Working Paper on Mitigating Currency Risk for Investing in Microfinance Institutions in Developing Countries
This paper focuses on the risks associated with the use of foreign direct investments (FDI) by investors in microfinance. Among the many risks involved in such investments, currency and exchange rate fluctuations are principal stumbling blocks reducing private investment in microfinance institutions in less developed countries.
The paper explores the subject through:
- Background on currency fluctuations and five methods commonly used to mitigate currency risk;
- Application of each method in a hypothetical US $1 million investment/loan in an Indian MFI and;
- Recommendations for investors on assessing and mitigating currency risk.
The paper identifies key findings to successfully mitigate currency risk. For the hypothetical scenario of a US $1 million investment in an Indian MFI, currency risk is hedged or covered by purchasing 'Put Options'. Quantified scenario results demonstrate that given the nature of MFI investments, the most appropriate currency risk mitigation method is currency options. However, these mechanisms must be investigated at a country level and each project requires cost-benefit analysis of a hedged versus unhedged investment to ensure financial value.
[Author's Abstract]
