An assessment of the impact of foreign exchange fluctuations on projects partly funded through foreign currency denominated loans

Abstract

Foreign exchange risk is a subject worrying many holders of foreign currency denominated debt, particularly in the developing countries. Foreign currency funds are usually long-term in nature and, in Kenya, are administered by development finance organizations, mainly to finance industrial ventures. The exchange risks arising are borne by the projects • financed. This study is about exchange risk and how it affects recipient projects. The four main objectives of this study were; (a) To investigate and determine the impact of exchange risk on projects, (b) To demonstrate the need for, and suggest appropriate method of, incorporating exchange risk in the analysis of projects; (c) To develop a model for predicting exchange 7risk impacts, and (d) To determine minimum hurdle rate(s) for projects holding foreign denominated currency debt. To meet the objectives of the study, a sample of 55 projects was drawn from 109 projects financed

through foreign currency denominated loans, by the Industrial Development Bank (IDB) and the Development Finance Company of Kenya (DFCK), in the period 1974 - 1984 inclusive. Data to facilitate the computation of expected and "actual" net present values (NPVS) and internal rates of return (IRRS), and to develop the predictive model was collected for each of the projects in the sample. "Actual" NPVS and IRRS were computed by adjusting the cashflows of a project to reflect exchange losses. The regression model was designed to predict the absolute impact, of exchange risk, on a project's expected NPV. The predictor variables selected were the cost of the projects the expected NPV, and the amount of the foreign currency denominated funds. The results of the study revealed significant impacts on the net present 'values of projects. Exchange risk changed the expected NPVS of projects by as much as 4.56 to 2313 percent. The regression model developed has an R2 of 59.3 percent. The hurdle rates of return were. found to range from 0.5 to 7.9 percentage points above the expected IRR, with an average of 2.6 percentage points. Cashflow adjustment was established as the "best" met,hod of incorporating exchange risk in the analysis of projects.