Foreign Exchange Risk Management in Microfinance

This paper examines the risks faced by MFIs in accessing loans or lines of credit in hard currency. Based on an analysis of currency fluctuations in a sample of 23 reference countries over a period of five years, the conclusion of this paper is clear: MFIs risk considerable financial problems if they take on foreign currency obligations without any protection against unfavorable movements in the currency exchange rate.

The paper provides strategies for MFIs in evaluating the cost of hard currency vs. local currency borrowing. Moreover, this paper evaluates the benefits, challenges, and applicability of four different mechanisms for mitigating foreign exchange risk.

The four hedging mechanisms, which are discussed in depth, are:

1. Local currency loan payable in hard currency with a currency devaluation account;
2. Back-to-back hard currency/local currency loans;
3. Forward contracts;
4. Swaps.

Finally, the role of international lenders in helping MFIs mitigate foreign exchange risk is discussed, and the activities of a number of lenders in this area are highlighted.