The Management of Foreign Exchange Risk by Microfinance Institutions and Microfinance Investment Funds

Although FX risk occurs in almost every transaction between microfinance investors (especially foreign investors) and MFIs, too many MFIFs and MFIs are not hedging appropriately. Hedging is seldom used because common hedging mechanisms are not available in the countries where MFIs operate, or prohibitively costly for the small amounts of the transactions involved. While hedging increases transaction costs, lack of hedging results in losses that can be significant, especially for MFIs and MFIFs that do not have well diversified portfolios.

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In addition, MFIFs often compensate for FX risk by increasing their interest rates to MFIs to cover potential losses. FX risk therefore increases the lending costs for the MFIs (and ultimately, for their clients), regardless of whether or not they have access to local currency loans. Unless MFIFs are able to assume more of the FX risk linked to their lending to MFIs, other funding instruments such as guarantees may be more appropriate for MFIs that face small margins.

“Best practices” for hedging by MFIFs should include strategies of when to hedge, how much to hedge, how to hedge. Sharing experiences with successful and innovative hedging mechanisms, such as FX insurance funds, would greatly encourage MFIFs to absorb more of the FX risk that MFIs are so ill equipped to address,

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reducing costs for MFIFs and MFIs.