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Managing exchange rate risk for IT projects – Part I

September 3, 2014

Managing exchange rate risk for IT projects – Part I

In this two-part post, we’ll look at the effect of exchange rates on project budgets. In part I, we’ll look at exchange rate risk and how firms mitigate it from an overall company perspective, and whether this would include IT projects. In part II, we’ll go into detail on IT projects specifically and look at the mechanisms for managing exchange rate risk and how it figures in project reporting.

HOW CURRENCY FLUCTUATIONS IMPACT PROJECT BUDGETS

Even before the global economy’s rollercoaster ride of August 2011, which saw both the US and Europe in the line of fire from investors and rating agencies, currencies had already been yo-yo’ing for some time. For example, between Jan-May 2011, the US Dollar (USD) depreciated 10% against the Euro (EUR). As for the Swiss Franc (CHF), a safe haven currency, it appreciated over 20% against the USD between Jan and Aug 2011.  (For a really neat chart of these movements, plug in your currencies and timescales into the following historical exchange rates feature on Oanda).

Besides making a cup of coffee in dollars outrageously expensive in Geneva, and enabling European vacationers to throw money around in New York, what’s this got to do with IT projects? Well, quite a lot actually, if we’re talking about projects with significant exposure to foreign currencies, eg a global ERP implementation budgeted in EUR with international resourcing invoiced in USD.

A SWISS CHEESE PROJECT BUDGET

Let’s look at a real-world example of a global CRM programme at a Swiss health sciences company which ran from 2008-2010. The Geneva-based core team comprised a mix of local and European affiliate employees, contractors from various European countries and consultants from the integrator (who in turn managed an offshore team in India). The programme budget was in EUR, the integrator contract was in USD, and all costs were paid out of Geneva in CHF.

There were wild currency swings as the project got under way. Between Jul-Nov 2008 the CHF/USD exchange rate dropped -15% (and then promptly regained +10% one month later). It then dipped again -8% by March 2009 – before regaining just under +15% by year’s end!  You don’t have to be a financial expert to know that with exchange rate fluctuations of +/-10% every 3-6 months, costs were turning into a crap shoot, from the integrator’s milestone payments (every few months) to the daily rate of contractors (locked in through 3-6 months Purchase Orders) to the cost of living in Geneva (which even in the best of times is already expensive).

Unfortunately, there were no mechanisms in place to mitigate exchange rate risk at the project level, and the PMO (Project Management Office) was not aware of enterprise-level hedging by the Treasury department that might have covered the exposure anyway (we’ll talk about this further on). For the PMO, this meant monthly reporting was dependent on forex (ie foreign exchange) to a non-negligible degree – but no allowance was made for this when comparing plan to actuals. For the integrator, even if there was no revenue impact since payment was in USD, there was a non-negligible cost impact in living expenses for the Geneva-based team, since the contract was fixed price.

Fortunately, there is a happy ending to this story: after 2 years the PMO was able to get additional funding from the investment committee to compensate for the net exchange rate loss compared to the original plan. As we’ll see further on, what the PMO should have done was to provide full ongoing forex transparency by monitoring and reporting on exchange rate impact right from the start as part of its project reporting.

WHAT IS EXCHANGE RATE RISK?

Let’s now take a look at exchange rate risk for projects in general, and for IT projects in particular.

Exchange rate risk can be defined as the variability in the value of a project that results from unpredictable variation in the exchange rate. There are two types of exchange rate risk:

  • project exchange rate risk, linked to inputs (costs) and outputs (revenue)
  • financing exchange rate risk, linked to loans requiring repayment in foreign currency

Financing exchange rate risk is usually present in infrastructure projects in developing countries (eg building dams, bridges or tunnels) and is usually much greater than project exchange risk. It is therefore not applicable to IT projects, which are usually funded internally as part of the annual business plan. If you’re interested in learning more about financing exchange rate risk, check out the article “Exchange Rate Risk – allocating exchange rate risk in private infrastructure projects”, from which I adapted the above definition.

For large IT projects (eg ERP, CRM or Supply Chain) in a globalized world, characterized by outsourcing, offshoring and near-shoring, project exchange rate risk linked to inputs (costs) and outputs (revenue) is more and more the norm.

Let’s now take a look at how companies manage exchange rate risk at an enterprise level, and see whether this covers IT projects too.

MANAGING EXCHANGE RATE RISK AT ENTERPRISE LEVEL

Companies with foreign currency exposure in their costs and revenues – which in a global economy is virtually any company with international sales and/or international sourcing of products, services and raw materials – have to protect themselves from the effects of currency movements, since exchange rates are constantly fluctuating in response to economic and environmental factors.

This is the responsibility of the Treasury department, which uses a combination of hedging mechanisms, the most common of which are forwards, futures and options. The details need not interest us here, suffice to say that these are essentially contractual mechanisms for a firm to pay (or receive) a specified amount of foreign currency at a specified exchange rate at a specified date, or over a specified time period. This essentially eliminates uncertainty by locking in an amount in the home currency which is then independent of any change in the exchange rate over the life of the contract. A common example is airline fuel-hedging (priced in USD, fuel represents over 30% of an airline’s operating costs). For further reading on the subject, check out the paper “Techniques for Managing Exchange Rate Exposure.

There are two types of hedging:

  • P&L hedging for opex, which protects the company’s profit, which is the net between revenue and costs (if currencies are moving against you on the cost side, then by definition they must be moving in your favour on the revenue side, therefore you only need to protect the net of the two).
  • Balance Sheet hedging for capex, a similar process which protects the net between assets and liabilities.

MANAGING EXCHANGE RATE RISK AT PROJECT LEVEL

Now since your IT project comprises both opex and capex, and Treasury protects both the P&L and the Balance Sheet through appropriate hedging, you might say “Goody! As a PM I therefore don’t need to do anything because my IT project is part of the company’s business plan and therefore its currency exposure is already covered.”

Well, not necessarily. Your project might not be covered by Treasury hedging if the forex exposure is below the hedging threshold. Of course, nothing stops the PMO or IT controller from specifically requesting currency protection anyway, but answers can vary. For example, the head of Treasury at a European telco said that while their current forex exposure for IT was limited, they would accommodate any request for currency protection. On the other hand, one of the heads of IT Finance at a global European electrical distribution and energy management company said that her attempts to get Treasury to cover IT currency exposure are usually turned down, forcing her to buffer up certain project budgets to manage the risk. And the Finance VP of a computer manufacturer said that P&L hedging would always cover the IT budget of an expensed project, regardless of its size.

In short, the rules vary by company. Your head of IT Finance is probably the best person to turn to for the right answer. As a project manager or PMO Director, you might therefore have to manage exchange rate risk yourself. And regardless of your currency protection, you also have to monitor the effect of exchange rates on your budget and show it in your project reporting. In our second post, we’ll see how to do this.

MG

 

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