.
Derivatives
are a powerful risk management tool that shifts risk from individuals with a
low appetite for risk to those with a high appetite for risk. They are utilized
to protect against price swings that are not favorable. Derivative instruments
offer more leverage than any other financial instrument. Interest rate and
foreign currency derivatives shield a company's cash flow and earnings from
adverse interest rate and exchange rate changes. Financial derivatives are
common tools used by financial institutions and corporations in the money
market to manage and hedge business risks (Gibson and Murawski, 2013; Hon,
2012).
The key to a company's ability to keep its investors, including
shareholders, debt holders, and other stakeholders, is to consistently create
and realize the company's value. Because the firm's performance is a measure of
the company's level of success, the value of the company plays a significant
part. The firm's strong success will inspire market confidence in not only the
company's current performance, but also its long-term potential (Luo, 2016).
Specifically, practically all firm activities (especially those of
international scale) are tied to the international market circuit, exposing the
company's cash flow to exchange rate fluctuations (Altuntas, Liebenberg, Watson
and Yildiz, 2017). Financial derivatives are financial instruments whose prices
are linked to the prices of other underlying assets. They are used by banks as a risk management
strategy to prevent unforeseen events from obstructing their desired profit
(Osayi, Kasimu and Nkwonta, 2018). Buffett (2002), on the other hand, refers to
them as "financial weapons of mass destruction," emphasizing that the
speculative use of financial derivative instruments automatically produces new
hazards. Financial derivatives have become so widespread that they are now
considered asset classes, despite the fact that their values are often derived
from one or more underlying securities that may belong to multiple asset
classes. They are sometimes embedded in new debt and equity investment
vehicles, as Valdivia-Velarde (2012) pointed out, which is often one of the
reasons why the intricacies of these instruments make them very dangerous.
By betting on
movements in currency rates, interest rates, and commodity prices, banking
institutions can utilize derivatives as a risk management tool to hedge
on-balance sheet transactions. These benefits encourage banks to position their
businesses and improve their risk management efficiency so that risk management
efficiency can be quantified in order to maintain value creation and avoid
adverse events that may not have been properly considered in the relevant
business scenario Zakaria (2017).
The usage of derivatives in the Nigerian market has recently increased,
particularly in transactions involving international counterparties. According
to Abdel-khalik and Chen, the total notional amount of all financial
derivatives held by the 25 world's largest holding corporations was valued at
$308 trillion in 2012. (2015). That's more than four times the global GDP,
which is only $74 trillion according to the International Monetary Fund (IMF,
2013). As a result, improved risk management solutions that can survive the
test of time are required.
1.2 STATEMENT OF THE PROBLEM
Commercial banks, in particular, operate in a volatile and
dangerous environment that produces unpredictability, volatility, and
complexity. Effective risk management methods in terms of costs and resources
are becoming increasingly vital to the success of any local or international
business (Lam, 2014; Power, 2004; Figueira-de-Lemos, Johanson, and Vahlne,
2011). Globalisation has developed tight linkages in financial systems,
allowing risks to spread swiftly, as evidenced by the devastation caused by the
financial crisis of 2007–2008. As a result, improved risk management solutions
that can survive the test of time are required. Commercial banks'
typical borrowing and lending activities expose them to financial market risk,
which is why they participate in derivative activities. Financial derivatives
offer a low-cost way to manage financial market risk without incurring
additional fees. Derivatives enable banks to hedge liability and asset
positions by allowing them to take a position in the derivative market that is
opposite and equal to a planned future or current position in the cash or spot
market.
Nigeria
suffered a currency/foreign exchange and commodities risk crisis in 2016, owing
to a drop in the price of crude oil and the loss of markets such as the United
States, which it relied on heavily for crude oil exports. This put a pressure
on Nigeria's foreign reserves and, as a result, made international transactions
complex and expensive. These dangers have the potential to jeopardize an
investor's investments and earnings. In order to eliminate or reduce their
exposure to currency/foreign exchange and commodity risk, market participants,
particularly banks in efficient markets, have taken advantage of developments
in capital markets, particularly the growth of derivatives markets, and are now
using derivatives to manage such risks. Financial organizations (such as banks)
now offer a variety of products, such as financial derivatives, to help
businesses manage their financial risks.
Derivative
instruments, on the other hand, are extremely complicated since their values
can be tied to nearly any underlying asset or obligation, including other
derivatives, to achieve a variety of goals. It's difficult to say whether using
derivative assets and liabilities would expose investors to more risk and
damage the company's debt capacity, which would have an impact on its financial
performance. However, because recent research shows that analysts frequently
underestimate the earnings implications of a firm's derivatives activity
(Chang, Chow, Tellier, Vattikuti, Purcell, and Lee 2015), it's unclear whether
and under what circumstances the complexity of derivatives would be a
value-enhancing activity. It has to be seen whether the derivatives disclosure
rules will alter the information quality of financial reports, and whether risk
management through hedging would provide further development opportunities in
derivative trading profits. However, the purpose of this research was to look
into the impact of financial derivatives on the financial performance of
Nigeria's publicly traded commercial banks.
1.3 OBJECTIVES
OF THE STUDY
The primary goal of this
research is to evaluate financial derivatives and the financial performance of
Nigeria's publicly traded commercial banks. The study's particular goals, on
the other hand, are to:
1.
Determine the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on return on assets.
2.
Examine the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on return on equity.
3.
Analyze the influence of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on earnings per share.
4.
Evaluate the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on return on capital employed.
1.4 RESEARCH QUESTIONS
The research questions to guide the study
are as follows:
1.
What is the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on return on assets?
2.
What magnitude of effect does
financial derivatives (derivative assets, derivative liabilities, derivative
trading income and derivative disclosure) on return on equity?
3.
What is the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on earnings per share?
4.
What is the effect of financial
derivatives (derivative assets, derivative liabilities, derivative trading
income and derivative disclosure) on return on capital employed?
1.5 RESEARCH HYPOTHESES
Based on the objectives and to answer the research
questions, the following hypotheses were tested:
H01: Financial derivatives (derivative
assets, derivative liabilities, derivative trading income and derivative
disclosure) have no significant effect on return on assets.
H02: Financial derivatives (derivative
assets, derivative liabilities, derivative trading income and derivative
disclosure) have no significant effect on return on equity.
H03: Financial derivatives (derivative
assets, derivative liabilities, derivative trading income and derivative
disclosure) have no significant effect on earnings per share.
H04: Financial derivatives (derivative
assets, derivative liabilities, derivative trading income and derivative
disclosure) have no significant effect on return on capital employed.
1.6 SIGNIFICANCE OF THE STUDY:
The study is significant because it attempts to build
on previous research by examining how the usage of financial derivatives has
enhanced corporate performance from 2013 to 2019. It has also added to current
corporate finance information, which will be useful to the following parties:
The findings of the study will provide Financial
Sector Regulators with a deeper understanding that can be used to help them
formulate best practices and regulatory policies. The findings,
recommendations, and conclusions of this study can be used by regulators such
as the Capital Markets Authority, the Central Bank of Nigeria, and the Nigerian
Bankers Association to adopt and enhance financial derivatives policies and
procedures in Nigeria.
The findings of
this study will be valuable to academics since they will provide up-to-date and
high-quality information on how the use of financial derivatives affects the
financial performance of commercial banks. Fellow researchers will value it as
well, as it will provide additional proof and understanding on how the usage of
financial derivatives affects commercial bank financial performance.
The conclusions of
this study will benefit investors and potential investors since they will be
able to determine how the use of financial derivatives affects commercial bank
financial performance, allowing them to make better financial decisions.
1.7 SCOPE OF THE STUDY
Because most banks
rarely employ financial derivatives disclosure before to 2012, this study
analyzed financial derivatives and financial performance of listed commercial
banks in Nigeria utilizing banks audited annual reports of fourteen (14)
deposit money institutions for a period spanning from 2013 to 2019 for a
balanced data set. To measure the bank's financial derivatives, data on
derivative assets, derivative liabilities, derivative trading revenue, and
derivative disclosure were used, while return on assets, return on equity,
earnings per share, and return on capital were used as proxies for financial
performance. Control variables were company age, growth, and leverage.
1.8 OPERATIONAL DEFINITION OF TERMS
Derivative
Assets: Derivative assets are trading or non-hedging
underlying assets that a company acquires or incurs with the intention of
selling or buying in the near future. When the fair value of all derivatives
carried as assets is positive, this is the notional value.
Derivative
Liabilities: These are the notional values of all
derivatives that have been recognized and are being evaluated at fair value.
When their fair value is negative, they are recorded as liabilities.
Derivative
Trading Income: Unrealized gains/losses from derivatives
due to changes in fair value are recorded on the income statement as derivative
trading income.
Derivative Disclosure: Financial derivatives figures, methods, and related risks of the
instruments are reported in the published financial statements as derivative
disclosure.
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