Currency Risk Management Essay

Currency or Exchange target happen of infection heed is an integral part in every slosheds decisions about outside(prenominal) specie exposure. Currency find hedge st esteemgies entail eliminating or reducing this adventure, and require understanding of both(prenominal) the ways that the veer tramp risk could affect the operations of economical agents and techniques to deal with the consequent risk implications.Selecting the appropriate hedgerow st come outgy is oft fourth dimensions a daunting task due to the complexities involved in amount accu identifyly current risk exposure and deciding on the appropriate degree of risk exposure that ought to be c overed. The need for capital risk management started to arise after the break down of the Bretton Woods system and the end of the U.S. dollar complete to gold in 1973.The issue of furrows risk management for non-financial firms is independent from their core Business and is usually dealt by their somatic treasurie s. Most multinational firms shit too risk committees to oversee the treasurys st posegy in managing the diversify rate (and interest Rate) risk.This shows the importance that firms put on risk management issues and techniques. Conversely, international investors usually, but non always, manage their transform rate risk independently from the underlying assets and/or liabilities. Since their capital exposure is related to translation risks on assets and liabilities denominated in distant currencies, they tend to consider currencies as a separate asset class requiring a Currency overlay mandate. It mass be argued that judicious management of multinational firms requires currency risk hedgerow for their hostile transaction, translation and economic operations to avoid potentially adverse currency effects on their profitability and market valuation.DEFINITION AND TYPES OF CURRENCY RISKA common definition of currency risk relates to the effect of unexpected supervene upon ra te changes on the treasure of the firm. In particular, it is delimit as the possible direct passing play (as a result of an unhedged exposure) or indirect loss in the firms hard currency flows, assets and liabilities, illuminate profit and, in turn, its stock market value from an stand in rate move. To manage the supersede rate risk inherent in multinational firms operations, a firm needs to determine the specific type of current risk exposure, the hedgerow strategy and the available movers to deal with these currency risks.transnational firms are participants in currency markets by virtue of their international operations. To measure the wedge of re-sentencing rate movements on a firm that is engaged in foreign-currency denominated transactions, i.e., the implied value-at-risk (var) from deputize rate moves, we need to identify the type of risks that the firm is exposed to and the amount of risk encountered. The four main types of currency / transposition rate risk th at exist1. Translation risk A firms translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to interior(prenominal) currency. slice translation exposure may not affect a firms cash flows, it could involve a significant impact on a firms reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different account treatments. Translation gives special consideration to assets and liabilities with regards to foreign exchange risk, whereas exposures to revenues and expenses can frequently be managed ex ante by managing transactional exposures when cash flows take mac ulation2. Transaction risk A firm has transaction exposure whenever it has bargainual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange place due to a contract organism denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a mercurial foreign exchange market with exchange place constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. Firms generally become exposed as a direct result of activities such(prenominal)(prenominal) as importing and exporting or borrowing and investing. Exchange rates may move by up to 10% within any single year, which can significantly affect a firms cash flows, meaning a 10% dec disembowel in the value of a receivable or a 10% rise in the value of a p ayable. such outcomes could be troublesome as export profits could be negated entirely or import m superstartary values could rise substantially3. Economic jeopardize A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firms prepare with regards to its competitors, the firms hereafter cash flows, and ultimately the firms value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be fared by other business activities and enthronements which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some ground would also be an economic exposure for a firm that sells that good and4. Cont ingent Risk A firm has contingent exposure when squallding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an immediate receivable. While waiting, the firm faces a contingent exposure from the uncertainty as to whether or not that receivable will happen. If the bid is accepted and a receivable is paid the firm thus faces a transaction exposure, so a firm may prefer to manage contingent exposures.MEASUREMENT OF EXCHANGE RATE RISK by and by defining the types of exchange rate risk that a firm is exposed to, a crucial aspect in a firms exchange rate risk management decisions is the measurement of these risks. Measuring currency risk m ay prove difficult, at least with regards to translation and economic risk. At present, a wide intentd method is the value-at-risk (var) model. Broadly, value at risk is defined as the maximum loss for a minded(p) exposure over a given time horizon with z% confidence.The VAR methodology can be used to measure a variety of types of risk, helping firms in their risk management. However, the VAR does not define what happens to the exposure for the (100 z) % point of confidence, i.e., the worst case scenario. Since the VAR model does not define the maximum loss with 100 percent confidence, firms often set practicable limits, such as nominal amounts or stop loss orders, in increase to VAR limits, to r from each one the highest possible coverage.VALUE-AT-RISK CALCULATIONThe VAR measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange part resulting from a firms activities, including the foreign exchange position of its treasury, over a certain time period under public conditions. The VAR weighing depends on 3 parameters The guardianship period, i.e., the length of time over which the foreign exchange position is planned to be held. The typical holding period is 1 day. The confidence level at which the estimate is planned to be made. The usual confidence levels are 99 percent and 95 percent. The unit of currency to be used for the denomination of the VAR. assumptive a holding period of x days and a confidence level of y%, the VAR measures what will be the maximum loss (i.e., the hang in the market value of a foreign exchange position) over x days, if the x-days period is not one of the (100-y)% x-days periods that are the worst under normal conditions. Thus, if the foreign exchange position has a 1-day VAR of $10 million at the 99 percent confidence level, the firm should expect that, with a chance of 99 percent, the value of this position will decrease by no to a greater extent(prenominal) than $10 million during 1 day, provided that usual conditions will prevail over that 1 day. In other words, the firm should expect that the value of its foreign exchange rate position will decrease by no more than $10 million on 99 out of 100 usual trading days or by more than $10 million on 1 out of every 100 usual trading days.To calculate the VAR, there exists a variety of models. Among them, the more widely-used are(1) the historical modelling, which assumes that currency buy the farms on a firms foreign exchange position will retain the same distribution as they had in the past (2) the variance- covariance model, which assumes that currency returns on a firms total foreign exchange position are always (jointly) normally distributed and that the change in the value of the foreign exchange position is linearly dependent on all currency returns and(3) Monte Carlo simulation which assumes that future currency returns will be randomly distributed. The historical simulation is the simplest method of calc ulation. This involves running the firms current foreign exchange position across a set of historical exchange rate changes to proceeds a distribution of losses in the value of the foreign exchange position, say 1,000, and then computing a percentile (the VAR).Thus, assuming a 99 percent confidence level and a 1-day holding period, the VAR could be computed by sorting in ascending order the 1,000 daily losses and winning the 11th largest loss out of the 1,000 (since the confidence level implies that 1 percent of losses 10 losses should exceed the VAR). The main benefit of this method is that it does not assume a normal distribution of currency returns, as it is well documented that these returns are not normal but rather leptokurtic. Its shortcomings, however, are that this calculation requires a large database and is computationally intensive.The variance covariance model assumes that(1) the change in the value of a firms total foreign exchange position is a linear combination of all the changes in the values of individual foreign exchange positions, so that also the total currency return is linearly dependent on all individual currency returns and(2) the currency returns are jointly normally distributed.Thus, for a 99 percent confidence level, the VAR can be calculated as VAR= -Vp (Mp + 2.33 Sp)Where,Vp is the initial value (in currency units) of the foreign exchange positionMp is the mean of the currency return on the firms total foreign exchange position, which is a weighted average of individual foreign exchange positionsSp is the standard variance of the currency return on the firms total foreign exchange position, which is the standard deviation of the weighted transformation of the variance-covariance matrix of individual foreign exchange positionsWhile the variance-covariance model allows for a quick calculation, its drawback includes the restrictive assumptions of a normal distribution of currency returns and a linear combination of the total fo reign exchange position. Note, however, that the nitrogen assumption could be relaxed. When a non-normal distribution is used instead, the computational price would be higher due to the additional estimation of the confidence interval for the loss exceeding the VAR.Monte Carlo simulation usually involves principal components analysis of the variance-covariance model, followed by random simulation of the components. While its main advantages include its ability to incubate any underlying distribution and to more accurately assess the VAR when non-linear currency factors are present in the foreign exchange position (e.g., options), its heartrending drawback is the computationally intensive process. MANAGEMENT OF CURRENCY RISKAfter identifying the types of exchange rate risk and measuring the associated risk exposure, a firm needs to regulate whether to hedge or not these risks. In international finance, the issue of the appropriate strategy to manage (hedge) the different types o f exchange rate risk has yet to be settled. In practice, however, collective treasurers have used various currency risk management strategies depending, ceteris paribus, on the prevalence of a certain type of risk and the coat of the firm.A. hedge StrategiesIndicatively, transaction risk is often hedged tactically (selectively) or strategically to preserve cash flows and earnings, depending on the firms treasury resume on the future movements of the currencies involved. Tactical hedgerow is used by most firms to hedge their transaction currency risk relating to short-term receivable and payable transactions, plot of ground strategic hedgerow is used for longer-period transactions. However, some firms decideto use unresisting hedging, which involves the maintenance of the same hedging structure and execution over regular hedging periods, irrespective of currency expectationsthat is, it does not require that a firm takes a currency view.Translation, or balance sheet, risk is hedged very infrequently and non-systematically, often to avoid the impact of possible abrupt currency shocks on net assets. This risk involves chiefly long-term foreign exposures, such as the firms valuation of subsidiaries, its debt structure and international investments. However, the long-term nature of these items and the fact that currency translation affects the balance sheet rather than the income statement of a firm, make hedging of the translation risk less of a priority for management. For the translation of currency risk of a subsidiarys value, it is standard practice to hedge the net balance sheet exposures, i.e., the net assets (gross assets less liabilities) of the subsidiary that might be affected by an adverse exchange rate move.Within the framework of hedging the exchange rate risk in a consolidated balance sheet, the issue of hedging a firms debt profile is also of predominant importance. The currency and maturity composition of a firms debt determines the susc eptibility of its net equity and earnings to exchange rate changes. To reduce the impact of exchange rates on the volatility of earnings, the firm may use an optimization model to devise an optimal set of hedging strategies to manage its currency risk. hedgerow the remaining currency exposure after the optimization of the debt composition is a difficult task. A firm may use tactical hedging, in addition to optimization, to reduce the residual currency risk. Moreover, if exchange rates do not move in the anticipated direction, translation risk hedging may cause either cash flow or earnings volatility. Therefore, hedging translation risk often involves careful weighing the costs of hedging against the potential cost of not hedging.Economic risk is often hedged as a residual risk. Economic risk is difficult to quantify, as it reflects the potential impact of exchange rate moves on the present value of future cash flows. This may require measuring the potential impact of an exchange rat e deviation from the bench mark rate used to forecast a firms revenue and cost streams over a given period. In this case, the impact on each flow may be netted out over product lines and across markets, with the net economic risk becoming small for firms that invest in many foreign markets because of offsetting effects. Also, if exchange rate changes follow pretentiousness differentials (through uvulopalatopharyngoplasty) and a firm has a subsidiary that faces cost inflation above the general inflation rate, the firm could find its competitiveness eroding and its original value deteriorating as a result of exchange rate adjustments that are not in line with PPP.Under these circumstances, the firm could best hedge its economic exposure by creating payables (e.g., financing operations) in the currency that the firms subsidiary experiences the higher cost inflation (i.e., in the currency that the firms value is vulnerable).Sophisticated corporeal treasuries, however, are developing e fficient frontiers of hedging strategies as a more integrated onward motion to hedge currency risk than buying a superfluous vanilla extract hedge to cover certain foreign exchange exposure. In effect, an efficient frontier measures the cost of the hedge against the degree of risk hedged. Thus, an efficient frontier determines the most efficient hedging strategy as that which is the cheapest for the most risk hedged.Given a currency view and exposure, hedging optimization models usually compare 100 percent unhedged strategies with 100 percent hedged exploitation vanilla anteriors and option strategies in order to find the optimal one. Although this approach to managing risk provides the least-cost hedging structure for a given risk profile, it critically depends on the corporate treasurers view of the exchange rate. Note that such optimization can be used for transaction, translation or economic currency risk, provided that the firm has a specific currency view (i.e., a possible exchange rate forecast over a specified time period).B. Hedging Benchmarks and PerformanceHedging doing can be measured as a distance to a given benchmark rate. The risk embedded in the hedge is usually expressed as a VAR number that will be consistent with the performance measure. Hedging optimization models, as methods for optimizing hedging strategies for currency-denominated cash flows, help find the most efficient hedge for individual currency exposures, while most of them do not provide a hedging process for multiple currency hedging.Thus, both performance and VAR are measured as effective hedge rates, calculated for each hedging instrument used and the risk in terms of a confidence level. A single optimal hedging strategy is then selected by defining the risk that a firm is willing to take. This strategy is the lowest possible effective hedge rate for an acceptable level of uncertainty. In this way, when the firms currency view entails a perception of volatility, options ge nerate a better or similar effective hedge rate at lower uncertainty than the unhedged position. Furthermore, when local currency has a relatively high yield and low volatility, options will almost always generate a better effective hedging rate than forward hedging.As part of the currency risk management policy, firms use a variety of hedging benchmarks to manage their hedging strategies effectively. Such benchmarks could be the hedging level (i.e., a certain percent), the reporting period especially for firms that use forward hedging to limit the volatility of their net equity (e.g., quarterly or 12-month benchmarks) and budget exchange rates, depending on the prevailing accounting rules. Moreover, benchmarks enable the performance of individual hedges to be measured against that of the firm.C. Hedging and Budget RatesBudget exchange rates provide firms with a reference exchange rate level. Setting budget exchange rates is often linked to the firms sensitivities and benchmarking priorities. After deciding on the budget rate, the corporate treasury will have to secure an appropriate hedge rate and ensure that there is minimal deviation from that hedge rate. This process will determine the frequence and instruments to be used in hedging. It should be further pointed out that persistent moves relative to the numeracies (functional) currency should be reflected in the budget rates, or strategic positioning and hedging should be considered. Firms have different practices in setting budget exchange rates.Many corporate treasurers of multinational firms prefer to use PPP rates as budget exchange rates, often with the understanding that tactical hedging may be mandatory over the short-term where the forecasting performance of the PPP model is usually poor.2 However, other multinational firms prefer to set the budget rate in unison with their sales calendar and, in turn, with their hedging strategy. For example, if a firm has a quarterly sales calendar, it may dec ide to hedge its next years quarterly foreign currency cash flow in such a way that they do not differ by more than a certain contribution from the cash flow in the same quarter of oddment year.Accordingly, this will necessitate four hedges per year, each of one-year tenor, with hedging being done at the end of the period, using the end-of-period exchange rate as its budget rate. Alternatively, a firm may decide to set its budget exchange rate at the daily average exchange rate over the previous fiscal year. In such case, the firm would need to use one hedge through, perhaps, an average-based instrument like an option or a synthetic forward. This hedging operation will usually be executed on the last day of the previous fiscal year, with starting day the first day of the new fiscal year. Furthermore, a firm may also use passive currency hedging, such as hedging the average value of a foreign currency cash flow over a specified time period, relative to a previous period, through op tion structures available in the market. This type of hedging strategy is fairly simple and easier to monitor. The relative version of the PPP theory states that bilateral exchange rates would adjust to the relative price differentials of the same good traded in the two countries.Setting budget exchange rates is also crucial for a firms pricing strategy, in addition to their importance for defining the benchmark hedging performance and tenor of a hedge (as the latter generally match cash flow hedging requirements). However, the budget exchange rate used to forecast cash flows needs to be close to the spot exchange rate in order to avoid possible major changes in the firms pricing strategy or to reconsider its hedging strategy. In this connection, it should be noted that forecasting future exchange rates is a key aspect of a firms pricing strategy. Since it has been well-documented that forward rates are poor predictors of future spot rates, structural or time-series exchange rate mo dels need to be employed for such an endeavour. This becomes evident if we compare a firms net cash flows estimated by using the forecast rate and the future spot exchange rate. For an investment in a foreign subsidiary, moreover, the budget exchange rate is often the accounting rate, i.e., the exchange rate at the end of the previous fiscal year.D. beaver Practices for Exchange Rate Risk ManagementFor their currency risk management decisions, firms with significant exchange rate exposure often need to establish an operational framework of best practices. These practices or principles may include1. Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure. As mentioned before, this involves determination of the transaction, translation and economic risks, along with specific reference to the currencies that are related to each type of currency risk. In addition, measuring these currency risksusing various models (e.g . VAR)is another critical element in identifying hedging positions.2. Development of an exchange rate risk management strategy. After identifying the types of currency risk and measuring the firms risk exposure, a currency strategy needs to be established on how to deal with these risks. In particular, this strategy should specify the firms currency hedging objectiveswhether and why the firm should fully or partially hedge its currency exposures. Furthermore, a detailed currency hedging approach should be established. It is imperative that a firm details the overall currency risk management strategy on the operational level, including the execution process of currency hedging, the hedging instruments to be used, and the monitoring procedures of currency hedges.3. Creation of a centralized entity in the firms treasury to deal with the practical aspects of the execution of exchange rate hedging. This entity will be responsible for exchange rate forecasting, the hedging approach mechan isms, the accounting procedures regarding currency risk, costs of currency hedging, and the establishment of benchmarks for measuring the performance of currency hedging. (These operations may be undertaken by a specialized team headed by the treasurer or, for large multinational firms, by a native(prenominal) dealer.)4. Development of a set of controls to monitor a firms exchange rate risk and ensure appropriate position fetching. This includes setting position limits for each hedging instrument, position monitoring through mark-to-market valuations of all currency positions on a daily basis (or intraday), and the establishment of currency hedging benchmarks for hebdomadary monitoring of hedging performance (usually monthly).5. Establishment of a risk oversight committee. This committee would in particular approve limits on position taking, examine the appropriateness of hedging instruments and associated VAR positions, and review the risk management policy on a regular basis. Managing exchange rate risk exposure has gained prominence in the last decade, as a result of the unusual occurrence of a large number of currency crises. From the corporate managers perspective, currency risk management is increasingly viewed as a prudent approach to reducing a firms vulnerabilities from major exchange rate movements. This attitude has also been reinforced by recent international management on both accounting and balance sheet risks.HEDGING INSTRUMENTS FOR MANAGING EXCHANGE RATE RISKWithin the framework of a currency risk management strategy, the hedging instruments allowed to manage currency risk should be specified. The available hedging instruments are enormous, both in variety and complexity, and have followed the dramatic increase in the specific hedging needs of the modern firm. These instruments include both OTC and exchange-traded products. Among the most common OTC currency hedging instruments are currency onwards and cross-currency swaps. Currency forw ards are defined as buying a currency contract for future delivery at a price set today. Two types of forwards contracts are often used outright forwards (involving the physical delivery of currencies) and non-deliverable forwards (which are settled on a net cash basis). With forwards, the firm is fully hedged. However, the high cost of forward contracts and the risk of the exchange rate moving in the paired direction are serious disadvantages.The two most commonly used cross-currency swaps are the cross-currency coupon swap and the cross-currency basis swaps. The cross-currency coupon swap is defined as buying a currency swap and at the same time pay fixed and find outs floating interest payments. Its advantage is that it allows firms to manage their foreign exchange rate and interest rate risks, as they wish, but it leaves the firm that buys this instrument vulnerable to both currency and interest rate risk. Cross-currency basis swap is defined as buying a currency swap and at t he same time pay floating interest in a currency and receive floating in another currency. This instrument, while assuming the same currency risk as the standard currency swap, has the advantage that it allows a firm to allow prevailing interest rate differentials. However, the major disadvantage is that the primary risk for the firm is interest rate risk rather that currency risk.For exchange-traded currency hedging instruments, the main types are currency options and currency futures. The development of various structures of currency options has been very rapid, and is attributed to their flexible nature. The most common type of option structure is the plain vanilla call, which is defined as buying an upside strike in an exchange rate with no obligation to exercise. Its advantages include its simplicity, lower cost than the forward, and the predicted maximum losswhich is the premium. However, its cost is higher than other sophisticated options structures such as call spreads (buy an at-the-money call and sell a low delta call).Currency futures are exchange-traded contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. They are similar to forward contracts in that they allow a firm to fix the price to be paid for a given currency at a future point in time. Yet, their characteristics differ from forward rates, both in terms of the available traded currencies and the typical (quarterly) settlement dates. However, the price of currency futures will normally be similar to the forward rates for a given currency and settlement date.Comparing currency forward and currency futures markets, the size of the contract and the delivery date are shipshape to individual needs in the forward market (i.e., determined between a firm and a bank), as opposed to currency futures contracts that are exchangeable and guaranteed by some organized exchange. While there is no separate clearing-house function for forward markets, all clearing operations for futures markets are handled by an exchange clearing house, with daily mark-to-market settlements. In terms of liquidation, while most forward contracts are settled by actual delivery and only some by offsetat a cost, in contrast, most futures contracts are settled by offset and only very few by delivery. Furthermore, the price of a futures contract changes over time to reflect the markets anticipation of the future spot rate. If a firm holding a currency futures contract decides before the settlement date that it no longer wants to maintain such a position, it can close out its position by selling an equivalent futures contract. This, however, cannot be done with forward contracts.Finally, since currency hedging is often costly, a firm may first consider natural hedging, such as (1) matching, which involves sexual union suitably a multinational firms foreign currency inflows and outflows with respect to amount and timing (2) netting, which involves the consolidated settlement of receivables, payables and debt among the subsidiaries of a firm and (3) invoicing in a foreign currency, which reduces transaction risk related primarily to exports and imports.HEDGING PRACTICES BY U.S. FIRMSAccording to the BIS (see Tables 1-4) and the International Swap and Derivatives Association, the OTC derivatives market has experienced an exponential function growth. Even with the recent slowdown due to the special disclosure requirements of FAS 133, derivatives continue to be the main hedging instrument for most firms. However, the increased availability of derivative instruments, coupled with the advent of mark-to-market hedge accounting (FAS 133 and IAS 39), implies a difficult to follow impact of derivatives on firms financial statements.Several surveys have shown certain characteristics and practices of U.S. non-financial firms using derivatives. Thus, the big the size of sales of U.S. non-financial firms, the more likely is to use derivativ es in their risk management. Foreign currency derivatives usage is most common, with almost three-fourths of the reporting firms taking positions. The primary goal of exchange risk hedging is the minimization of the variability in cash flow and in accounting earnings, arising from the firms operational activities and characteristics. Preoccupation with accounting earnings may be related to their role in analysts perceptions and predictions of future earnings and in management compensation. Furthermore, it is interesting to note that U.S. firms do not place high importance in minimizing the variation in the market value of the firm (the present discounted value of the stream of future cash flows) when they use derivatives in risk management.The choice of derivative instruments for foreign exchange management by U.S. firms is concentrated in simple instruments, with OTC currency forwards being by far the most popular instrument (over 50 percent of all foreign exchange derivatives inst ruments), OTC currency options being the second most like hedging instrument (around 20 percent of all foreign exchange derivative instruments) and OTC swaps being the third (around 10percent).Forward-type (volatility elimination) instruments are used to hedge foreign exchange exposures arising from U.S. firms contractual commitments (accounts receivable/payable, and repatriations), as recommended by the international financial literature. Option-type instruments, on the other hand, are used to hedge uncertain foreign currency-denominated future cash flows (usually, related to anticipated transactions beyond one year and to cover economic exposures). The tendency of US firms to use OTC currency forwards rather than OTC options or swaps should mainly be attributed to the relatively higher liquidity and depth of forward markets.The use of OTC instruments (forwards/swaps and options) dominates that of exchange traded hedging instruments, with currency futures being preferred by less t han 10 percent of U.S. firms and currency options being preferred by a very small percentage of firms. The prevalence of OTC instruments should be attributed to firms very specific hedging needs that can primarily be accommodated in the more-flexible OTC market.The majority of U.S. firms with a set frequency for revaluing derivatives do so on a monthly basis, with a quarter of the total firms valuing their derivatives at least weekly and a very small percentage doing so only on an annual basis. Finally, the most common methods to evaluate the riskiness of their foreign exchange positions are stress testing of derivatives and VAR techniques. lastMeasuring and managing currency risk exposure are important functions in reducing a firms vulnerabilities from major exchange rate movements. These vulnerabilities mainly arise from a firms involvement in international operations and investments, where exchange rate changes could affect profit margins, through their effect on sources for inpu ts, markets for outputs and debt, and the value of assets. Prudent management of currency risk has been increasingly mandated by corporate boards, especially after the currency-crisis episodes of the last decade and the consequent heightened international attention on accounting and balance sheet risks.In managing currency risk, multinational firms utilize different hedging strategies depending on the specific type of currency risk. These strategies have become increasingly complicated as they try to address simultaneously transaction, translation and economic risks. As these risks could be detrimental to the profitability and the market valuation of a firm, corporate treasurers, even of smaller-size firms have become increasingly proactive in controlling these risks. Thereby, a greater demand for hedging protection against these risks has emerged and, in response, a greater variety of instruments has been generated by the ingenuity of the financial engineering industry.This paper p resents some of the main issues in the measurement and management of exchange rate risks faced by firms, with special attention to the traditional types of exchange rate risk (transaction, translation, and economic), the currently predominant methodology in measuring exchange rate risk (VAR), and the advantages and disadvantages of various exchange rate risk management approaches (tactical vs. strategical, and passive vs. active). It also outlines a set of widely-accepted best practices in currency risk management, and reviews the use of some of the widely-used hedging instruments in the OTC and exchange traded markets. It also reports on the use of various derivatives instruments and hedging practices of U.S. multinationals.Based on the reported U.S. data, it is interesting to note that the larger the size of a firm the more likely it is to use derivative instruments in hedging its exchange rate risk exposure the primary goal of U.S. firms exchange rate risk hedging operations is t o minimize the variability in their cash flow and earning accounts (mainly related to payables, receivables and repatriations) and the choice of foreign exchange derivatives instruments is concentrated in OTC currency forwards (over 50 percent of all foreign exchange derivatives used), OTC currency options (around 20 percent) and OTC currency swaps (around 10 percent). From the available exchange-traded foreign exchange hedging instruments, currency futures is preferred by less than 10 percent of U.S. firms and currency options by around 2 percent.Overall, it should be noted that the data on U.S. firms are only representative of the reporting period that they refer to and are indicative of the level of sophistication of U.S. corporate treasurers and the level of development of local derivatives markets. By no means can these stylized facts be generalized for other time periods and countries, especially those with different corporate structures and capital market development. To form a better understanding of global firms practices in this area, more empirical studies would need to be undertaken to explore their exchange rate risk measurement and hedging behaviours.