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 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 (2005) 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 (2005) 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. Yazid and Muda (2006) 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 minimize operational overall cash flows, which are affected by currency volatility. Also, the majorities of multinationals centralize 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. The present study has extended the work of Dash et al (2008), 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 and explores various strategies for managing transaction exposure from this viewpoint. The cash flows for the study have been taken from a...