Quantifying Risk Exposure

The example below shows how the servicing requirements on foreign currency debt obligations rise dramatically for local currency operators if there is depreciation or devaluation of the local currency. Likewise, gains result if the reverse were true.

Example: Changes in the value of a USD Loan for an Ethiopian based MFI
Ethiopian Currency: Birr (ETB)

Case A: Annual depreciation of 10% for 3 years

If the Ethiopian Birr loses its value at a steady rate of 10 percent annually, by the time the loan matures, ETB 13.31 million will be needed to pay back the USD 1 million principal, which is an increase of 21 percent. Similarly, due to depreciation, the original fixed interest rateon the loan of 10 percent per annum has effectively increased to 21 percent.

The depreciation effectively adds 11 percent to the interest rate, an increase of more than 100 percent over the original fixed nominal interest rate of 10 percent.

Case B: 300% devaluation after 1 year

If the value of the Ethiopian Birr collapses due to a devaluation from USD1:ETB10 to USD1:ETB30 at the end of the first year of the loan, then by the time the loan matures, ETB 30 million will be needed to pay back the USD 1 million principal, an increase of 300%. Similarly, due to devaluation, the original fixed loan rate of 10% has effectively increased to 59%.

The devaluation effectively adds 49 percent to the interest rate, an increase of more than 400 percent over the original fixed nominal interest rate of 10 percent

Also See Identifying Risk - Managing Risk