A STUDY ON THE IMPACT OF CURRENCY FLUCTUATION ON

THE INDIAN IT SECTOR

AKSHAY MADHAVA Y.S.

MIHIR DASH1

Alliance Business Academy,

BTM Layout II Stage,
Bangalore - 560076

ABSTRACT
The last twelve months have seen the Indian Rupee (INR) soaring to new highs
against the Dollar (USD), and subsequently falling to new lows. This has been a key
concern, with the INR rising notably from around INR 47/$ level in July 2007 to its level
around INR 38/$ in September 2007, and back to around INR 43/$ currently. This is
expected to have had an impact on the Information Technology (IT) sector, which mainly
depends on the earnings from exports of software and hardware products, and also from
the services of the Indian IT workforce in the US.
The present study investigates the impact of this INR/USD exchange rate fluctuation
on the IT sector as a whole, and surveys the different types of measures/strategies
adopted by IT companies to mitigate this impact. The analysis is performed on a random
sample of fifty major IT companies, and uses the concept of foreign exchange exposure
to assess the same.

Keywords: exchange rate, foreign exchange exposure.

1
Corresponding author

Electronic copy available at: http://ssrn.com/abstract=1326506

INTRODUCTION AND REVIEW OF LITERATURE
The foreign exchange rate exposure of a firm measures of the sensitivity of its cash
flows to changes in exchange rates. However, since cash flows are difficult to measure,
most researchers have examined exposure by studying how the firm’s market value, the
present value of its expected cash flows, responds to changes in exchange rates.
Exchange rate exposure certainly has the potential to be a significant risk factor for firms.
As pointed out by Jorion (1990), the volatility of exchange rates is substantially larger
than that of interest rates or inflation.
There have been several empirical studies of the foreign exchange rate exposure of
U.S. firms (for example, Jorion (1990), Bodnar and Gentry (1993), Amihud (1994), Choi
and Prasard (1995), Griffin and Stulz (1997), and Allayannis (1997)). Most of the studies
have typically found low or negligible levels of exposure for most firms, even when the
firms examined have significant foreign operations. None of these studies were based
explicitly on a model of firm behavior, however, so it is difficult to interpret their
findings of low exposure in terms of economic behavior.
For example, Jorion (1990) examined U.S. multinational firms and found that only
5% of them exhibit significant exposures. Although the evidence for firms domiciled in
other countries was somewhat stronger, it was still relatively weak. For example, He and
Ng (1998) and Glaum, Brunner and Himmel (2001) investigated Japanese and German
firms, respectively, and found a greater relation between stock returns and exchange rate
movements. But even in these countries, where presumably the large firms have
relatively more foreign trade than do their U.S. counterparts, the percentage of firms with
significant return exposures was still less than would be expected.
Several possible explanations have been offered for such small exposures for U.S.
firms. First, the small observed exposures may be due to the offsetting nature of currency
exposures. Since researchers generally lack complete data on individual firms’ imports,
exports and business competitors, they cannot identify which firms are exposed to a given
currency. For example, Brown’s (2001) study of the hedging practices of a U.S. firm
found that the firm hedged twenty-four different currencies due to both extensive foreign
sales and the importation of a major portion of their manufacturing inputs. As a result,
some studies have chosen to examine exchange rate exposure at the industry level where

Electronic copy available at: http://ssrn.com/abstract=1326506

it is more appropriate to proxy for exchange rate movements with changes of a trade-
weighted index.
Second, the small observed exposures may be due to the complexity of the firms’
foreign exchange exposures since exchange rate risk can vary over time as well as cross-
sectionally. For example, it can vary with the level of a firm’s foreign trade, the demand
elasticity of the firm’s product, or the competitive reactions of other firms in the same
industry. Allayannis (1997), Bodnar, Dumas, and Marston (2002), Allayannis and Ihrig
(2001), and Francis, Hasan and Hunter (2005) examined time-varying exposure at the
industry level. They provided evidence that exchange rate exposures increase with the
level of foreign trade and decrease with firms’ ability to mark up prices and pass through
the impact of exchange rate movements to customers. These studies indicated that it is
important to measure exposure in a specification that allows it to vary both cross-
sectionally and over time.
Third, with the rapid development of hedging instruments since the 1980s, more firms
are actively involved in the management of foreign exchange risk. However, a survey of
derivative usage by Bodnar, Hayt and Marston (1998) indicated that although many firms
engaged in currency hedging, they hedged selectively. Further, Guay and Kothari (2003)
found that the potential effects of hedging with derivatives were small compared to firm
size. Hentschel and Kothari (2001) found no differences in risk for firms that hedge with
derivatives versus those that do not. Given these evidences, it is unlikely that hedging can
completely insulate firms from currency risk.
Bodnar and Marston (2000) developed a simple model of exposure that, when
calibrated, provided estimates of exposure consistent with the previous findings of low
exposure. The model was that of a monopoly firm whose revenues and expenses are
exposed to changes in exchange rates. It demonstrated that exposures were related to net
foreign currency revenues and profit margins, and that firms that developed operational
hedges can shield themselves from the large scale effects of exchange rate changes.
Bodnar, Dumas, and Marston (2002) provided an explicit theoretical model, and they
found relatively high levels of exposure. But their model was estimated for a group of
Japanese firms that have been chosen because they were likely to have high levels of
exposure. Other theoretical studies of exposure include Adler and Dumas (1984),
Hekman (1985), Shapiro (1975), Flood and Lessard (1986), von Ungern-Sternberg and
von Weizsacker (1990), Levi (1994) and Marston (2001). None of these studies have
attempted to provide empirical estimates of their models.
Sparks and Wei (2003) argued that exchange rate movements are more likely to affect
a firm through direct effects on short-term cash flows, which in turn depend on the firm’s
sensitivity to short-term cash flow volatility. For example, if a firm’s liquidity is already
low, then a large fluctuation in its cash flows due to an exchange rate movement can push
the firm into financial distress, and as a result, lead to changes in its fundamental value.
Similarly, when a firm has substantial growth opportunities, exchange rate movements
can have greater effects on firm value due to the firm’s larger underinvestment costs. If
exchange rate changes have pronounced effects on fundamental values primarily when
the resulting short-term cash flow fluctuations force the firm into financial distress or
cause it to forsake positive NPV investment opportunities, the magnitude of exposures
would vary cross-sectionally with the expected cost of financial distress in terms of both
the probability of distress and the cost related to it, so that firms that have greater
expected costs of financial distress should be more exposed to exchange rate risk.
The literature addressing foreign exchange rate exposure is almost entirely focused on
firms operating in developed economies. Foreign exchange rate exposure is perhaps all
the more important for developing economies, as movements in the exchange rate can
affect export sectors, and perhaps even the entire economy.
The present study addresses the issue of foreign exchange rate exposure in the Indian
information technology (IT) sector. Foreign exchange revenues are the component of the
total revenue of the Indian IT players, and the sector’s performance depends greatly on
the FOREX trend.

DATA AND METHODOLOGY

The objectives of the present study were to analyse the FOREX exposure of Indian IT
companies, to relate the FOREX exposure with the profitability of Indian IT companies,
and to analyse the impact of the fluctuation of exchange rates on the profitability of IT
companies.
The data for the study consisted of the financial details of a sample of forty-four IT
companies. The sample was selected randomly from among the IT companies registered
with NASSCOM. The sample contained 63.04% of small-cap companies, 19.57% of
mid-cap companies, and 17.39% of large-cap companies. The research period
encompassed the years 2005-06 and 2006-07. The data for the study was collected from
the CapitaLine database.
The FOREX exposure of the sample companies was assessed using Bodnar and
Marston’s (2000) formula: FE = h1 + (h1 −h2 ) * ⎛⎜ 1 − 1⎞⎟ , where h1 represents the ratio of
⎝r ⎠

FOREX revenue to total revenue, and h2 represents the ratio of FOREX expenditure to
total expenditure, and r represents the expected rate of return/cost of capital. For the
purpose of the study, the cost of capital was assumed to be 15% p.a. FOREX exposure, so
defined, measures the sensitivity of a firm’s profits to changes in the exchange rate, in
1
proportional terms. The extreme values are FE = , which arises when h1 = 1 & h2 = 0
r
(i.e. for a pure exporter), and ⎛1 ⎞
FE = −⎜ − 1⎟ , which arises when h1 = 0 & h2 = 1 (i.e. for a
⎝r ⎠

pure importer).

ANALYSIS & INTERPRETATION

The FOREX exposures and the profitability measures of the sample IT companies are
shown in Table 1. The descriptive statistics of the FOREX exposure and profitability
measures of the sample IT companies are shown in Table 2.
The FOREX exposure of the sample companies varied considerably, from a minimum
of 0.0000 to a maximum level of 0.9237. Though the maximum level was not very high,
it assumed significance relative to exchange rate fluctuation. Extreme fluctuation of the
INR/USD exchange rate was experienced in mid-2007, from around INR 47/$ level in
July 2007 to its level around INR 39/$ in September 2007, an appreciation of 17.02%. At
the maximum exposure level, this would translate into a 15.73% decrease in profitability.
In this context, the cut-off values for exposure corresponding to a 5% and 10% decrease
in profitability, respectively, were 0.2938 and 0.5875.
 Table 1: FOREX exposures and profitability measures of sample IT companies
2005-06 2006-07
FOREX FOREX
Capitalisation Exposure APATM ROCE Exposure APATM ROCE
ASM small-cap 0.5908 6.22% 15.36% 0.4949 4.02% 22.84%
SATYAM large-cap 0.6265 21.87% 31.34% 0.6639 22.85% 31.18%
WIPRO large-cap 0.3401 19.68% 41.01% 0.3414 20.66% 39.73%
INFOSYS large-cap 0.5719 26.82% 45.09% 0.6252 28.77% 45.99%
TCS large-cap 0.5901 24.18% 67.77% 0.6028 25.15% 60.69%
HCL large-cap 0.3702 18.57% 21.28% 0.3594 29.24% 39.33%
PATNI large-cap 0.1820 20.62% 14.79% 0.2033 33.06% 18.55%
3i Infotech Ltd mid-cap 0.2584 14.20% 9.65% 0.1595 11.58% 7.33%
Accel Frontline Ltd small-cap 0.0477 4.10% 15.05% 0.1129 5.90% 17.81%
Aztecsoft Ltd small-cap 0.1756 15.78% 15.06% 0.2026 15.73% 28.16%
Cambridge Soluti mid-cap 0.0700 2.80% 6.58% 0.0655 -1.01% 0.00%
Core Projects mid-cap 0.0142 24.48% 54.18% 0.0279 16.81% 26.96%
Four Soft small-cap 0.0558 19.11% 8.78% 0.0335 13.95% 7.05%
Genesys Intl. small-cap 0.1219 1.15% 0.81% 0.2005 10.74% 5.58%
Geodesic Inform. mid-cap 0.1636 45.18% 34.22% 0.0825 57.14% 37.30%
Geometric Ltd small-cap 0.1760 14.95% 19.66% 0.1552 17.60% 21.04%
Goldstone small-cap 0.0044 1.66% 4.61% 0.0404 19.01% 23.82%
Glodyne Tech small-cap 0.0004 8.41% 39.05% 0.0577 10.94% 41.31%
HTMT Global small-cap 0.0000 0.00% 0.00% 0.0269 13.22% 8.13%
Info-Drive Softw small-cap 0.0000 0.00% 0.00% 0.0000 25.00% 0.46%
Infotech Enterpr mid-cap 0.1618 13.28% 18.37% 0.4920 18.87% 30.62%
Interworld Digi small-cap 0.0000 2.80% 13.17% 0.0013 1.39% 6.51%
IT People small-cap 0.7210 4.69% 4.96% 0.8054 17.59% 11.94%
Lanco Global Sys small-cap 0.0129 5.19% 8.98% 0.0183 12.25% 14.16%
Mindtree Ltd mid-cap 0.4307 12.08% 34.01% 0.4340 15.25% 27.95%
Northgate Techno small-cap 0.9079 29.47% 48.14% 0.7522 63.15% 30.75%
Nucleus Software small-cap 0.2301 30.66% 35.14% 0.1848 29.28% 37.16%
Omnitech Info small-cap 0.0170 11.55% 32.44% 0.0324 15.72% 42.89%
Orient Informatn small-cap 0.9237 -2.07% 0.00% 0.8497 65.35% 0.00%
Quintegra Soln. small-cap 0.7811 8.92% 5.17% 0.5071 10.59% 7.30%
Saksoft small-cap 0.1480 34.96% 41.67% 0.1701 25.83% 21.37%
Sonata Software small-cap 0.3486 16.14% 18.20% 0.3360 18.90% 21.02%
Subex Ltd small-cap 0.7623 21.60% 26.64% 0.7867 9.82% 3.68%
Tata Elxsi small-cap 0.3345 14.57% 67.99% 0.3124 16.92% 77.34%
Allied mid-cap 0.0288 13.63% 73.73% 0.0182 14.70% 64.42%
Flextronics small-cap 0.3104 21.55% 32.56% 0.3145 20.21% 29.78%
Hexaware small-cap 0.1313 28.75% 23.70% 0.1141 19.13% 14.02%
I-flex mid-cap 0.3255 20.87% 22.95% 0.3146 22.85% 20.48%
Igate mid-cap 0.5756 2.71% 6.01% 0.5978 6.26% 15.45%
L&T Infotech small-cap 0.5399 8.85% 34.00% 0.6102 11.82% 43.91%
Logix microsystems small-cap 0.2023 18.11% 21.50% 0.1743 16.18% 16.81%
Mphasis large-cap 0.2408 20.03% 15.37% 0.2067 11.93% 20.93%
NIIT Tech small-cap 0.0384 27.17% 25.87% 0.0305 37.25% 39.84%
Polaris small-cap 0.4201 1.94% 3.94% 0.4598 8.80% 17.11%
Sasken small-cap 0.3107 6.62% 9.59% 0.2095 10.41% 11.35%
Tech Mahindra Ltd large-cap 0.5127 18.39% 44.53% 0.6209 19.28% 86.22%
 Table 2: Descriptive statistics of FOREX exposures and profitability measures
2005-06 2006-07 Change
FOREX FOREX FOREX
Exposure APATM ROCE Exposure APATM ROCE Exposure APATM ROCE
small-cap Mean 0.2866 0.1251 0.1973 0.2757 0.1885 0.2149 -0.0110 0.0634 0.0176
Std. Dev. 0.2968 0.1062 0.1663 0.2689 0.1462 0.1680 0.0749 0.1524 0.0997
mid-cap Mean 0.2254 0.1658 0.2886 0.2436 0.1805 0.2561 0.0182 0.0147 -0.0324
Std. Dev. 0.1908 0.1288 0.2303 0.2209 0.1627 0.1869 0.1242 0.0573 0.1158
large-cap Mean 0.4293 0.2127 0.3515 0.4530 0.2387 0.4283 0.0237 0.0260 0.0768
Std. Dev. 0.1691 0.0292 0.1812 0.1960 0.0670 0.2216 0.0437 0.0641 0.1554
Total Mean 0.2995 0.1483 0.2419 0.3002 0.1957 0.2601 0.0007 0.0474 0.0181
Std. Dev. 0.2644 0.1060 0.1887 0.2546 0.1382 0.1943 0.0823 0.1270 0.1159
F-value 1.3740 2.4390 2.6110 1.8660 0.4690 4.3440 0.8000 0.6320 1.9610
p-value 0.2640 0.0990 0.0850 0.1670 0.6290 0.0190 0.4560 0.5360 0.1530

The large-cap companies in the sample were found to have a moderate level of
exposure, ranging between 0.1820 and 0.6265, with mean exposure 0.4293, and standard
deviation 0.1691 (in 2005-06); and ranging between 0.2033 and 0.6639, with mean
exposure 0.4530, and standard deviation 0.1960 (in 2006-07). The mid-cap companies in
the sample were found to have a low/moderate level of exposure, ranging between 0.0142
and 0.5756, with mean exposure 0.2254, and standard deviation 0.1908 (in 2005-06); and
ranging between 0.0182 and 0.5978, with mean exposure 0.2436, and standard deviation
0.2209 (in 2006-07). The small-cap companies in the sample were found to have a very
wide range of exposure, from very low to very high, ranging between 0.0000 and 0.9237,
with mean exposure 0.2866, and standard deviation 0.2968 (in 2005-06); and ranging
between 0.0000 and 0.8497, with mean exposure 0.2757, and standard deviation 0.2689
(in 2006-07). It was found that 13.33% of the small-cap companies had exposures in
excess of 0.6000, i.e. very vulnerable to exchange rate fluctuation of the nature that was
experienced in mid-2007.
Correlation analysis across the sample companies of the FOREX exposure level with
the adjusted profit after tax margin (APATM) [r = 0.267*] and with the return on capital
employed (ROCE) [r = 0.123] showed that profitability was significantly correlated to
FOREX exposure for IT companies. Regression analysis across the sample companies
showed that FOREX exposure had a significant impact on both the APATM and the
ROCE. FOREX exposure was found to explain 40.2% and 52.7% of the cross-sectional
variation in APATM in 2005-06 and 2006-07, respectively, and 39.3% and 44.0% of the
cross-sectional variation in ROCE in 2005-06 and 2006-07, respectively.
 The paired-samples t-tests of FOREX exposures and profitability measures between
the two years are shown in Table 3.

Table 3: Paired-samples t-tests of FOREX exposures and profitability measures

Mean Std. Dev. Correlation Sig. t Sig. (2-tailed)
FOREX exposure (2006) 0.2995 0.2644 0.9500 0.0000 -0.061 0.952
FOREX exposure (2007) 0.3002 0.2546
APATM (2006) 14.83% 10.60% 0.4850 0.0010 -2.529 0.015
APATM (2007) 19.57% 13.82%
ROCE (2006) 24.19% 18.87% 0.8170 0.0000 -1.060 0.295
ROCE (2007) 26.01% 19.44%

The results of the paired-samples t-tests indicated that there was no significant change
in the FOREX exposure levels between the two years. However, it was found that there
was a significant increase in the APATM and moderate increase in the ROCE.
Correlation analysis of the change in FOREX exposure level with the change in APATM
[r = 0.125] and with the change in ROCE [r = 0.282*] showed that the change in FOREX
exposure had an impact on the profitability of the IT companies.
Analysis of the impact of currency fluctuation on the profitability was performed for
each company in both time periods. The results of the analysis are shown in Table 4.

Table 4: Percentage of sample companies which would suffer losses

in different exchange rate fluctuation ranges
fluctuation range 2005-06 2006-07
1%-4% 2.27% 2.27%
5%-6% 6.82% 2.27%
7%-9% 9.09% 2.27%
9%-10% 11.36% 2.27%
10%-11% 13.64% 4.55%
11%-12% 15.91% 4.55%
13%-16% 15.91% 6.82%
17%-19% 18.18% 6.82%
19%-20% 18.18% 11.36%
20%-21% 18.18% 13.64%
22%-25% 20.45% 15.91%

It was found that there was a considerable improvement in 2006-07 in the percentage
of sample companies which would suffer losses in different exchange rate fluctuation
ranges. This indicates that most of the vulnerable companies had taken steps to hedge
their exchange risk and to improve their profitability. Most of these vulnerable companies
were small-cap companies; the figures for 2005-06 suggest that 15-20% of them would
have suffered losses without appropriate steps being taken.

DISCUSSION

The results of the study showed that FOREX exposure was especially alarming for a
small fraction of small-cap IT companies. The mid-cap and large-cap IT companies had
relatively low/moderate exposure levels. The majority of large-cap companies had
already hedged their FOREX risk, and were not significantly affected by their respective
FOREX exposures. The FOREX exposure of the companies was found to have improved
slightly in 2006-07; overall, however, exchange rate fluctuation has brought down the
revenues of the IT sector by around 6% in the last year.
It was also found that the IT companies had used different hedging tools to manage
exchange risk. Several companies had taken steps to shift their major export interests to
markets other than the US, especially in Asia and Europe. The companies also used
different financial hedging tools such as forwards and options, if wished to hedge for a
short period and expect the rates to stabilize soon, and currency swaps, if they wished to
hedge for a longer period.
A limitation of this study is that only one type of risk is analysed, viz. exchange risk.
A more comprehensive framework, incorporating measures of multiple sources of risk,
would be more appropriate for understanding risk management in IT companies. Another
limitation is due to the limited size of the sample used in the study, and the limited
research period. There is scope for more rigorous study along these lines.

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