Hedging for the Greater Good: Devising Risk‐Management Strategies for Microfinance Firms

Abstract

Microfinance firms cater to the financial needs of underprivileged people, who because of their unstable and uncertain sources of income cannot avail these services through banks. By virtue of the nature of their clientele, these firms are exposed to a lot of credit risk. Using primary data from Indian MFIs, a region that witnessed a major crisis in the microfinance sector in the year 2010, this thesis has attempted to devise hedging strategies for these firms to help mitigate risk and enhance operational efficiency. While discussing various possible hedging instruments, the main focus of this thesis is insurance contracts. Using Importance Sampling techniques, we were able to simulate the expected number of defaults helping us gauge the number of insurance contracts needed. Applying the simulation to Future Financial Services Ltd., an MFI in India, we found that had this firm purchased insurance contracts based on the default predictions made by our model, its loan loss for the worst crisis year would have been reduced by almost 36%. Another major finding of this research was that the insurance contracts would be cheaper if the MFI charges lower interest rates from its clients. This would help counteract one of the major criticisms of MFIs-­‐ that they push the clients into debt traps by charging extremely high interest rates. We hope that this research reiterates the need for the MFIs to start managing their risks as financial firms and to make adequate investments in hedging schemes. This is intended so that the aim of economic empowerment of the poor can be met in a way that is sustainable for these firms.