Outsourcing a business or technology function to an offshore service provider can result in cost savings to companies. However, particularly in an environment where the value of the U.S. dollar is falling, companies need to appropriately allocate foreign currency exchange risk in order to reap the full economic benefits of offshore outsourcing. This Outsourcing Update explains this challenge and describes various methods for handling it in the parties’ outsourcing contract.

1. Foreign Currency Risk

Foreign exchange risk arises whenever the service provider incurs performance costs in one country but is paid in the currency of a different country. For example, in a typical offshore outsourcing arrangement in India, the service provider must lease space, hire personnel, and pay for other resources in Indian rupees, but typically receives the service fees in U.S. dollars.

For purposes of illustration, assume that a service provider’s cost to perform in India is 40,000 Indian rupees per month, and that the contract provides for payment of fees of $1,000 per month, payable in U.S. dollars. In November of 2006, the foreign exchange rate was approximately 45 Indian rupees per one U.S. dollar1. In this contract, the service provider would receive $1,000 from the customer and exchange it for 45,000 Indian rupees, of which it would use 40,000 to pay its costs and retain 5,000 Indian rupees in profit. However, moving forward in time, the value of the U.S. dollar has now fallen such that as of November 2007 (one year later) the exchange rate between the Indian rupee and the U.S. dollar was 39 to 12. The $1,000 payment will now yield only 39,000 Indian rupees (when converted), which is insufficient to both cover the service provider’s performance costs and provide a reasonable profit. Of course, when the U.S. dollar strengthens and the exchange rate is more than 45 Indian rupees per one U.S. dollar, the service provider will benefit from a windfall.

2. Competing Interests of the Parties

In addressing foreign exchange risk, the customer is typically more concerned about avoiding a fee increase when the U.S. dollar declines, than it is in preventing the service provider from reaping a windfall when the U.S. dollar strengthens. This is because the customer is usually much more concerned about locking in cost reductions and obtaining budgetary certainty than it is about participating in every gain that the service provider may realize. Likewise, the service provider is also more concerned about a declining U.S. dollar, because it will find its profits eroded when the U.S. dollar declines and if the decline is serious, as in recent times, the service provider may even realize a loss, because it will no longer be able to cover its local costs following conversion of the service fees into the local currency.

3. Methods of Allocating Currency Risk

For the foregoing reasons, the parties must address foreign exchange risks in an off-shoring agreement. The parties may employ a variety of methods to allocate foreign exchange risk, as illustrated below.

At one extreme, the service provider can elect to take on all of the foreign exchange risk. Under this approach, the service provider continues to offer the customer a fixed fee for the services, regardless of fluctuations in the applicable currency exchange rate. If the rates move favorably, the service provider receives a windfall. But if the rates move in the opposite direction, the service provider’s costs will be correspondingly increased and its margins correspondingly squeezed. This scenario is illustrated by the initial example above. To offset the foreign exchange risk, the service provider typically increases its fees by an amount that it estimates will be required to cover anticipated exchange rate fluctuations. In this way, if the exchange rate becomes less favorable, the built-in additional fees will provide the service provider an extra cushion to absorb the resulting reduction in total local currency realized following conversion at the less favorable exchange rate. The service provider may also use some of the increased fees to hedge its foreign exchange risk by purchasing futures contracts that lock in the desired foreign exchange rate. Customers tend to favor this approach, as well; while they may have to pay a higher service charge, they are able to avoid the uncertainty of facing even larger potential increases as a result of dramatic negative swings in the underlying exchange rates.

At the other extreme, the customer can assume the foreign exchange risk in its entirety. Under this approach, the service provider typically sets its fees in the local currency (e.g., 45,000 Indian rupees per month in our example) rather than the currency of the customer’s host country. Each month, the service charges (in this case 45,000 Indian rupees) are converted to U.S. dollars at the then-prevailing spot rate, and the customer pays the resulting amount in U.S. dollars. To illustrate if the exchange rate is initially 45 to 1, the customer would pay $1,000 after the 45,000 Indian rupees service charges is converted to U.S. dollars. If declines in the value of the U.S. dollar subsequently result in an exchange rate of 39 to 1, then the customer will be required to pay $1,155 following conversion at the adjusted rate. Under this approach, the customer not only bears the downside risk of adverse exchange rate fluctuations, but reaps the benefits of any upside profit realized because of a favorable shift in the exchange rate.

Various risk-sharing alternatives are available to allocate foreign exchange risk. For example, the parties may agree to an exchange rate that is initially fixed. The spot rate for the applicable currencies involved in the transaction as of the contract effective date may be selected for this purpose. The fees to the customer are not adjusted so long as the fluctuations in the prevailing exchange rate do not exceed a specified threshold, such as plus or minus 10 percent around the baseline rate. If the actual exchange rate varies (up or down) by more than the threshold, however, the fixed contract exchange rate is adjusted to match the new level, where it remains fixed until another fluctuation, up or down, exceeds the specified threshold. With this approach, the service provider bears the foreign exchange risk resulting from fluctuations that remain within the threshold (at least until the threshold is exceeded), while the customer bears the risk for fluctuations that exceed the threshold.

To illustrate further, assume that the exchange rate between the Indian rupee and the U.S. dollar is 10 to 1 at the contract effective date. Assume further that the parties agree to use this ratio as the baseline contract exchange rate and that they also agree to set the adjustment threshold at 20 percent. So long as the U.S. dollar does not strengthen above 12 or decline below 8, the customer continues to be invoiced the $100 fixed amount, giving it a degree of pricing certainty within such range. If the U.S. dollar declines to 7 to 1, however, then the contract exchange rate is reset to that rate going forward, and the monthly fee is reset to $143 per month. Conversely, if the U.S. dollar strengthens to 13 to 1, then the contract exchange rate is reset to that rate, and the monthly fee is reset to $77 per month. In either case, the adjusted rate continues to apply until another fluctuation exceeds the 20 percent threshold, using the adjusted rate as the baseline, in which case the service charges are further adjusted.

As an alternative, the parties may agree to a lower threshold than the previous example and equally split the increase or decrease in price resulting from a fluctuation in the exchange rate. For example, if the exchange rate threshold is set in the contract at 5 percent, and the actual exchange rate increase is 9 percent, the service provider agrees to bear 7 percent of the increase and the customer agrees to bear 2 percent of the increase.

The methods of allocating foreign exchange risk vary widely and should be thoughtfully tailored to meet the needs of both parties. In some cases, a more simplistic approach is acceptable, but in others, a more complex allocation structure is warranted.

4. Negotiating the Allocation of Currency Risk

The allocation of foreign exchange rate fluctuations is often negotiated in tandem with another unpredictable cost element – the allocation of inflation adjustments, often referred to as the cost of living adjustment or COLA. For example, one party may agree to bear inflation risk, while the other party bears foreign currency risk. Although sometimes these risks off-set each other, often they do not. An increase in the value of one currency does not necessarily mean that the cost of living rate will increase. In fact, in the case of India over the last year, the rupee’s value has substantially increased against the U.S. dollar (over 15 percent), while inflation has been at 7.3 percent based on the Indian Consumer Price Index and approximately 3 percent based on the Wholesale Price Index3. Trading inflation risk for currency risk can simplify negotiations, but it does not always result in an even trade.

When negotiating the allocation of any risk, it is important to understand how the risk can be mitigated and which party is in the best position to mitigate the risk. One way to mitigate risk associated with currency fluctuations is to move the performance of the services to a country whose foreign exchange rate is fluctuating less (or in a positive direction). If a customer gives the service provider the flexibility to relocate the performance of the services, the service provider is more likely to agree to bear more of the currency risk. If, however, it is important to the customer that the services be performed from a specific location, the ability of the service provider to mitigate the risk of foreign exchange rate fluctuations is limited, and the service provider may not be as willing to assume as much of the currency risk.

Although offshore outsourcing presents unique risks, such as risks associated with foreign exchange rate fluctuations, when such a transaction is thoughtfully structured, the customer can benefit from substantial cost-savings and improved performance, while the service provider can expect to realize significant profits.