Background and Methodology
Risk is a measure of the degree of uncertainty associated with the return on one asset relative to an alternative asset. This four day intensive module will focus on understanding all aspects of risk associated with interest rate from both an investors’ point of view and the MFIs, including the real cost of capitalization.
Through lectures, case studies and examples we will examine the opportunity cost of alternative capitalization strategies to international donor agencies, and to private and public sector entities that are actively engaged in funding microfinance institutions (MFIs). We will also focus on the currency risk exposure faced by foreign investors and MFIs when the original investment or capital originated in a hard currency. We will take a look, for example, at the risk associated with the $106m USD bond backed by loans to 22 MFIs, issued in early 2006 by BlueOrchard, a Geneva-based specialist company.
Other topics will include inflation and its impact on capitalization (nominal vs. real interest rates), liquidity risk management (the ease and speed with which an asset can be turned into cash), the impact of a local government’s budget deficit on the interest rate equilibrium, and the risk of default and associated risk-related premium. We will conclude the session by calculating the risk premium and the real cost that MFIs face in financing loans to their clients.
Objective
Very few financial variables are known with certainty. Investors, however, are basically risk averse and the private sector in particular takes great care to understand risks associated with their required rate of return. Our objective will be to gain a clear understanding to help quantify risk, so that we are able to effectively calculate the interest rate charged to clients, or to cost a financial product more effectively, thus providing investors with a higher level of certainty.
To address this objective, we will consider major categories of risk and investment costs as they apply to Microfinance. In particular we will address opportunity costs and direct costs, liquidity, default, and foreign exchange risks, and the impact of the real cost of inflation and local government deficits.
Required Reading Material
Ledgerwood, Joanna. Microfinance Handbook - An Institutional and Financial
Perspective, Sustainable Banking with the poor (1998), Washington, D.C. The
World Bank Publication, chapters 5& 6 pp. 133-168.
Liquid Management - A Toolkit for Microfinance Institution (2000). Prepared by Bankakademie , Published by Deutsche Gesellschaft Fur Technische Zusammenaiebit (GTZ) GmbH pp. 37-105.
Guaranteed Loans to Microfinance Institutions: How Do They Add Value? (No. 40 January 2007).
Foreign Exchange Risk Management in Microfinance (2004). Occasional Paper. Women’s World Banking, Vol. 1, No. 2.
Foreign Exchange Rate Risk in Microfinance: What is it and how can it be managed? ( No. 31, January 2006). CGAP, Washington DC.
Rosenberg, Richard. CGAP Reflection on Compartamos Initial Public Offering: A Case Study on Microfinance Interest Rates and Profits (May 2007). CGAP, Washington
Day 1:
Liquidity management--default risk - Measuring liquidity on the balance sheet, the basic concept of working capital, integrating liquidity into risk management, assessing liquidity needs including sources and usage of funds, understanding better the risk associated with volatile cash position, investing excess funds, reducing asset -liability mismatch, and managing liquidity in multiple currencies.
Day 2:
Foreign Exchange Risk Management for MFIs with foreign currency liabilities, country risk in dollarized economies, understanding and pricing the products based on foreign exchange risk exposure (devaluation, appreciation, and depreciation of local currency), hedging against the foreign exchange risk (loan guarantees, options, swaps and back-to-back lending, forward contracts and futures), feasibility of utilization of hedging techniques—alternatives, lending in local currency, and supporting policies to encourage local capital market development.
Day 3:
Interest Rate Risk, risks associated with inflation and budget deficit, interest rate parity, calculating costs associated with foreign exchange risks including; commissions, wire transfer fees, legal fees. Setting sustainable interest rate, weighted average cost of capital (deposits, loans & equity—diversification of funding instruments and sources), desired capitalization rate, investment income rate, recalculation of interest rate.
Day 4:
When and how microfinance institution can go to the international capital market tapping in new sources of funds while assuring financial stability and growth. Case Studies, lessons from several MFIs’, including Compartamos.
