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Hedging Foreign Exchange

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Solution for Hedging Foreign Exchange Risk in Microfinance Investments


Introduction


As the number of microfinance institutions (MFIs) that rely on commercial sources of funding grows, the issue of foreign exchange (FX) risk is becoming a more prevalent concern for
both investors and MFIs. The risk to investments posed by currency fluctuations has led many microfinance investment vehicles (MIVs) to lend predominately in dollars or euros. While this practice of lending in hard currency protects investors, it shifts the FX risk to MFIs, which employ the hard currency debt to fund portfolios of micro loans denominated in local currency. This currency mismatch between the MFIs’ loans and the capital that funds MFIs creates risk to the MFI: if the local currency of the country in which an MFI operates depreciates against the U.S. dollar, then the MFI will be saddled with a largerthan-anticipated debt obligation. Recognizing that MFIs are poorly equipped to manage FX risk, the microfinance industry is
currently seeking ways to minimize or eliminate the FX risk inherent to its global business.

One proposal in particular, appears promising: creating a “natural
hedge” by pooling loans denominated in different emerging market
currencies.



  • 1. Creating a pool of currency risks that would be managed by financial advisors familiar with FX trading and risk management; and

  • 2. Employing capital sourced from the philanthropic community to create a "backstop" that would allow the portfolio to weather short-term turbulence in the markets.


To achieve optimal FX risk management, it is essential that the microfinance industry benefit from the risk management expertise of the financial sector. Therefore propose a partnership between the private sector and philanthropic community to overcome a major obstacle which currently prevents the private sector from providing risk management services to the microfinance industry. It would draw upon the established infrastructure and expertise of the former and the patient capital of the latter. Such a collaborative effort will build a portfolio of currency exposures that assumes the FX risks facing MFIs. The partnership will allow MFIs to reduce or eliminate FX risk, thereby alleviating the mismatch between revenue and debt, securing the real value of their debt obligations, and providing added stability to their business models. By effectively leveraging the expertise and resources of one and the financial resources of the other, such collaboration across sectors has the potential to eradicate a major source of risk to microfinance investments.

Creating a pool of FX risks


The creation of a foreign exchange risk management service (or RMS) that would pool together the FX risk of microfinance investments across different MIVs. RMS would assume the FX risk by entering into a forward contract that allows an MIV to lock in a future exchange rate. In this way, an MIV would be immune to future fluctuations in exchange rates, and RMS would be able to manage the FX risk through diversification. There have been efforts that seek to mitigate FX risk through portfolio diversification, but so far, a solution tailored to the needs of the microfinance community has yet to exist.

The concept of mitigating risk through diversification is based on modern portfolio theory, which proposes that grouping relatively uncorrelated and diversified investments will reduce the risk of an overall portfolio, allowing the portfolio to weather economic disruptions that impact specific investments. Underperformance or value loss that affects some portions of the portfolio should be counteracted by the positive performance of other portions of the portfolio. With sufficient diversification across positions that move independently from one another over time, the portfolio will aim to produce stable long-term returns.

RMS takes a slightly different approach by allowing investors to parcel out the FX risk from the credit risk of their investments through the use of derivatives. The separation of FX risk from credit risk allows investors to issue local currency loans to MFIs without facing the risk of local-currency depreciation. By eliminating currency risk, MIVs will be able to focus on their core business of analyzing and managing the credit risk of loans to MFIs. This separation of FX risk from credit risk would ultimately benefits MFIs, as loan margins would then reflect only their credit risk. Given the fact that many of the MFIs receiving commercial funding have a strong credit standing, this should reduce the overall cost of debt. Diagram 1 below illustrates how hedging the FX risk lowers the cost of borrowing to MFIs.

To create a portfolio of FX risk, RMS enters into non-deliverable forward contracts (NDF) with MIVs. NDFs are forward contracts that set an exchange rate for a future date. The term “non-deliverable” refers to the fact that no actual exchange of currencies takes place. Rather, at the settlement of the contract, the two parties settle the difference between the spot exchange rate and the previously agreedupon exchange rate in a hard currency (generally U.S. dollars). By allowing settlement in hard currency, NDFs avoid the potential problems of converting and expatriating illiquid currencies. As each NDF contract matures, RMS will either make a payment to, or receive a payment from, the MIV counterparty, depending on whether the currency depreciated or appreciated relative to the U.S. dollar. The settlement amount will be determined by comparing the exchange rate specified in the NDF contract with the spot exchange rate on the date of settlement and multiplying the difference by the notional value of the contract. All settlements will be in USD, thereby avoiding the complexities and costs of delivering local currencies. A significant benefit of NDFs is the absence of an upfront cost—the cost of the hedge is factored into the future exchange rate. For currencies that are traded, like the Indian rupee and the Mexican peso, there are NDF markets from which RMS can take its price. For other currencies, however, RMS will set a price based on the principle of covered interest rate parity. Covered interest rate parity postulates that the differential between the forward exchange rate and the spot exchange rate is determined by the interest rate differential between the two countries, such that no arbitrage opportunities exist to crystallize profit by shifting capital to higher interest rate countries.