FOREX RISK MANAGEMENT STRATEGIES FOR INDIAN IT COMPANIES

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1 FOREX RISK MANAGEMENT STRATEGIES FOR INDIAN IT COMPANIES Mihir Dash Alliance Business School ABSTRACT Foreign exchange risk is the effect that unanticipated exchange rate changes have on the value of the firm. There are a variety of strategies which are designed to manage foreign exchange risk. Each of them, however, is constructed under specific assumptions, for a specific risk profile. 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. 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 risk management strategies considered for the study are: forward currency contacts, currency options, and cross-currency hedging. The study analyzes and evaluates these foreign exchange risk management strategies to find out which of the strategies is appropriate in particular situations. KEYWORDS: foreign exchange risk, risk management strategies, forward currency contracts, currency options, cross-currency hedging INTRODUCTION There have been several recent studies on foreign exchange risk management which have focused on managing foreign exchange risk while doing business in developing countries. Murray (005) studied the types of risk associated with foreign currency denominated assets and liabilities. Transaction risk is incurred whenever money is physically converted from one currency to another. Translation risk is incurred when assets or liabilities are held in a foreign currency. These two risks can be related if one takes the example of a sale of goods in a foreign currency. Holding the accounts receivable over the end of a closing period will result in translation risk and possibly an unrealized foreign exchange gain or loss. Abor (005) suggested that foreign exchange risk can be managed by adjusting prices to reflect changes in import prices resulting from currency fluctuation, and also by buying and saving foreign currency in advance. The main problems that firms face are the frequent appreciation of foreign currencies against the local currency and the difficulty in retaining local customers because of the high prices of imported inputs, which tend to affect the prices of their final products sold locally. Jesswein et al (1995) studied the usage pattern of foreign exchange management strategies by American firms. They found that forward currency contracts were still the most popular instruments, despite the introduction of new, sophisticated instruments. Yazid and Muda (006) studied the usage pattern of foreign exchange management strategies in multinational corporations. They found that multinationals are involved in foreign exchange risk management primarily because they sought to minimise operational overall cash flows, which are affected by currency volatility. Also, the majority of multinationals centralise their risk management activities and at the same time impose greater control by frequent reporting on derivative activities. This level of caution could perhaps be because of huge financial losses related to derivative trading in the past. Though many studies have suggested that active currency management by using derivatives is very much necessary for the firm to be on par with the competitors in a global business environment, some studies argue otherwise. According to Copeland and Joshi (1996), foreign exchange risk management programs may cause more harm than good. Their study of nearly two hundred large companies has yielded enough evidence to cast serious doubt about the economic benefits of foreign exchange hedging programs. Given scarce management time and the substantial amount of capital currently devoted to hedging, it is clear that many programs diminish value instead of creating it. theories assume a static world in which all factors apart from foreign exchange rates stay exactly the same. In addition, the relationships between these factors are shifting constantly. Hard enough to understand in hindsight, they are virtually impossible to predict in advance. Although derivatives are generally ineffective in managing foreign exchange risk, senior managers should not simply throw up their hands and resign themselves to being pummeled by the markets. Even though the study Electronic copy available at: 1

2 was against using derivatives for foreign exchange risk management, it concludes by suggesting that individual transactions may not work, but foreign exchange exposures at the company cash flow level can be managed. The present study has extended the work of Dash et al (008), who 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 forwards 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. DATA & METHODOLOGY 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 1 st January, 007, and the USD/INR spot rate on the reference date was taken as Rs. 44.0/$. The following foreign exchange risk management strategies were considered: 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 corresponding spot USD/INR exchange rates in the research period are presented in Table 1. TABLE 1 1 : Spot USD/INR exchange rates in the research period Date USD EURO -Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Dec 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 Electronic copy available at:

3 TABLE : Interest rates and inflation rates in the research period Date 1 Month LIBOR 1 Month MIBOR 3 Inflation (India 4 ) Inflation (US 5 ) 1-Jan % 13.70% 6.37%.08% 1-Feb % 7.90% 6.69%.4% 1-Mar % 6.11% 6.0%.78% 1-Apr % 14.4% 5.94%.57% 1-May % 8.77% 6.01%.69% 1-Jun % 0.78% 5.15%.69% 1-Jul % 1.68% 4.4%.36% 1-Aug % 0.17% 4.70% 1.97% 1-Sep % 6.1% 3.7%.76% 1-Oct % 6.1% 3.36% 3.54% 1-Nov % 6.11% 3.11% 4.31% 1-Dec % 7.88% 3.89% 4.08% 31-Dec % 7.0% 3.83% 4.08% 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 ( T t) rf ( T t) r( T t ) rf ( T t ) C = Xe N ( d ) + Se N ( d1) and P = Xe N ( d ) Se N( d1), 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, r f 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 shortterm returns over one year), N(.) represents the standard normal cumulative distribution function, and d 1 and d S 1 ln + r rf + σ.( T t) are given by the formulae: X d and 1 = d = d1 σ. ( T t). The strike prices used in σ. ( T t) 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 8.39%. 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 /$. The corresponding spot EURO/INR exchange rates in the research period are presented in Table 1. The realized 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

4 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. The sample projects were also categorized 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. DATA ANALYSIS & INTERPRETATION The descriptive statistics of the project-wise cash flows (in INR) under the different FOREX risk management strategies are shown in Table 3. TABLE 3: Descriptive statistics of the cash flows (in INR) under different risk management strategies Minimum Maximum Mean Std. Dev. Without (1,65,6) 19,958,871,780,730 3,743,41 (1,73,085) 1,91,19 3,001,955 4,040,890 (1,730,310) 1,90,775,975,99 4,015,837 (1,671,07) 1,049,890,898,370 3,899,867 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 Chart 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 4. TABLE 4: Descriptive statistics of the cash flows (in INR) under different risk management strategies for different project types Type Without FPP T&M Mean,811,455 3,07,346 3,011,573,933,114 Std. Dev. 4,365,91 4,708,947 4,69,717 4,553,61 Mean,751,731,977,990,94,88,865,578 Std. Dev. 3,067,493 3,316,609 3,78,433 3,188,58 Mean,780,730 3,001,955,975,99,898,370 Std. Dev. 3,743,41 4,040,890 4,015,837 3,899,867 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 5. 4

5 TABLE 5: Descriptive statistics of the cash flows (in INR) under different risk management strategies for different project categories Category Without AD AS Mean,305,817,496,391,478,837,488,998 Std. Dev. 3,45,791 3,58,599 3,517,03 3,55,8 Mean 5,79,151 6,140,66 6,06,041 6,130,083 Std. Dev. 5,144,961 5,48,31 5,48,390 5,488,033 Mean,780,730 3,001,955,975,99,994,10 Std. Dev. 3,743,41 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 6. TABLE 6: Descriptive statistics of the % gains under different risk management strategies Minimum Maximum Mean Std. Dev. (4.83%) 13.63% 4.38% 7.81% (4.7%) 13.63%.63% 30.1% (1.14%) 11.79% 1.70% 5.8% 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 7. TABLE 7: Descriptive statistics of the % gains under different risk management strategies for different project types Type FPP T&M Mean 5.87% 4.94% 3.3% Std. Dev. 5.60% 6.86% 4.6% Mean.98% 0.44% 0.5% Std. Dev % 41.47% 35.04% Mean 4.38%.63% 1.70% Std. Dev. 7.81% 30.1% 5.8% 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 8. 5

6 TABLE 8: Descriptive statistics of the % gains under different risk management strategies for different project categories Category AD AS Mean 3.80% 1.95% 1.7% Std. Dev. 9.91% 3.39% 7.1% Mean 7.98% 6.8% 4.35% Std. Dev. 3.3% 4.03%.68% Mean 4.38%.63% 1.70% Std. Dev. 7.81% 30.1% 5.8% 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. CHART 1: USD/INR exchange rate trend in the research period USD/INR Exchange Rate Trend DISCUSSION 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 Dash et al (008), as there was a consistent decreasing trend in the USD/INR exchange rate over the research period (as shown in Chart 1). 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 6

7 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 riskshifting 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. REFERENCES Abor, J. (005), Managing foreign exchange risk among Ghanian firms, Journal of Risk Finance ( ). Copeland, T.E. and Joshi, Y. (1996), Why Derivatives Don't Reduce FX Risk, Risk Management Dash, M., Babu, N., Kodagi, M., and Vivekanand, B.Y. (008), An Empirical Study on FOREX Risk Management Strategies, Indian Journal of Finance, Vol. II, No. 8 Jesswein, K. R.; Kwok, C. C. Y.; Folks Jr., W. R. (1995), Corporate Use of Innovative Foreign Exchange Risk Management Products, Columbia Journal of World Business Murray, Robert D. (005), Keeping up with world currencies, CMA Management. Yazid, A.S. and Muda, M.S. (006), The Role of Foreign Exchange Risk Management in Malaysia Irish Journal of Management, Vol. 6, Issue 7