Managing Risk Exposure

Before choosing a method for mitigating currency risk, a borrower or lender should assess its tolerance for variability in earnings and adopt a strategy for managing currency risk consistent with its overall risk policy. An example of a Foreign Exchange Risk Management Policy may be to set a maximum numerical limit on the level of depreciation or devaluation in the exchange rate that could be absorbed by the MFI's equity. A formula often used to calculate the foreign currency exposure of an MFI’s balance sheet is:

Convertibility risk and transfer risk can be included in the calculation by adding probability factors on scenarios such as likelihood of financial regime change.

Once a foreign exchange exposure limit is determined, exposures above that limit can be managed using hedge products and other tools. There are two basic methods to manage foreign exchange risk.

• Use derivatives such as MFX Hedging Products.
• Use various non-derivative alternatives for mitigating currency risk such as back-to-back lending, letters of credit, indexation of loans to hard currency.

An example of a risk management strategy using a combination of the above methods could be to leave 15% of the total debt obligations un-hedged and use the spot market for transactions. Another 25% of the total debt obligations of the MFI may use available loan structuring alternatives to reduce foreign exposure. The final 60% of the exposure may be hedged using various derivative products such as forward contracts and cross-currency swaps. An effective risk management strategy can reduce foreign exchange exposure and provide more flexibility while reducing the cost associated with hedging. As noted, passing on currency risk to the micro-entrepreneur borrower is not an effective currency risk mitigation strategy.

Also See Identifying Risk - Quantifying Risk