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- This month we look at currency hedging – a tool that aims to reduce exposure to currency risk
- A lending company may consider hedging when they have liabilities in foreign currency and want to offset the risk of those liabilities increasing due to changes in the exchange rate
- The decision to hedge depends on a company’s willingness and ability to take on currency losses
- Even if the currency exchange rate is volatile, a company may choose not to hedge if it has the appropriate capitalization to absorb potential loss, or if the cost of the hedging instrument is higher than the potential depreciation of the domestic currency against the EUR
- In terms of activity in March, investors on Mintos earned €2.6 million in interest at an average rate of 10.1%
- The average net return for last month was 1.74%, and the average portfolio value was around €2.5k
Currency hedging in a nutshell
When a lending company undertakes business in foreign currency, changes in the exchange rate can be unpredictable – exposing the company to currency (or exchange rate) risk. Although this is just one of the risks that companies face, it has been in the spotlight due to recent geopolitical instability and changes in the macro-environment. Which begs the question: What can be done about this risk? Well, hedging is one strategy that can effectively reduce currency risk, depending on some essential factors.
What is currency hedging?
Currency hedging can be thought of as taking out an insurance policy that protects a lending company against unfavorable changes in a currency’s exchange rate (up to a certain limit). Some lending companies hedge currency risk through financial instruments which give them the right to buy or sell foreign currency:
- At a set price (e.g. using swap contracts), or
- At a set price on a predetermined date (using instruments like forwards or options)
However, hedges are only effective at reducing currency risk if the counterparty who issued the hedging instrument fulfills its obligations.
When deciding on currency hedging, there are certain considerations to be taken into account. “Currency hedging is costly and even as such, can’t be applicable in all cases and for all currencies. As an alternative, other financial performance factors can influence a lending company’s ability to fulfill its obligations. Evaluating the size of the business vs. liabilities, equity ratio, specific currency risk, and exposure, play into the final decision of whether to hedge or not,” says Ieva Grigalune, Head of Credit Risk at Mintos.
- How volatile is the foreign currency?
Many currencies have exchange rates that are fixed or closely follow a target rate that’s set (or “pegged”) towards a major currency by a central bank. The volatility of these regimes depends on the strength and amount of foreign currency reserves of a central bank, as this is what helps bring a currency back to a fixed or pegged rate in market downturns. Currencies adopting the floating exchange rate regime are considered volatile as they move freely based on market transactions with no central bank involvement. Therefore, such currencies are more likely to need hedging. Examples of countries that have adopted this regime are Mexico, Georgia, Poland, and Zambia.
- What’s the overall exposure to the foreign currency and upcoming payment time horizon?
If the lending company’s total exposure to a volatile foreign currency is relatively small, it may not be worth incurring hedging costs because the overall damage of any exchange rate fluctuations would be minimal.
- Is there a buffer for losses from exchange rate fluctuations?
If a lending company has a healthy equity-to-assets ratio, it can absorb losses from exchange rate fluctuations. This makes the extra cost of currency hedging unnecessary, up to a certain level of volatility.
- What’s the cost of the hedge?
Foreign currency hedging costs vary depending on the currency pair. “For example, the KZT/EUR hedge – considering the interest rate differences within the markets, it would be more expensive than MXN/EUR pair hedge. This mainly comes from the liquidity and availability of the currency in the markets. Therefore, the cost of a hedge is a significant factor to consider” states Ieva.
The bottom line
Because hedging requires lending companies to incur sometimes significant costs, it’s a beneficial strategy only when the volatility of the currency, cost, and availability of the hedge is considered. But when appropriate, it’s a strategy that can significantly reduce exposure to currency risk.
When it comes to the Mintos Risk Score, both unhedged debts and currency volatility are considered within the Buyback Strength subscore. These hedging-related variables make up the subscore along with multiple financial ratios, such as capitalization. Among others, financial ratios are a significant part of the Buyback Strength subscore which help measure a company’s ability to fulfill its buyback obligations.
Every Mintos Risk Score is a result of weighted subscores and dozens of variables. So currency hedging represents only a small percentage of the total Mintos Risk Score for loans from a particular lending company. Variables that determine the loan performance, servicer’s operational efficiency, and company’s financial ratios are the main variables built into the final Mintos Risk Score for loans from a particular company.
Mintos Activity: March 2022
In March, over 300 000 loans were funded equivalent to €76.8 million, and investors on Mintos earned €2.6 million in interest at an average rate of 10.1%. The top 3 markets for investments in loans were: Spain, Latvia, and Poland.
According to Peteris Mikelsons, Account Management Team Lead at Mintos, “the first part of March was characterized by a drop in investor sentiment relating to the war that started in Ukraine in late February – which lead to a drop in outstanding investments to €366m (if excluding Russia, Belarus, and Ukraine-issued loans). But during the second part of the month, the sentiment started to return gradually with outstanding investments reaching close to the pre-war level (excluding the abovementioned loans). Offered interest rates jumped significantly, reaching an average of 11.5% for loans denominated in Euro. And on top of this, several lending companies offered cashback campaigns to investors on Mintos.”
Mintos information on the war in Ukraine
For updates on the war in Ukraine, sanctions for Russia, and other related topics, please visit the Mintos blog. We gave a summary of the state of the financial markets related to Russia and took a deep dive into the impacts of the sanctions and Russian retaliation measures on the payments from Russia to Mintos and investors.
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This is a marketing communication and in no way should be viewed as investment research, advice, or recommendation to invest. There is no guarantee to get back the invested amount. Past performance of financial instruments does not guarantee future returns. Investing in financial instruments involves risk; before investing, consider your knowledge, experience, financial situation, and investment objectives.