Foreign exchange risk management in microfinance

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Many microfinance institutions (MFIs) fund a portion of their portfolio by accessing loans or lines of credit in hard currency. In doing so, MFIs incur foreign exchange risk, which is defined as the possibility of a loss or a gain from varying exchange rates between currencies. If not properly managed, foreign exchange risk can result in losses. Taking on exposure to foreign exchange risk makes an MFI vulnerable to factors that are beyond its control. In addition to the risk in changing rates, incurring foreign exchange risk also includes the danger that it might become impossible to carry out currency transactions because of government interventions or a market disruption. The objective of this paper is:

  1. to provide MFIs with ways to evaluate and manage foreign exchange risk to minimize exposure and avoid losses, and
  2. to highlight the role that lenders and donors can play in reducing the exposure of MFIs to foreign exchange risk.

The authors explain the meaning of currency depreciation, devaluation and appreciation and provide evidence to show how currencies change in practice and how this can impact on an MFI. After describing how developed countries manage foreign exchange risk, the paper goes on to provide some case studies of how WWB members have managed these risks.

Their first example is of a loan structure used by the Ford Foundation with MFIs such as the Kenya Women Finance Trust which is essentially a local currency loan payable in US dollars with a reserve mechanism designed to provide protection to the lender against depreciation of the local currency vis-à-vis the US dollar over the life of the loan. WWB’s Colombian and Dominican affiliates use a system in which the proceeds from a dollar-denominated loan are deposited in a bank in US dollars, while the bank in turn issues a loan to the MFI in local currency, taking the US dollar deposit as collateral.

Other methods described are forward contracts - the MFI borrows in hard currency and separately enters into a forward contract, frequently with a third party, to lock in the future rate at which it will buy the hard currency to repay the lender; and swaps - in which an MFI with a liability in foreign currency can in effect exchange it for a local currency obligation. All the methods are well explained and illustrated with diagrams.

The final section of the paper deals with how international lenders can play a role in helping MFIs to mitigate their foreign exchange risks by providing loans in local currencies. Obviously an international lender must first devise a mechanism to mitigate its own foreign exchange risk. Oikocredit, for example has set up a Local Currency Risk Fund (LCRF). In conclusion WWB recommend that MFIs perform sensitivity analysis on their projections by exploring the impact of potential movements in exchange rates on their profitability and financial condition. Such an exercise can provide valuable insight into an MFI’s ability to withstand currency volatility and be useful in setting foreign exchange risk policies that are tailored to each institution’s situation and financial structure.

Document Information

Document Type Article
Author Women's World Banking
Year of Publication 2004
Publisher Women's World Banking
Number of Pages 28 pp.
Edition Ocassional paper
Region / Country Global /
Primary Language English (en)
Keywords
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