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CHAPTER ONE
1. INTRODUCTION
1.1 Background of the Study
Globalization and economic liberalization have enabled the Indian software industry to grow
exponentially at over fifty percent per year since 1991. From about USD hundred and fifty
million in the early 1900s, the Indian software exports have crossed USD hundred billion
dollar in the year 2013. It has been a remarkable success story. The success of Indian
software industry can be attributed to low cost advantage, large pool of talented and english
speaking professionals, and the high quality service offerings.
The origins of the Indian software industry dates back to 1970 with the entry of TCS into the
domain of outsourced application migration work. According to Mr. Ramadorai, it began in
early seventies’ with the main frame manufacturer, Burroughs asking its Indian sales agent
TCS, to export programmers for installing system software for a US client.
The Indian software industry has successfully faced and overcome many challenges during
its brief history and today it is faced with quite a few headwinds that threaten its pace of
growth and its move towards the USD two hundred billion plus exports goal it has set for
itself for the year 2020.
The Indian software industry has not only been among the fastest growing industries
globally, it has played a key role in transforming India from a largely inward looking
economy to an emerging knowledge power that is today perceived as being one of the more
dynamic and entrepreneurial in the world. The growth in Indian software industry has been
spurred mainly by the growth in export market demand. The export market is concentrated in
the US and Europe. Almost two-thirds of the software revenue of Indian companies accrues
from export sales in the US market.
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The rise of the software and services industry during the 1990s represents one of the most
spectacular achievements of the Indian economy. The industry has grown at an incredible
rate of fifty percent per annum over the past few years, is highly export oriented, has
established India as an exporter of knowledge intensive services, and has brought in a
number of other spillover benefits such as creating employment and a new pool of
entrepreneurship. (Kumar, 2001).
In 1991, the Indian software industry was modest in size, employing twelve thousand
persons, and contributing an insignificant part of GDP. Between 2000 and 2004, it had
emerged as the largest incremental contributor to GDP, with six percent coming from this
sector. Over ninety-five percent of the absolute growth in foreign exchange inflows in the
service sector during this period is estimated to have come from the software and BPO
industries alone.
In the financial year 2009, as a proportion of national GDP, the Indian software industry
revenues have grown from mere one percent in financial year 1998 to an estimated six
percent and software services accounted for over ninety nine percent of the total exports,
reached USD forty seven billion and employed over one and half million professionals.
Moreover, compared to 2009 in the financial year 2012, as a proportion of national GDP, the
Indian software sector revenues have grown to an estimated seven and half percent and its
share of total Indian exports reached to about twenty five percent.
The Indian software industry expects to contribute about seven percent to annual GDP and
create around fourteen million employment opportunities both directly and indirectly by
Financial Year 2015 and expects to cross USD two hundred and twenty five billion revenues
by 2020. The software service exports were fastest growing at over nineteen percent
compared to financial year 2011 with export revenue of USD forty billion, accounting for
fifty eight percent of total exports.
India continues to be the nerve-centre for global sourcing with over two-third of the Fortune
500 and a majority of Global 2000 firms leveraging global service delivery – now sourcing
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from India. The US and the UK remain the largest export markets (accounting for about sixty
one percent and eighteen percent respectively, in 2007) the industry footprint is steadily
expanding. Strong fundamentals of a large talent pool, sustained cost competitiveness and an
enabling business environment have helped establish India as the preferred sourcing
destination. (NASSCOM, 2008).
The industry has played a significant role in transforming India’s image from a slow moving
bureaucratic economy to a land of innovative entrepreneurs and a global player in providing
world class technology solutions and business services. The industry has helped India
transform from a rural and agricultural based economy to a knowledge based economy.
The information technology-BPO industry in India has today become a growth engine for the
economy, contributing substantially to the GDP, urban employment and exports and to
achieve the vision of the “Young and Re-silent” India. With a young demographic profile,
where over three and half million graduates and post-graduates are added annually to the
talent base, no other country offers a mix and scale of human resources. India enjoys a cost
advantage of around sixty to seventy percent as compared to source markets. (NASSCOM,
2009).
The Indian software industry has captured a significant portion of the world trade in software
services and it acts as complementary to the US software industry which accounts for nearly
sixty percent of Indian software services exports. Studies conducted by the McKinsey Global
Institute and other research outfits have also shown that moving “white collar” service work
to countries with low labor costs such as India can be a win-win for both US and India.
Furthermore, establishment of STPs stands out a seminal policy action, specifically targeted
towards encouraging, promoting and boosting the export of software and services from India.
Indian companies are now trying to adopt a culture that encourages innovation, embrace new
trends such as Green IT, and deliver solutions that are focused on re-engineering and
transformation.
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The growth rate of the Indian software industry has been substantially higher than the global
software industry. India is the only one country in the world to register a growth rate of
around fifty percent in the software industry (Kumar, 2001).
The Phenomenal growth of Indian software industry can be attributed to various steps taken
by the Government of India to boost software exports such as simplifying procedures, tax
concessions, establishment of Software Technology Parks (STPs), establishment of Special
Economic Zones (SEZs), more liberal foreign investment policies, availability of second
largest pool of English speaking technically competent manpower, proactive role of
NASSCOM, locational time difference with the Western part of the world enabling round the
clock development.
Indian IT industry has built-up a reputation for innovation in service delivery and superior
quality management through internationally accepted methodologies such as CMMi and Six
Sigma. Indian software is extremely of good quality with relatively low cost. As of
December 2003, India has sixty five Software Engineering Institute, Capability Maturity
Model (SEI CMM) Level 5 software firms. Over half of the world’s CMM Level 5 software
firms are in India (Bhatnagar, 2001).
Indian software industry which has been largely export oriented, became sufficiently global
in its outlook. More than two hundred Indian software companies have set up more than five
hundred overseas subsidiaries or offices, of which around three hundred are in North
America, hundred in Europe and close to hundred in Asia excluding India.
The export-oriented Indian software industry earns nearly two-third of its revenues through
software exports. Since India does not have a high domestic market, most of the growth
involves export to US and European countries. India exports software and services to more
than one hundred countries and over half of Fortune 500 companies outsource their software
requirements from India. Nearly fifty-six percent of total Indian software services are
exported to North America, thirty-one percent of software services are exported to European
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Union countries and the remaining thirteen percent are exported to Middle-East and Asian
Countries.
Proportion of Indian Software Exports
Others
21%
UK
18%
Source:NASSCOM
USA
61%
Figure 1.1.1
The aftermath of financial crisis of 1991 had led to the devaluation of Indian currency and
forcing the government of India to switch towards managed floating exchange rate system.
Under managed float system the currency is allowed to move freely in response to market
forces which increases the volatility of exchange rate, which consequently will have an
adverse impact on the revenues of Indian software companies which are primarily exportoriented.
Indian software industry earns more than seventy five percent of revenues from exports.
This kind of business model, where the majority of revenues comes from exports, exposes
businesses to risks involved with foreign trade. After 1993, the Indian rupee has been
fluctuating a lot vis-à-vis dollar. Since more than seventy percent of exports are made to
North-America, the profitability of Indian software companies depends largely on the
movement of INR-USD exchange rate.
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Moreover, the integration of Indian financial markets with global financial markets has
increased the volatility of exchange rates, consequently increasing the concerns of corporate
sector particularly export oriented companies.
According to Infosys Chairman Mr. N R Narayana Murthy, for every one percent movement
in the INR against the USD has an impact of approximately fifty basis points on operating
margins of a software company.
1.2 Justification of the Study
In view of globalization trends, a booming economy and the emergence of India as an
Information Technology hub, the Indian software industry seems to be the fastest growing
sector in the country over the last decade. In India, a large number of software companies are
small and medium sized and these companies play a significant role in driving the Indian
software industry to new heights by sustaining the current growth.
According to NASSCOM, Indian small and medium software companies have the potential
to compete in the global arena and to play a significant role in promoting both regional and
national economic development. Software Technology Parks of India had also played a
developmental role in the promotion of software exports with a special focus on small and
medium companies and startups. Today, more than eighty percent software technology park
of India member units are small and medium companies.
However, the small and medium software companies have been facing problems of volatile
exchange rates, lack of means and information to hedge export risks, lack of market
intelligence, and lack of skill and technical expertise in handing foreign exchange risk.
There is much scope for public policy to support small and medium companies, efforts to
build competitiveness, in terms of developing technical and marketing skills and fostering
technological and innovative capabilities.
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Although many studies have been made on the foreign exchange risk management practices
of large US, UK, German, Belgian, Sweden, Canadian, Malaysian, Korean, New Zealand,
Jordanian, Lithuanian and Australian non-financial firms. Almost, all of these studies were
conducted on large companies from diversified industries. However, there are a very few
studies conducted in India, and these studies have negligible representation of software
companies in their sample. A study by Debashish 2008, conducted an industry wide cross
sectional study on foreign exchange risk management practices and derivative usage by large
non-banking Indian firms.
In general, the available literature on the foreign exchange risk management practices of
software companies does not give a precise and uniform picture. This is partly because the
earlier studies have not adequately represented the software companies in the sample.
Moreover, the issue of the relationship among the Indian software exports, US economic
activity and INR-USD exchange rate volatility was not specifically addressed in any of the
earlier studies.
Therefore, the current state of knowledge about the foreign exchange risk management
practices of software companies and the relationship among Indian software exports, US
economic activity and INR-USD exchange rate volatility warrants further investigation, and
it was against this background that the present study was undertaken.
1.3 Statement of the Problem
In India over eighty percent of information technology companies are small and medium
enterprises. A small and medium Indian software company would have a turnover, less than
INR 1000 million and staff strength of less than 500 people. The contribution of Indian
software exports to GDP has increased over the past years but SME’s share in the entire
information technology export in India is only thirty percent. The looming problems of
SMEs are Indian rupee appreciating, lack of means and information to hedge export risks,
lack of market intelligence, lack of financial patronage etc., (Upadhyay, 2007).
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In International trade foreign exchange rates are key factors.
Recent global economic
scenario has had an adverse impact on USD which was the dominating currency till recently.
Aftermath of failure of large investment banks such as Merrill Lynch, Goldman Sachs,
Fannie Mae and Freddie Mac has led to the weakening of the USD against most other
currencies including the rupee.
This has affected India’s software companies, because more than sixty percent of their
revenues come from North America and about ninety percent of Indian software exports are
invoiced in US dollars. Consequently operating margins of software companies have been
hit hard with adverse impact on their value. The competitive environment is such that the
foreign exchange rate volatility needs to be monitored and managed. Thus, volatility can
have profound effects on software companies earnings and consequently on their value.
The Indian rupee has been a market determined exchange rate since 1993 onwards. The
Indian rupee fluctuates a lot with global currencies such as US dollar, Euro, Pound, etc., the
volatile nature of Indian rupee exposes the Indian Software companies to foreign exchange
risk. Since India exports a significant percent of its software exports to US, fluctuations of
INR against USD will have an adverse impact on the revenues of the Indian software
companies and it requires a strong strategy to handle such foreign exchange rate risks.
The INR has been fluctuating sharply against USD. In the year 2009-10, INR appreciated by
about ten percent against the USD and about three percent against the JPY, whereas it
depreciated by about six percent against GBP and around three percent against the EUR. The
INR has been largely volatile since January 2009, trading in a wide range between 44.37 and
68.36 at the end of August, 2013. This kind of change will have a huge impact on business
and it requires a strong strategy to handle such exchange rate risks.
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INR-USD Exchange Rate Volatility
0.12
0.1
0.08
0.06
0.04
0.02
Source: RBI
2012Q4
2012Q1
2011Q2
2010Q3
2009Q4
2009Q1
2008Q2
2007Q3
2006Q4
2006Q1
2005Q2
2004Q3
2003Q4
2003Q1
2002Q2
2001Q3
2000Q4
2000Q1
0
Figure 1.3.1
Indian Software Exports
USD Mn
Source: RBI
2012Q4
2012Q1
2011Q2
2010Q3
2009Q4
2009Q1
2008Q2
2007Q3
2006Q4
2006Q1
2005Q2
2004Q3
2003Q4
2003Q1
2002Q2
2001Q3
2000Q4
2000Q1
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
Figure 1.3.2
According to NASSCOM, small and medium software companies have the potential to
compete in the global arena and to play a significant role in promoting both regional and
national economic development. From the figures 1.3.1 and 1.3.2, both the INR-USD
exchange volatility and the Indian software exports have been increasing since 2000.
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Thus, there is a need to study and understand the foreign exchange risk management
practices of software companies and also to examine the relationship among Indian software
exports, US economic activity and INR-USD exchange rate volatility.
Moreover, this study aims at providing adequate information concerning the foreign
exchange risk management practices of software companies and also the relationship among
Indian software exports, US economic activity and INR-USD exchange rate volatility to the
management, potential investors, risk management practitioners, and policy makers.
1.4 Research Questions
The central focus of this research is to study and understand objectively the foreign exchange
risk management practices of selected software companies, as well as to examine the
relationship among Indian software exports, US economic activity, and INR-USD exchange
rate volatility. In particular the study answers the following research questions:

What types of exposures are identified and managed by these software companies?

What is the primary objective of managing foreign exchange risk?

What kind of policy is adopted towards foreign exchange risk?

Do these firms have documented foreign exchange risk policy?

How frequently do they revise their documented foreign exchange risk policy?

What kind of control is followed by these companies and what is the degree of
control?

What techniques and instruments are used to manage foreign exchange exposure?

What factors influence the choice of usage of these techniques or instruments?

Whether there exists any relationship between Indian software exports and US
economic activity? and

What is the impact of INR-USD exchange rate volatility on Indian software exports?
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1.5 Objectives of the Study
1.5.1
General Objective
The major objective of this thesis has been to describe the foreign exchange risk
management practices of selected software companies. In this respect the study has
provided objective evidence on what kind of relationships exist between the firm
characteristic variables (type of the firm, form of ownership, firm size and degree of
foreign involvement) and firm’s foreign exchange risk management practice variables
(foreign exchange risk identification, policy and management variables). In addition, the
study also attempted to examine the relationship among Indian software exports, US
economic activity, and INR-USD exchange rate volatility.
1.5.2
Specific Objectives
This study, Foreign Exchange Risk – An Empirical Study of Software Companies has the
following specific objectives:

To describe the foreign exchange risk management practices of selected software
companies.

To examine the association between type of the firm and firm’s foreign exchange
risk management practice variables.

To examine the association between form of ownership and firm’s foreign
exchange risk management practice variables.

To examine the association between firm size and firm’s foreign exchange risk
management practice variables.

To examine the association between firm’s degree of foreign involvement and
firm’s foreign exchange risk management practice variables.

To examine the relationship among Indian software exports, US economic
activity, and INR-USD exchange rate volatility.
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1.6 Hypotheses of the Study
For their currency risk management decisions, firms with significant exchange rate exposure
often need to establish an operational framework of best practices (Jacque, 1996). In existing
risk management literature, a firm’s exposure to a risk factor is generally considered to be a
function of the firm’s own characteristics and its own decision to hedge.
To put it differently, a firm’s foreign exchange risk is determined by its involvement in
foreign trade, its decision to engage in financial or operational hedges, and the financial
constraints faced by the firm (Bartov and Bodnar, (1994), He and Ng (1998)). This argument
ignited an idea in the researcher’s mind to test the association between firm characteristic
variables and firm’s foreign exchange risk management practice variables.
Thus, the
following hypothesis has been framed:
H1: Firm’s foreign exchange risk management practice variables are independent of firm
characteristic variables.
Indian software industry is primarily export oriented, which earns nearly two-third of its
revenues comes through Software exports. Since India does not have a high domestic
market, most of the growth involves export to US and European countries. India exports
software and services to more than one hundred countries and over half of Fortune 500
companies outsource their software requirements from India. Nearly sixty percent of total
Indian software services are exported to North America.
According to NASSCOM, the Indian IT has hit revenues of USD 108 billion in financial year
2013 with exports contributing USD seventy six billion. During the period 2007-13, around
sixty-two percent of export revenues have come from Unites States of America.
Indian software services sector fortune looks strong amid improvement in global economies
such as US, UK and Europe along with the huge fall in the home currency. Improvement in
the consumer confidence and real economic conditions in the developed nations is expected
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to give good growth kick to the emerging nations in terms of higher exports including higher
IT spends.
The spending on the technology and the related services on the worldwide basis was close to
USD two trillion in year 2012, a growth of about five per cent over the previous year. Out of
the total expenditure, nearly USD one trillion was spent on software industry.
In the previous earnings season, the managements of the Indian big software giants were
found to be more confident for the days to come. NASSCOM expects the Indian information
technology sector to grow at a rate of twelve to fourteen percent in revenues in dollar terms
to USD eighty five to eighty seven billion in the fiscal year ending 2014. According to the
Electronics and Computer Software Export Promotion Council, Software services exports are
expected to grow by just ten per cent to around USD seventy five billion during the current
fiscal (2012-13) as demand from the US, India's largest market, slows.
In 2012-13, India’s software and services exports grew by eighteen percent to USD about
sixty eight billion with the US as the top destination, accounting for about USD forty billion
or fifty eight percent of the total exports. (Deccan Herald, March 21st, 2013).
A number of studies have argued that exchange rate volatility would impose costs on risk averse market participants, who will generally respond by favoring domestic to foreign trade.
This argument views traders as bearing undiversified exchange rate, if hedging is impossible
or costly and traders are risk-averse, risk adjusted expected profits from trade will fall when
exchange rate increases. (Chowdhury, 1993).
Moreover, there exists conflicting evidence in the literature about the relationship between
exchange rate volatility and trade flows. The above mentioned facts have developed interest
to examine the relationship among Indian software exports, US economic activity, and INRUSD exchange rate volatility. Therefore, the following hypotheses have been developed:
H2: There exists no significant statistical relationship among Indian Software Exports, US
economic activity, and INR-USD exchange rate volatility.
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1.7 Significance of the Study
As discussed in the background and statement of the problem sections, the success and
growth of software companies has a paramount importance in the development endeavor of
Indian economy.
Most of the research studies in the area of corporate foreign exchange risk management
practices have done outside India and these studies have presented contradictory results. In
India a few studies have been conducted but the representation of software companies in the
sample was limited to two to five large software companies. The approach of large software
companies towards foreign exchange risk management would be entirely different from the
small and medium software companies.
Moreover, these large companies have dedicated department to take care of treasury related
activities and also have sound technical expertise to monitor and manage foreign exchange
risk, whereas small and medium software companies do not have required expertise and skill
to monitor and manage the foreign exchange risk.
In line with the above facts, it is hoped that the results of this study would:
Provide relevant information to the policy-makers about the foreign exchange risk
management practices currently being followed by software companies in order to cope with
foreign exchange risk. Inform the management of the sample companies about effectiveness
of foreign exchange risk management practices followed by them.
The findings of this research work will be expected to tackle the problems that are faced by
software companies. Suggest possible recommendations to improve the effectiveness of the
foreign exchange risk management practices followed by selected software companies.
Finally, by virtue of the above facts, the results of the study are hoped to serve as a base for
further researchers that enable a sustained operation.
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1.8 Scope of the Study
This research has been confined to describe the foreign exchange risk management practices
of selected software companies which have registered office in Hyderabad and to examine
the association between firm characteristic variables and firm’s foreign exchange risk
management practice variables.
In addition, efforts have been made to examine the
relationship among the Indian software exports, US economic activity, and INR-USD
exchange rate volatility.
To meet the objectives sought, the study has been undertaken based on the secondary data
collected from RBI and BEA for the period of 2000-01 Ist Quarter to 2012-13 IVth Quarter
and the primary data was collected from the executives of the sample firms.
Nonetheless, it would have been much better and exhaustive for the study had there been a
chance for considering all the software companies established in the Southern Region of
India. However, to make the study manageable and to evaluate the problem in depth, the
researcher was forced to delimit the study to incorporate only thirty-eight companies that
have registered office in Hyderabad.
The software companies included in the study were enlisted in the ACE-Equity database and
have registered office in Hyderabad.
1.9 Structure of the Thesis
The thesis has been devoted to describe the foreign exchange risk management practices of
selected software companies.
Accordingly, sample companies foreign exchange risk
management practices have been evaluated with descriptive analysis, frequency tables, crosstabulation tests, chi-square tests, and pie-charts.
Furthermore, the study also aimed to
examine the relationship among Indian software exports, US economic activity and INRUSD exchange rate volatility. Therefore, Cointegration analysis as suggested by EngleGranger was used.
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The thesis is structured so that the information presented to the reader is arranged in a logical
sequence. The contents of the thesis, therefore, are presented in the following manner:
CHAPTER I – Introduction: deals about general background of the thesis. It gives the
reader general information about the research work, reason for initiating the study,
justification of the study, statement of the problem and research questions, objectives of the
study, hypotheses of the study, significance of the study, scope of the study and finally, how
the whole research work is organized.
CHAPTER II – Theoretical Background: This chapter reviews the theoretical underpinnings
related to the study.
The purpose of this chapter is to provide the reader with the
fundamental principles of the Foreign Exchange Risk (Definition, types, etc.,) and recent
developments around the subject.
CHAPTER III – Empirical Evidence: This chapter presents the available empirical
evidences regarding the corporate foreign exchange risk management practices and also the
relationship among exports, income or growth, and exchange rate volatility.
CHAPTER IV – Research Design and Methodology: The purpose of this chapter is to
explain the different methodologies adopted while conducting the study, specifically, this
section presents a brief description of quantitative research methods and the justification
behind applying quantitative research methods in the study. Furthermore, the chapter
includes descriptive statements about the logic behind using different methods of data
collection, sampling techniques, and data analysis techniques adopted in this study.
CHAPTER V – Foreign exchange risk management practices of select software companies:
The purpose of this chapter is to describe the foreign exchange risk management practices of
selected software companies and to examine the association between firm characteristic
variables such as type of the firm, form of ownership, firm size, and degree of foreign
involvement and firms’ foreign exchange risk management practice variables such as foreign
exchange risk identification, policy, and management variables.
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CHAPTER VI – Indian Software Industry and Foreign Exchange Risk:
This chapter
presents a brief overview of Indian software industry and Indian foreign exchange market
and also presents the results of the analysis carried out to examine the relationship among
Indian software exports, US economic activity, and INR-USD exchange rate volatility.
CHAPTER VII – Summary of major findings, conclusions and recommendations: This
chapter presents summary of the major findings, conclusions drawn from the study, and
provide possible suggestions regarding future improvements in the foreign exchange risk
management practices along with areas where further research may be conducted.
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