Offshore Outsourcing: Pay Attention to Exchange Rates

But a savvy offshore outsourcing client can negotiate terms that provide some protection for their half of the deal.

Next: Strategies for Mitigating Currency Risk

Methods for Mitigating the Risk of Currency Fluctuations

1. Ask the provider to bear the brunt of the risk of currency fluctuations. Clients can negotiate to have the provider absorb the majority of exchange rate risk because the vendor generally has better capabilities for absorbing currency shifts, according to Forrester principal analyst Dr. Paul Roehrig.

In such an arrangement, the outsourcer bears the risk of currency fluctuations up to an agreed upon percent above or below a baseline exchange rate. This is usually referred to as "banding." If the exchange rate rises above the "band," the client pays more. If it sinks below the "band," the client pays less. To make this work, customer and provider must agree on the indices for tracking the currency, the frequency of monitoring fluctuations and the process for handling variances, says Karoor.

2. Pay in dollars tied to foreign currencies. In this kind of deal, the customer pays in dollars, but the amount of the payment varies based on the movement of the currency where services are being provided. If that local currency tends to devalue against the dollar, the customer will wind up paying less and that savings may help to cover other financial risks like inflation, says Pace Harmon's Rutchik. The approach also tends to stabilize profit margins for the provider, so when the outsourcer is on the wrong side of the exchange rate, it isn't scrambling to cover those losses by cutting service.

3. Hedge against fluctuations in exchange rates. Offshore outsourcing customers can, in theory, use the same hedging strategies that their IT service providers do. However, creating a dedicated team of financial analysts to develop and execute a hedging strategy would be a costly option for the casual outsourcing client-and extraordinarily risky if the analysts bet the wrong way on the future movement of the currency markets.

4. Pay for services in the provider's local currency. Some customers, especially those with longer-term deals, prefer to pay in the local currency of the offshore provider-the Mexican peso or the Chinese yuan or the Estonian kroon. After all, the U.S. dollar trends higher against emerging market currencies over the long term.

But short term, the movements of the currency markets are more sporadic. There are periods where the dollar loses value against these currencies, so simply paying in local legal tender can end up costing during these phases. However, paying in the local currency can be cumbersome for clients who don't already do other business in the market, notes Rutchik.

5. Apply a "look-back" average to future payments going forward. With this approach, the customer pays in dollars tied to local currency fluctuations but not in real time. Customer and vendor take the average currency fluctuation "looking back" over a certain period-say, the last six months. They then apply that average fluctuation against the dollar to a forward looking period of payments-say, the next year. This is repeated each year over the course of the contract term. This provides some stability for both parties each year, except in cases where the "look back" period involves some wild fluctuation in exchange rates, which is certainly possible.

Some offshore outsourcing customers ultimately may decide it's simpler to pay for IT services in fixed U.S. dollars even if that means some loss of savings.

But it's important to at least consider the options for mitigating currency risk, even for customers well into their offshoring contracts.

Says Rutchik, "Service providers are willing to renegotiate because they often have experienced significant margin expansion due to the currency benefits they have gained at the expense of the customer."