Foreign Exchange Rate Risk in Microfinance: What Is It and How Can It be Managed?

This paper aims to raise awareness in the microfinance sector of the issues associated with foreign exchange risk. The paper explains what exchange risk is and examines techniques used by MFIs and investors to manage it. It describes the different methods that MFIs use to hedge their exposure, and details the advantages and disadvantages of each method.The paper makes broad recommendations for different stakeholders in the microfinance sector to manage exchange rate risk. They include:

• MFIs should give priority to domestic sources of funding or foreign funding in local currency;
• MFIs should adopt suitable methods to mitigate their exposure to risk;
• MFIs should seek legal advice for negotiating the best terms with foreign and domestic lenders;
• Investors should take more responsibility when managing foreign exchange risk, and consider the possibility that a hard currency loan might damage an MFI;
• Investors should ensure that their borrowers understand the foreign exchange risk they are taking on and have appropriate plans for managing it;
• Sector players should encourage development of local capital markets to increase access to local currency funding.