Using financial derivatives to hedge against market risks in IT outsourcing projects – a quantitative decision model

Abstract

Besides the project-inherent risk of an information technology (IT) outsourcing project, related to the management of the project, other types of risk driven by the markets have not been addressed until now. Although financial derivatives are well known as a powerful tool for hedging market risk, there are no approaches to utilize this tool for risk management in IT outsourcing projects. We show a way to address two types of market risk threatening outsourcing success: insolvency of the project counterpart and a slump in prices of the counterpart’s stocks. This paper therefore provides a quantitative decision model to determine how much money should be spent on hedging these risks using financial derivatives. We discover that the lower the probability of damage the higher the degree of cheap hedging that should be applied. In contrast, other means of hedging should be considered when facing a rather high probability of damage, because financial hedging gets too expensive.

Keywords:

• IT-outsourcing
• market risks
• hedging
• decision model

Acknowledgements

The authors gratefully acknowledge the DFG (German Research Foundation) for their support of the project ‘ITPM (BU809/10-1)’, which made this paper possible.