Foreign Exchange Risk and Microfinance Institutions: A Discussion of the Issues

Instruments to deal with the foreign exchange risk

This paper discusses the foreign exchange risk for MFIs when they borrow from foreign sources, and the possible solutions. It lists the types of risks for MFIs and the foreign lenders as:

  • Interest rate risk - difference in the interest rates between the countries of MFI and lenders;
  • Country risk - adverse political and economic situation;
  • Exchange rate risk - change in the value of currency in the borrowing and/or the lending country.

The paper presents the pros and cons of the available risk hedging instruments such as:

  • Countervailing foreign exchange deposits;
  • Dollar/domestic currency swaps;
  • Borrowing and on-lending;
  • Domestic currency guarantees by a foreign financial institution;
  • Guarantees through a secondary market;
  • Other conventional methods like forwards, futures and options.

The authors also discuss the drawbacks faced by MFIs in using these instruments:

  • Availability of limited instruments;
  • Unfavorable regulations and banking systems;
  • High costs due vis-a-vis small amount of transactions.

The paper explored the possible ways of overcoming these drawbacks and conclude that the development of local financial markets must be the long-term solution for the MFIs.

About this Publication

By Holden, P. & Holden, S.