Assessment and Management of Foreign Exchange Risks in Commercial Banks

Abstract

Foreign exchange (FOREX) risk has become a critical challenge for commercial banks due to the increasing volatility in global currency markets. Since the collapse of the Bretton Woods system, banks have faced fluctuating currency values that affect their financial stability, profitability, and international competitiveness. While extensive research exists on the relationship between currency volatility and banking performance, findings remain inconclusive and context-dependent, especially regarding how banks psychologically assess and manage these risks. This study aims to evaluate the impact of foreign exchange risk on commercial bank profitability using Prospect Theory to explain behavioral responses in decision-making. The findings show that exchange rate fluctuations can significantly affect banks’ profitability, particularly when risk is not mitigated through adequate hedging, open position controls, or diversification strategies. Empirical analysis based on data from the Central Bank of Uzbekistan and international sources confirms that banks with proactive FX risk frameworks maintain better capital adequacy and operational stability. This study uniquely applies Prospect Theory to analyze how psychological attitudes toward losses influence bank strategies in managing currency exposure, enriching the behavioral finance discourse in the context of international banking. Effective currency risk management—through instruments such as forward contracts, options, and swaps—enhances financial planning, profit margins, and capital market confidence. The research underscores the importance of aligning FX risk strategies with bank size, regulatory frameworks, and global exposure levels to ensure sustainable profitability in an increasingly volatile financial environment.