Aid projects and currency risk exposure: a first view
Our development of our exchange risk analysis tool is progressing and we hope that we will be able to show you all a first version soon. We are currently in a dialogue with aid practitioners to make sure our tool will be able to handle the currency risk exposure of their projects. It can be concluded that aid projects look very different — and the possible currency risks as well!
In this post we are describing an pretty normal example project, and how it would be exposed to currency risks. Get in touch with us and tell us about your projects! We would love to hear about different projects, and how they are organised. How do donors set up their pledges and disbursements and then how do you budget and distribute your funds?
Our illustrative aid project
In this example we have imagined up a project which is a two year effort with activities in Zambia and Namibia. The project organisation is a regional NGO which budgets in USD, but all the costs are in ZKM and NAD. This important project is funded by Sweden and Norway through their agencies (Sida and Norad).
Sida and Norway have pledged funds to cover activities for two years. Both of them pledge USD 1 000. They have a slightly different disbursement schedule, where Sida makes one larger payment in the end of year one and then two smaller payments during year two. Norad on the other hand makes equal two disbursements, one per year in September. Here are the disbursements, as budgeted in USD.
But as both Sida and Norad pledges money in their respective national currencies, the project is exposed to a currency rate risk that arises in the time from the pledge to the actual disbursement of funds.
So there arises an uncertainty about how much funds actually will arrive with each payment. Let us look at how that risk develops, and how it can affect the budget for our project.
The risk from SEK to our budget in USD. So, how much will those SEK actually amount to when they reach us? Depending on the relationship between the SEK and the USD during the time from the pledge to the payments the sum could actually differ quite a lot. When that first big payment is due, in december the first year a risk calculation gives us an estimation that we can be 95% sure that the sum will be within about +-13 per cent.* With a budget for that payment at USD 700 we cant thus be quite sure that we will get something in the range USD 611 to 789. Now that is quite a large span.
The two payments year two are smaller, so the potential impact from those is smaller (USD +-23 and USD +-27 respectively). The total risk to our budget from the SEK pledge is thus about 28 per cent (+-14 per cent). With a total budget we can say that with a 95 per cent certainty that we will get somewhere between USD 860–1140.
We can see how the risk from our SEK pledge develops. As Sida has decided to make a first big disbursement, the risk deflates once that payment has been made.
The risk from NOK to our budget in USD So how about that other half of our incoming funds, those NOK? Norad have, in this imagined case, pledged to disbursements of USD 500 each. As the risk increases in time the risk is higher with the second payment. It goes from +- 11 per cent on the first payment to +-17 per cent. The total risk ends at just above that from SEK (+-14.5 per cent).
The thing is however that Norad, as opposed to Sida, requires currency rate gains to be paid back. So there is in fact only a negative risk exposure from the NOK pledge.
The risk from ZMK and NAD to our budget in USD So we now we have some understanding of the risk exposure for the incoming funds. Lets move on the the expenses. We decided that the Zambian part of our project will have quarterly costs evenly divided throughout the project. That means a risk exposure to the project that slowly decreases as more and more payments are made. The total risk lands at +- 16.5 percent, so an uncertainty interval of 33 per cent hitting the two year budget.
In Namibia the project budget is different. We have only two payments during the two year budget. We use a local partner and have budgeted that they should receive USD 500 in july each year. That gives us a completely different risk profile. As the NAD is a quite volatile currency the risk increases rapidly until the first payment and then again a bit slower until the second payment. As all funds have been disbursed by July of Year two, the risk ends there. It still manages to rack up quite a substantial aggregate risk for the overall budget however.
It lands at +-21 per cent, a total range of a whopping 42 per cent for the NAD part of our project.
Total currency risk exposure. OK, lets try and sum all this up. Our little project has budgeted with USD 2 000, coming from Sweden and Norway.
Over two years changes in currency exchange rates creates a risk to our budget that amounts to a range from +7 per cent (USD 2 140) to — 14 per cent (USD 1 720).
A total range of USD 420. That is the total uncertainty that we have for our project funding.
But what about the expenses? Well, since both ZMK and NAD are more volatile than SEK and NOK the risk is higher here. The range is +-19 per cent. Our expenses can thus turn out in the range USD 1 627–2 373.
Below is a diagram showing how the risk develops throughout the project lifespan. The diagram shows the risk exposure to the total budget at any given moment. The risk starts to build quickly, and is slowly mitigated as funds are either received or transferred. As we don’t have a lot of incoming funds or expenses during the last six months the risk ebbs out in the end.
As the incoming and outgoing currencies are not closely connected we could face a situation where costs are down with 15–20 per cent while the incoming funds have increased with say 5 per cent. But the inverse could also be true, resulting in a substantial hole in our dear budget.
Some concluding comments It would be weird if the results shocked us, I mean we are building a tool just because there is a need to understand this issue. But some things became clear when writing this little blog post. The first is that our visual guru Jerker will have his hands full presenting all this in a manner than everyone will understand!
Secondly it will be really interesting to get some input on different funding options. We know that there is an enormous range of different actors and projects out there, all with different way to organise activities and budgets. We will continue to talk to you, and will also set up some online questionnaires to collect more data.
Another thing is that it will very important to make sure that results are presented in a manner that makes it clear that there are several other risks that can affect organisations or projects. This is just one. Many projects are implemented in fragile contexts, and can be affected by many other things. We will get back to this later on in the development of our tool, and on this blog.
With our tool you will be able to make this kind of analyses. The difference will hopefully be that the results are presented A LOT more pedagogical, and that they will be paired with a series of advice on risk management. We will keep you updated! (cant wait? Get in touch with us on @aidhedge).
*Comments on methodology OK, for all you who are interested in methodology. This was a quick showcase of how currency exchange risk can affect a project budget. We have not tried to make it representative for a “typical project” (if there is such a thing!). The risk is calculated using a very simple version of a VAR-algorithm. We will get back to how we will calculate risk in the finished tool in a special blog post. If you are curious already, do get in touch!
Originally published at www.aidhedge.org.
