Asian Journal of Pure and Applied Mathematics

1(1): 1-7, 2019; Article no.AJPAM.94

Forex Risk Management Strategies for Indian IT Companies

Mihir Dash1*
1
Department of Quantitative Methods and Economics, School of Business, Alliance University,
Chikkahagade Cross, Anekal, Bangalore, India.

Author’s contribution

The sole author designed, analysed, interpreted and prepared the manuscript.

Received: 02 March 2019

Accepted: 10 May 2019
Original Research Article Published: 30 May 2019
_______________________________________________________________________________

Abstract

This study deals with the impact of currency fluctuations on cash flows of IT service providers (who
would be receiving foreign currencies), and explores various strategies for managing transaction exposure
from this viewpoint. The study evaluates three foreign exchange risk management strategies, viz. forward
currency contacts, currency options, and cross-currency hedging, to find out which of the strategies is
appropriate in particular situations. The results of the study suggest that the forward currency hedging
strategy yielded the highest mean cash flows and the highest mean percentage gain amongst the forex risk
management strategies considered. Further, in terms of project type, the forex risk management strategies
investigated in the study seem to be more suitable for fixed price projects (FPP) than for time and
materials (T&M) projects, and in terms of project category, the forex risk management strategies
investigated in the study seem to be more suitable for application support (AS) projects than application
development (AD) projects.

Keywords: Foreign exchange risk; risk management strategies; forward currency contracts; currency
options; cross-currency hedging.

1 Introduction
Foreign exchange risk is the effect that unanticipated exchange rate changes have on the value of the firm.
There are a variety of strategies to manage foreign exchange risk; each of them, however, is constructed
under specific assumptions, for specific risk profiles. It is often the case that several strategies are applicable
to a given scenario. The question arises as to which strategy would be expected to yield the best results in a
given scenario.

There have been several studies on foreign exchange risk management which have focused on managing
foreign exchange risk. Copeland and Joshi [1] suggested that derivatives were generally ineffective in
managing foreign exchange risk, and that forex risk management programs may cause more harm than good.
However, they argued that though it may be difficult to effectively hedge individual transactions, forex
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*Corresponding author: E-mail: mihir@alliancebschool.ac.in, mihirda@rediffmail.com;
 Dash; AJPAM, 1(1): 1-7, 2019; Article no.AJPAM.94

exposures at the company cash flow level can be effectively managed. [2] suggested that finance managers
should use forex hedging strategies to make their firm resilient to changes in the market. He argued that
forward foreign currency contracts was a simple strategy for short-run hedging of forex cash flows, for up to
one year. However, he also argued that forward currency hedging would only be effective if the firm can
reliably forecast its future cash flows, else the strategy may increase rather than decrease forex risk. [3]
found that multinational corporations were involved in foreign exchange risk management primarily to
minimise forex exposure of their operational overall cash flows, and that most multinational corporations
centralise their risk management activities and impose greater control by frequent reporting on derivative
activities. [4] compared the performance of different forex risk management strategies for short-term foreign
exchange cash flows. Their results indicated that, for outflows, the currency options strategy yielded the
highest mean returns in all periods, irrespective of the movement in the exchange rate; while for inflows, the
forward strategy yielded the highest mean returns whenever there was a decreasing trend in the exchange
rate, and the cross-currency strategy yielded the highest mean returns whenever there was a cyclic
fluctuation in the exchange rate, however, when there was an increasing trend in the exchange rate, there was
no single strategy yielding the highest mean returns. [5] compared the forex exposure management Indian
and foreign MNCs operating in India. They found that most MNCs were managing only their transaction
exposure, while a few were managing both transaction and economic exposure. They also found a significant
effect of objective of management on estimation of exposure. [6] suggested that IT service firms with cross
currency exposure should adopt selective hedging strategies for different geographies, as a common strategy
across all geographies may result in higher cost of hedging with marginal improvements in benefits; though
for small IT firms, non-derivative related instruments should be used to hedge their forex exposure. They
also suggested that structuring the deal with forex contingencies embedded in the pricing is an effective way
to protect cash flows, and that the higher the deal size and longer its duration, the higher should be the
degree of hedging. They also suggested that higher onshore to offshore ratio increases exposure to forex-
related loses, and that foreign currency swaps can be an effective hedging instruments in such cases. [7]
studied the use of operational and financial hedging to manage forex exposure by Indian MNCs and found
that forward contracts to be the predominant strategy, though most firms used a combination of forward
contracts, swaps and option to hedge their exposure. [8] found that there was a significant increase in the
tendency to use financial derivatives among Indian MNCs in 2010-15, and that a substantial proportion of
companies were using financial derivatives for risk management purposes. [9] studied the forex management
strategies of a software company, and suggested that predicting relevant exchange rates is as critical for the
effectiveness the forex risk management strategy as determining the proper mix of foreign exchange
derivative instruments.

This study deals with the impact of currency fluctuations on cash flows of IT service providers (who would
be receiving foreign currencies), and explores various strategies for managing transaction exposure from this
viewpoint. The study evaluates three foreign exchange risk management strategies, viz. forward currency
contacts, currency options, and cross-currency hedging, to find out which of the strategies is appropriate in
particular situations.

2 Materials and Methods

This study deals with the impact of currency fluctuations on cash flows of IT service providers (who would
be receiving foreign currencies), and explores various strategies for managing transaction exposure from this
viewpoint. The cash flows for the study have been taken from a sample of one hundred and seventy-three
selected projects of different IT companies. The effects of hedging foreign exchange risk using forward
currency contracts, currency options, and cross-currency hedging on each of these cash flows were
calculated and compared. The objective of the study was to identify which of these strategies not only
hedged against foreign exchange risk, but also yielded good returns.

The data for the study was collected through database and financial websites. The research period chosen
was Jan. ‘07 to Dec. ‘07. The reference date was taken to be 1st January, 2007, and the USD/INR spot rate on
the reference date was taken as Rs. 44.20/$. The following foreign exchange risk management strategies
were considered.

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Without hedging: This represents the base series of cash flows in INR, when the transaction is not hedged.
This is the most risky way of handling international financial exposure. According to this strategy,
transactions will take place at the corresponding spot exchange rate. The spot USD/INR exchange rates in
the research period are presented in Table 1.
Hedging with forward currency contacts: According to this strategy, the trader will enter into forward
currency contracts at the beginning of the planning period to hedge the expected cash flows. The forward
rates were calculated giving equal weight to Interest Rate Parity and Purchasing Power Parity. Interest rate
parity was calculated using the (one month) inter-bank offering rates of MIBOR and LIBOR as at the
beginning of the research period, while purchasing power parity was calculated by using inflation rates in
India and USA as at the beginning of the research period. The interest rates and inflation rates used for the
calculations are shown in Table 1.
Cross-currency hedging: According to this strategy, the trader will enter into a contract at the beginning of
the planning period specifying that the transactions are to be in a third currency, correlated to the foreign
currency. For the purpose of the study, the EURO was chosen as the third currency, as the EURO/INR rates
have been less volatile than USD/INR rates in the last few years. The EURO/USD spot rate on the reference
date was taken as € 0.757748 /$. The corresponding spot EURO/INR exchange rates in the research period
are presented in Table 1.
Hedging with currency options: According to this strategy, the trader will enter into a currency options
contract at the beginning of the planning period to hedge the expected cash flows. A series of outflows of
foreign currencies can be hedged by buying currency call options, while a series of inflows of foreign
currencies can be hedged by buying currency put options. The Black-Scholes model was used to calculate
the call/put price using the following formulae:
 r f (T t )  r (T t )
C   Xe  r (T t ) N (d 2 )  Se N ( d 1 ) and P  Xe  r (T t ) N (  d 2 )  Se f N ( d 1 ) ,

where S represents the spot price, X represents the strike price, T – t represents the time remaining until
expiration (expressed as a percent of one year), r represents the continuously compounded risk-free rate of
interest for the domestic currency, rf represents the continuously compounded risk-free rate of interest for the
foreign currency, σ represents the annual volatility of spot price (defined as the standard deviation of the
short-term returns over one year), N(.) represents the standard normal cumulative distribution function, and
S  1 
ln    r  r f   2 .(T  t )
d1 and d2 are given by the formulae: X  2  and d 2  d1   . (T  t ) . The strike prices
d1 
 . (T  t )
used in the study were set at the exchange rate at the beginning of the planning period. For the purpose of the
calculations, the risk-free rates were taken to be 8% (Indian) and 5% (USA), and the standard deviation of
the USD/INR spot rate was assumed to be 82.39%.

The realised net cash flows in INR were calculated for each of the sample cash flows, under each of the
above risk management strategies. For inflows a profit resulted if the actual receipts were more than
expected (i.e. the cash flow which would have resulted if the transaction took place at the spot rate on the
reference date), while a loss resulted if the actual receipts are less than expected, whereas for outflows a
profit resulted if the actual payments made were less than expected, while a loss resulted if the actual
payments made were more than expected. This was applied for each of the sample cash flows under each
strategy, and the mean returns and standard deviation of returns were found out for each strategy. Finally,
the different risk management strategies were compared by performing paired-samples t-tests for equality of
mean returns.

The sample projects were of two types: fixed-price projects (FPP) and time & materials (T&M) projects.
Fixed price projects refer to projects whose cash flows are milestone-based, while time & materials projects
refer to projects with fixed regular (monthly) cash flows. It would be expected that forex hedging would
work better for T&M projects than for FPP projects. In fact, for FPP projects, the calculations and
comparisons were performed assuming that the cash flows were received at the expected times of different
project milestones.

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Table 1. Spot USD/INR & EURO/INR exchange rates, interest rates, and inflation rates

Date USD1 EURO 1 Month LIBOR2 1 Month MIBOR3 Inflation (India4) Inflation (US5)
2-Jan-07 44.20 58.53 5.32% 13.70% 6.37% 2.08%
2-Feb-07 44.10 57.44 5.32% 7.90% 6.69% 2.42%
1-Mar-07 44.30 58.53 5.32% 6.11% 6.20% 2.78%
2-Apr-07 43.10 57.64 5.32% 14.42% 5.94% 2.57%
3-May-07 41.20 56.07 5.32% 8.77% 6.01% 2.69%
1-Jun-07 40.50 54.51 5.32% 0.78% 5.15% 2.69%
2-Jul-07 40.70 55.05 5.32% 1.68% 4.42% 2.36%
1-Aug-07 40.60 55.35 5.32% 0.17% 4.70% 1.97%
3-Sep-07 40.90 55.79 5.77% 6.12% 3.72% 2.76%
1-Oct-07 39.70 56.63 5.12% 6.12% 3.36% 3.54%
1-Nov-07 39.30 56.90 4.71% 6.11% 3.11% 4.31%
3-Dec-07 39.60 58.04 5.24% 7.88% 3.89% 4.08%
31-Dec-07 39.40 58.12 4.63% 7.02% 3.83% 4.08%

The sample projects were also categorised into application development (AD) projects and application
support (AS) projects. Application development (AD) projects generally tend to be shorter-term projects,
with the size of the project varying considerably over the life-cycle of the project (e.g. the team size starts
small at the initiation stage, and increases in the development stage and especially the testing stage).
Application support (AS) projects are maintenance projects, generally with more regular (monthly) cash
flows. Again, it would be expected that forex hedging would work better for AS projects than for AD
projects.

3 Results

The descriptive statistics of the project-wise cash flows (in INR) under the different forex risk management
strategies are shown in Table 2.

It was found that the forward currency hedging strategy yielded the highest mean cash flows (in INR),
followed by the currency options hedging strategy, and the cross-currency hedging strategy. Paired-samples
t-tests showed that the differences in mean cash flows (in INR) between different strategies were statistically
significant: the forward currency hedging strategy yielded significantly higher mean cash flows (in INR)
than all other strategies, and all of the strategies yielded significantly higher mean cash flows (in INR) than
the unhedged strategy. It was also found that there were considerable negative cash flows (for about 5% of
the projects), which represented projects which were cancelled and refunded at a subsequent point in time;
the decreasing trend in the USD/INR exchange rate (as shown in Fig. 1) meant that this resulted in an overall
loss for the project.

The descriptive statistics of the project-wise cash flows (in INR) under the different forex risk management
strategies for different project types are shown in Table 3.

It was found that the forward currency hedging strategy yielded the highest mean cash flows (in INR),
followed by the currency options hedging strategy, and the cross-currency hedging strategy, for both FPP
and T&M projects. Further, the mean cash flows and the variation in cash flows were found to be higher
under each of the strategies for FPP projects than for T&M projects, but these differences were not
statistically significant.

The descriptive statistics of the project-wise cash flows (in INR) under the different forex risk management
strategies for different project categories are shown in Table 4.

1 http://www.oanda.com
2 www.bba.org.uk
3 www.nse-india.com
4 http://eaindustry.nic.in/
5 http://www.inflationdata.com

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Table 2. Descriptive statistics of the cash flows (in INR) under different risk management strategies

Minimum Maximum Mean Std. Dev.

Without Hedging (1,652,262) 19,958,871 2,780,730 3,743,421
Forward Currency Hedging (1,732,085) 21,921,192 3,001,955 4,040,890
Currency Option Hedging (1,730,310) 21,920,775 2,975,929 4,015,837
Cross-Currency Hedging (1,671,072) 21,049,890 2,898,370 3,899,867

Table 3. Descriptive statistics of the cash flows (in INR) under different risk management strategies
for different project types

Project Without Forward currency Currency option Cross-currency

Type hedging hedging hedging hedging
FPP Mean 2,811,455 3,027,346 3,011,573 2,933,114
Std. Dev. 4,365,912 4,708,947 4,692,717 4,553,621
T&M Mean 2,751,731 2,977,990 2,942,288 2,865,578
Std. Dev. 3,067,493 3,316,609 3,278,433 3,188,582
Total Mean 2,780,730 3,001,955 2,975,929 2,898,370
Std. Dev. 3,743,421 4,040,890 4,015,837 3,899,867

Table 4. Descriptive statistics of the cash flows (in INR) under different risk management strategies
for different project categories

Project Without Forward currency Currency option Cross-currency

Category hedging hedging hedging hedging
AD Mean 2,305,817 2,496,391 2,478,837 2,488,998
Std. Dev. 3,245,791 3,528,599 3,517,032 3,525,282
AS Mean 5,729,151 6,140,662 6,062,041 6,130,083
Std. Dev. 5,144,961 5,482,321 5,428,390 5,488,033
Total Mean 2,780,730 3,001,955 2,975,929 2,994,120
Std. Dev. 3,743,421 4,040,890 4,015,837 4,039,090

It was found that the forward currency hedging strategy yielded the highest mean cash flows (in INR),
followed by the currency options hedging strategy, and the cross-currency hedging strategy, for both AD and
AS projects. Further, the mean cash flows and the variation in cash flows were found to be higher under each
of the strategies for AS projects than for AD projects, and that these differences were statistically significant.

The descriptive statistics of the percentage gains in the project-wise cash flows (in INR) under the different
forex risk management strategies over the unhedged strategy are shown in Table 5.

It was found that the forward currency hedging strategy yielded the highest mean percentage gain, followed
by the currency options hedging strategy, and the cross-currency hedging strategy. Paired-samples t-tests
showed that the forward currency hedging strategy yielded significantly higher mean percentage gain than
the other strategies, but there was no significant difference between the percentage gain yielded by the
currency option hedging strategy and the cross-currency hedging strategy.

The descriptive statistics of the percentage gains in the project-wise cash flows (in INR) under the different
forex risk management strategies over the unhedged strategy for different project types are shown in Table 6.

It was found that the forward currency hedging strategy yielded the highest mean percentage gain, followed
by the currency options hedging strategy, and the cross-currency hedging strategy for both FPP and T&M
projects. Further, the mean percentage gain was found to be higher under each of the strategies for FPP
projects than for T&M projects, and that these differences were statistically significant. Also, the variation in
percentage gain was found to significantly higher for T&M projects than for FPP projects.

The descriptive statistics of the percentage gains in the project-wise cash flows (in INR) under the different
forex risk management strategies over the unhedged strategy for different project categories are shown in
Table 7.

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Table 5. Descriptive statistics of the % gains under different risk management strategies
Minimum Maximum Mean Std. Dev.
Forward Currency Hedging (4.83%) 13.63% 4.38% 27.81%
Currency Option Hedging (4.72%) 13.63% 2.63% 30.12%
Cross-Currency Hedging (1.14%) 11.79% 1.70% 25.28%

Table 6. Descriptive statistics of the % gains under different risk management strategies for different
project types
Project type Forward currency hedging Currency option hedging Cross-currency hedging
FPP Mean 5.87% 4.94% 3.23%
Std. Dev. 5.60% 6.86% 4.26%
T&M Mean 2.98% 0.44% 0.25%
Std. Dev. 38.44% 41.47% 35.04%
Total Mean 4.38% 2.63% 1.70%
Std. Dev. 27.81% 30.12% 25.28%

It was found that the forward currency hedging strategy yielded the highest mean percentage gain, followed
by the currency options hedging strategy, and the cross-currency hedging strategy for both AD and AS
projects. Further, the mean percentage gain was found to be higher under each of the strategies for AS
projects than for AD projects, and that these differences were statistically significant. Also, the variation in
percentage gain was found to significantly higher for AD projects than for AS projects.
Table 7. Descriptive statistics of the % gains under different risk management strategies for different
project categories
Project category Forward currency hedging Currency option hedging Cross-currency hedging
AD Mean 3.80% 1.95% 1.27%
Std. Dev. 29.91% 32.39% 27.21%
AS Mean 7.98% 6.82% 4.35%
Std. Dev. 3.23% 4.03% 2.68%
Total Mean 4.38% 2.63% 1.70%
Std. Dev. 27.81% 30.12% 25.28%

Fig. 1. USD/INR exchange rate trend in the research period

4 Conclusion
The results of the study suggest that the forward currency hedging strategy yielded the highest mean cash
flows and the highest mean percentage gain amongst the forex risk management strategies considered. This
is consistent with the results of [4], as there was a consistent decreasing trend in the USD/INR exchange rate
over the research period (Fig. 1).

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In terms of project type, however, the results of the study seem to be contrary to what was expected. The
forex risk management strategies investigated in the study seem to be more suitable for fixed price projects
(FPP) than for time and materials (T&M) projects, even though logically forex risk management strategies
would be expected to perform better for T&M projects. Perhaps this should be investigated in more detail to
obtain more representative results. In particular, simulation methodology could be used to model the
uncertainty in the timing of cash flows for FPP projects.
In terms of project category, the forex risk management strategies investigated in the study seem to be more
suitable for application support (AS) projects than application development (AD) projects, as was expected.
A major limitation of the study was in considering only a few foreign exchange risk management strategies,
under a stringent set of assumptions. For example, the strike price used in the study for the options strategy
was set at the exchange rate at the beginning of the planning period, but in practice, a range of strike prices is
usually available. Also, the EURO was used in the study for the cross-currency strategy, as the EURO/INR
rates have been less volatile than USD/INR rates in the last few years, but other currencies could have been
investigated in its stead; also, the currencies with low coefficient of variation would be expected to perform
well in the cross-currency strategy. Further, the cross-currency strategy could be used with a portfolio of
currencies, not just with single currency. There is a vast scope for further research in this area. Furthermore,
several other foreign exchange risk management strategies, including currency swaps, risk-sharing, and risk-
shifting could also be used to hedge foreign exchange risk. Another limitation is that the study did not
address a fundamental study of currencies, which would have helped in better implementation of the
strategies. In particular, there is scope for further research into the relationship between optimal foreign
exchange risk management strategies and the fundamentals of different currencies. Finally, the study has
used historical data to compare the strategies, so that the inferences that have been drawn can only hold for a
similar trend in exchange rates.

Competing interests
Author has declared that no competing interests exist.

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