Foreign Exchange Risk Mitigation Techniques - Structure and Documentation: A Technical Guide for Microfinance Institutions

This technical guide suggests hedging options for microfinance institutions (MFIs) exposed to foreign exchange risk. The guide states that:

• Hard currency loans create foreign-exchange risk for MFIs whose principal assets are micro-loans denominated in the local currency;
• Foreign exchange risk arises when an MFI incurs debt in a foreign currency and then lends those funds in a domestic currency;
• MFI suffers losses if the value of the domestic currency depreciates in relation to the foreign currency;
• Organizations exposed to foreign exchange risk can:
  • Hedge against their exposure by purchasing a financial instrument that protects the organization;
  • Partially hedge against risks, or limit their hard-currency exposure to set levels.
• MFIs can use the following conventional capital market instruments to hedge against foreign-exchange risk: forward contracts and futures, swaps and options;
• However, the MFI may not be able to purchase these instruments because of :
  • Lack of support from capital markets;
  • Prohibitive costs and credit worthiness problems.

The guide identifies ‘back-to-back loans and ‘letters of credit (LOC) as home grown hedging mechanisms that have emerged to fill the gap left by underdeveloped capital markets.The guide also provides technical guidance to help MFIs:

• Understand the principal legal and documentation features of back-to-back loans and LOC;
• Evaluate the relative appropriateness of the two structures in light of the MFIs particular circumstances;
• Negotiate the documentation relating to these structures with commercial counterparties.