Dear Friends of MFX,

This is our inaugural newsletter which we hope, along with our website, will be a useful resource for the microfinance community in thinking about issues of currency risk and asset-liability management. There are a few features that I would like to highlight:

Link to forward pricing: In the right hand column you will find a link to the MFX website where you can always find updated indicative forward price quotes on most of the currencies we hedge (which is a lot!). Online quotes may not be available for some of the more illiquid currencies so if you don’t see what you need please give us a call.

Latest MFX news, trades and new educational products: Get an idea of what currencies other MF lenders are hedging and updates on new decision support tools you can use to enhance your risk management.

What our clients are talking about: Each month we will choose a topic that we are seeing as an issue with our clients and provide some short commentary. The idea is to get people thinking about issues related to risk management and we welcome your feedback.

Regional focus: Each month we will focus on currency and interest rate markets in a particular region and provide short analytics on how events may impact the MF industry and the hedging market. If you are interested in discussing hedging strategy in any particular markets please give us a call.

We hope that you find our content useful as you continue to think about currency risk in microfinance and we always appreciate any comment or ideas on how we can make it better.

Thanks!
Brian Cox, President

MFX News and Update

MFX closed its first swap transaction on October 14th, 2009. The transaction hedges a 3-yr, $4M microfinance loan by Microvest in Columbian Pesos to Fundacion Mundo Mujer. MFX hedged its risk on the transaction with The Currency Exchange Fund (TCX) and also received support from Norfund, the Norwegian development bank.

MFX has developed a new, free liability planning tool to help MFIs stress-test their balance sheets and create better funding plans. The tool is designed for CFOs and Treasurers and for asset/liability management trainers, a number of whom are currently incorporating it into their training curricula. The tool is now in beta test mode and available on MFX’s website. If you would like to test it click to the link in the right hand column to get to the login page.

MFX recently held a seminar for ACCION International loan officers and TA providers on managing foreign exchange risk. Some of the comments we got were Riveting presentation! Great use of humor and clear examplesâ and, Excellent introduction to the role of hedging and cross currency swaps. I was able to follow the crystal-clear presentation of the concepts. A+! If you are interested in setting up a seminar for your organization, please contact Sonia Mukhi at sonia@mfxsolutions.com

What are MFX Clients talking about ?

We often work with MIV clients who are moving from dollar lending to lending in local currency with the currency risk covered by a hedge.  A topic we encounter  is how to compare and price the credit risk on a hard currency loan vs. a hedged local currency loan. Understanding the different effect on an MFI’s credit of these two types of loans can be important when determining an MIV’s hurdle rate and whether a swap price is acceptable.

There are two main elements of the risk to any loan: credit risk (the risk that the borrower won’t repay) and market risk (the risk that what is repaid is worth less than expected in the lender’s currency). Making a hard currency loan eliminates the market risk for the MIV but in doing so increases its credit risk as it raises the likelihood that MFI borrower could default in the event of devaluation in its local currency. Alternatively, providing a local currency loan lowers the MFI’s credit risk but, unless the loan is hedged, compensates by adding market risk for the MIV. By contrast, a hedged local currency loan reduces both credit risk and market risk.

So what are the implications for loan pricing? Clearly any loan to an MFI carries some credit risk premium. If adding dollar debt adds to credit risk and adding local currency does not (or much less so), there is a price to be put on that risk reduction. The question is how to determine it.

It helps to look at the MFI as a rating agency would. Normally raters will assign a risk score based on the percentage of equity that an MFI’s currency mismatch represents. So, for example, currency exposure less than 25% of equity would be a 1, less than 50% would be a 2, less than 75% would be a 3, and so on. That score would be weighted against other risk factors to achieve an overall credit score. So to determine the difference in credit risk between a dollar and a hedged local currency loan, a rater would compare the MFI score after the dollar loan vs. after the same loan in local currency.

Using this metric, the size of the loan relative to the client’s total equity is key; if loan/equity is small then it may not impact the overall credit picture but if it is over say 20% of equity then it would likely measurably affect the overall credit risk. Other factors also impact credit risk on a loan. For example, higher historic volatility of the currency and longer tenure both increase risk.

Given this, here is one way to think about pricing the credit for a hedged LC loan vs. a dollar loan:

• Determine the overall credit risk premium for the MFI borrower. This is the difference in the minimum rate in dollars the MIV would accept vs. making the same loan to a riskless (AAA) borrower.
• Set a percentage of the credit risk that is attributable to market/currency fluctuation. (20%-40% might be an appropriate range)
• Determine the amount of the MFI’s equity the loan represents.
• Determine if it is a high or low volatility country (normally 15% annual volatility is considered low and above 25% is considered high. MFX can provide this data on any currency).

Taking into account theses various factors, one might face the following hypothetical example: if the credit risk premium for the client on a dollar loan is 300bps, with 25% of that attributable to currency risk, with the loan equal to 25% of equity, in a volatile currency, with average tenor, the MIV might reduce its hurdle rate on the loan by 25-50bps.

Clearly there is no exact answer and ultimate pricing will depend on the market. However, particularly when competing in local markets where pricing can be tight, it can make sense to accept a lower dollar return on a hedged deal because of the reduced credit risk being incurred. Keeping this in mind can sometimes make the difference in closing or not closing a loan.

MFX Regional Focus: Central America

Given recent political developments in Central America, notably Honduras, there is some concern around the stability of the USD-pegged exchange rate regimes in the region. MFX has seen increased demand to hedge MF loans in HNL (Honduran Lempira) and NIO (Nicaraguan Cordoba). Rates on the 3 month Honduran T-bills and interbank rates have hardly moved from June to October but this stability may reflect the BCH (Banco Central de Honduras)’s efforts rather than the real economic circumstances facing the country. There is a sense that the BCH has been providing liquidity to keep rates down, but it is unclear how sustainable these policies are. And even in the case that the political tensions subside, emissions could turn out to be pro-cyclical as commodity prices rise in a global recovery. Since the peg prevents currency appreciation from absorbing inflationary pressures, this could put upward pressure on rates in the coming months. In light of this, some of our clients have indicated that now is an attractive time for them to consider USD-HNL hedging, in order to provide safe LC financing to MFIs in Honduras.

As there continues to be political interference in the microfinance industry in Nicaragua, we have seen clients growing increasingly concerned about credit risk issues in the country. In terms of markets, we have seen a little bit more interest rate volatility in the last few months. The 3-month Tasa Pasiva in Cordobas jumped from 6.30% to 7.02% between July and August, and then fell back to 6.61% in September. The NIO-USD exchange rate has held pretty steady in the last several months, but has experienced a 2-3% depreciation since June. Again some of these fluctuations appear not to match the overall political and economic pressures, implying build up of pressure and the potential for swings in the medium term.

Currently, of the non-dollarized countries in the region, MFX offers hedging in HNL, NIC and CRC. In the near future, MFX hopes to provide hedging in the other in the region in GTQ (Guatemalan Quetzales) and BZD (Belizean Dollar). Both of these currencies remain pegged to the USD, and MFX is working with its partners to find the appropriate interest rate benchmarks that will allow for accurate hedge pricing on MF investments in these markets.