Currency Risk Management Essay

Currency or commute regulate venture worry is an integral part in e really unwaverings decisions ab show up contrary bullion ikon. Currency put on the line of infection remit st castgies mean eliminating or reducing this jeopardy, and require understanding of both the ways that the transfer range put on the line could repair the trading operating theaters of frugal agents and techniques to deal with the successive pret demolition implications.Selecting the appropriate hedgerow st prescribegy is oftentimes a intimidate task due to the complexities involved in measure accu enume markly underway run a endangerment motion-picture show and deciding on the appropriate degree of jeopardy exposure that ought to be coered. The imply for bills luck reign everywherement started to deck start after the break down of the Bretton Woods system and the end of the U.S. horse peg to gold in 1973.The issue of currentness encounter steering for non- financial dis sipateds is independent from their core Business and is vernacularly dealt by their corpo range treasuries. virtu exclusivelyy transnational so utilizes get to as well as venture committees to oversee the exchequers st cropgy in managing the tack charge per unit (and interest Rate) jeopardize.This shows the importance that slosheds assign on risk of exposure solicitude issues and techniques. Conversely, multinational rangeors normally, but non cease littlely, manage their tack vagabond risk independently from the underlying as put downs and/or liabilities. Since their gold exposure is related to interpretation risks on assets and liabilities denominated in orthogonal currencies, they persist to consider currencies as a sepa range asset class requiring a Currency overlay mandate. It fecal matter be argued that responsible management of multinational riotouss requires property risk hedgerow for their opposed proceeding, supplanting and economical trad ing operations to avoid potentially indecorous pocks effects on their advantageousness and merchandise valuation.DEFINITION AND TYPES OF CURRENCY RISKA reciprocal explanation of currentness risk relates to the effect of unexpected commutation stride changes on the cherish of the smashed. In particular, it is drawd as the possible direct evil (as a moment of an unhedged exposure) or indirect deviation in the trains bullion flows, assets and liabilities, sort out profit and, in turn, its stock market comfort from an supervene upon straddle move. To manage the put back rate risk inherent in multinational theatres operations, a truehearted of necessity to visualize the specific type of current risk exposure, the hedgerow strategy and the forthcoming performers to deal with these coin risks.Multinational dissipateds be participants in notes markets by virtue of their external operations. To measure the invasion of shift rate movements on a unanimou s that is engaged in unlike- funds denominated dealingss, i.e., the implied assess-at-risk ( volt-ampere) from tack rate moves, we need to identify the type of risks that the dissolute is un get holdd to and the amount of risk encountered. The iv main(prenominal) types of currentness / stand in rate risk that exist1. transformation risk A loyals translation exposure is the finale to which its financial report is affected by commute rate movements. As all firms primarily must prepargon amalgamated financial narrations for insurance coverage purposes, the consolidation process for multinationals entails translating unconnected assets and liabilities or the financial statements of orthogonal subsidiaries from unlike to home(prenominal) gold. While translation exposure whitethorn not affect a firms interchange flows, it could have a world-shattering impact on a firms reported stipend and therefore its stock price. Translation exposure is distinguished from tra nsaction risk as a moment of income and losses from mixed types of risk having divers(prenominal) accounting treatments. Translation gives special consideration to assets and liabilities with regards to contradictory central risk, whereas exposures to revenues and expenses can often be managed ex ante by managing transactional exposures when notes flows turn over place2. Transaction risk A firm has transaction exposure whenever it has contractual coin flows (receivables and payables) whose values atomic number 18 subject to unanticipated changes in stand in pass judgment due to a contract being denominated in a foreign gold. To realize the domestic value of its foreign-denominated bullion flows, the firm must substitution foreign specie for domestic m oney. As firms transact contracts with set prices and pitching dates in the face of a volatile foreign replacement market with switch rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currentness. Firms generally become exposed as a direct result of activities such as importing and exporting or borrowing and investing. Exchange rates may move by up to 10% in spite of appearance any single course, which can significantly affect a firms cash flows, meaning a 10% decline in the value of a receivable or a 10% educate in the value of a payable. Such outcomes could be troublesome as export profits could be negated entirely or import comprise could rise substantially3. sparing Risk 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 conformments can severely affect the firms topographic charge with regards to its competitors, the firms incoming cash flows, and ultimately the firms value. Economic exposure can affect the present value of future(a) cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economi plowy, but economic exposure can be caused by some other business activities and investments which may not be mere foreign transactions, such as future cash flows from unbending assets. A slip-up in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good and4. Contingent Risk A firm has dependant on(p) exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for a firm to abruptly face a transactional or economic foreign exchange risk, detail on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be current by a foreign business or government that if sure would result in an immediate receivable. While waiting, the firm faces a dependant on(p) exposure from the un definitety as to whether or not that receivable pull up stakes happen. If the bid is accepted and a receivable is remunerative the firm thus faces a transaction exposure, so a firm may cull to manage contingent exposures.MEASUREMENT OF EXCHANGE RATE RISK later 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 money risk may prove difficult, at least with regards to translation and economic risk. At present, a widely used method is the value-at-risk ( volt-ampere) model. Broadly, value at risk is outlined as the maximum loss for a disposed(p) exposure over a given time horizon with z% authority.The var methodology can be used to measure a var. of types of risk, helping firms in their risk management. However, the volt-ampere does not define what happens to the exposure for the ( light speed z) % point of potency, i.e., the worst case scenario. Since the VAR model does not define the maximum lo ss with 100 percent confidence, firms often set for sale limits, such as nominal amounts or stop loss outranks, in addition to VAR limits, to r all(prenominal)(prenominal) the highest possible coverage.VALUE-AT-RISK CALCULATIONThe VAR measure of exchange rate risk is used by firms to imagine the danger of a foreign exchange localisation resulting from a firms activities, including the foreign exchange pose of its treasury, over a certain time result under sane conditions. The VAR calculation depends on 3 parameters The retention plosive consonant, i.e., the length of time over which the foreign exchange side of meat is planned to be held. The typical holding period is 1 twenty-four hour period. The confidence level at which the estimate is planned to be made. The usual confidence levels be 99 percent and 95 percent. The unit of currency to be used for the denomination of the VAR.Assuming a holding period of x days and a confidence level of y%, the VAR measures what will be the maximum loss (i.e., the decrease 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 opportunity of 99 percent, the value of this position will decrease by no much than than $10 million during 1 day, provided that usual conditions will hang in 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 show, which assumes that currency returns on a firms foreign exchange position will have the homogeneous statistical distribution as they had in the past (2) the variance- covariance model, which assumes that currency returns on a firms tot foreign exchange position are always (jointly) normally distributed and that the change in the value of the foreign exchange position is additively dependent on all currency returns and(3) Monte Carlo air which assumes that future currency returns will be randomly distributed. The historical simulation is the wide-eyedst method of calculation. This involves running the firms current foreign exchange position across a set of historical exchange rate changes to yield a distribution of losses in the value of the foreign exchange position, say 1,000, and then computing a percentile (the VAR).Thus, anticipate a 99 percent confidence level and a 1-day holding period, the VAR could be computed by sorting in ascending order the 1,000 periodical losses and taking the 11th braggart(a)st loss out of the 1,000 (since the confidence level implies that 1 p ercent of losses 10 losses should pass off 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 kind of 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 wei ghted average of individual foreign exchange positionsSp is the archetype deviation of the currency return on the firms total foreign exchange position, which is the measuring stick deviation of the weighted transformation of the variance-covariance ground substance of individual foreign exchange positionsWhile the variance-covariance model allows for a pronto calculation, its drawback includes the restrictive assumptions of a normal distribution of currency returns and a linear combination of the total foreign exchange position. Note, however, that the normality assumption could be relaxed. When a non-normal distribution is used instead, the computational speak to would be higher(prenominal) due to the additional estimation of the confidence interval for the loss exceptional(a) the VAR.Monte Carlo simulation unremarkably involves principal components analysis of the variance-covariance model, followed by random simulation of the components. While its main advantages include its ability to look at 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 grievous drawback is the computationally intensive process. MANAGEMENT OF CURRENCY RISK afterward identifying the types of exchange rate risk and mensuration the associated risk exposure, a firm needs to decide whether to hedge or not these risks. In international finance, the issue of the appropriate strategy to manage (hedge) the different types of exchange rate risk has yet to be colonised. In practice, however, in integrated treasurers have used various currency risk management strategies depending, ceteris paribus, on the prevalence of a certain type of risk and the size of the firm.A. Hedging StrategiesIndicatively, transaction risk is often hedged tactically (selectively) or strategicalally to preserve cash flows and earnings, depending on the firms treasury view on the future movement s of the currencies involved. Tactical hedging is used by close to firms to hedge their transaction currency risk relating to short-term receivable and payable transactions, while strategic hedging is used for longer-period transactions. However, some firms decideto use supine hedging, which involves the tutelage of the corresponding 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 planing machine, risk is hedged very infrequently and non-systematically, often to avoid the impact of possible abrupt currency shocks on send away assets. This risk involves mainly long-term foreign exposures, such as the firms valuation of subsidiaries, its debt structure and international investments. However, the long-term genius of these items and the fact that currency translation affects the balance sheet rather than the income statement of a firm, make hed ging 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 benefit 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 paramount importance. The currency and maturity subject of a firms debt determines the susceptibility 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 optimisation model to devise an optimal set of hedging strategies to manage its currency risk.Hedging 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 res idual 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 deliberation 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 rate deviation from the bench mark rate used to forecast a firms revenue and cost rate of flows over a given period. In this case, the impact on apiece flow may be netted out over increase lines and across markets, with the net economic risk becoming small for firms that invest in many foreign markets because of limbting effects. Also, if exchange rate changes follow fanfare differentials (through and through PPP) and a firm has a subsidiary that faces cost inflation in a higher place the general inflation rate, the firm could find its competitiveness eroding and its airplane pilot 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 assailable).Sophisticated corporate treasuries, however, are ontogeny competent marchess of hedging strategies as a more integrated draw near to hedge currency risk than buying a plain vanilla 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 vi ew and exposure, hedging optimization models usually compare 100 percent unhedged strategies with 100 percent hedged exploitation vanilla ships 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 qualify time period).B. Hedging Benchmarks and PerformanceHedging cognitive process 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 exercise measure. Hedging optimization models, as methods for optimizing hedging strategies for currency-denominated cash flows, help find the most efficient hedge for i ndividual 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 terminal possible effective hedge rate for an acceptable level of uncertainty. In this way, when the firms currency view entails a perception of volatility, options incur a get around or similar effective hedge rate at lower uncertainty than the unhedged position. Furthermore, when local currency has a congenatorly high yield and low volatility, options will almost always afford a better effective hedging rate than earlier 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 curiously 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 calculate RatesBudget exchange rates provide firms with a reference exchange rate level. mount 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 pick up that there is minimal deviation from that hedge rate. This process will determine the frequency 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 po sitioning and hedging should be considered. Firms have different practices in setting budget exchange rates.Many corporate treasurers of multinational firms opt to use PPP rates as budget exchange rates, often with the understanding that tactical hedging may be needed 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 consistency with their sales calendar and, in turn, with their hedging strategy. For example, if a firm has a quarterly sales calendar, it may decide to hedge its next years quarterly foreign currency cash flow in such a way that they do not differ by more than a certain percentage from the cash flow in the same quarter of last year.Accordingly, this will necessitate four hedges per year, each of one-year tenor, with hedging being done at the end of the period, use the end-of-period exchange rate as its budget rate. Alternatively, a firm may decide to set its bu dget exchange rate at the perfunctory 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 smart 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 option structures operable 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 hedgi ng 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 station exchange rate in order to avoid possible major(ip) changes in the firms pricing strategy or to regard 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 spatial relationlight rates, structural or time-series exchange rate models need to be apply 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. Best Practices for Exchange Rate Risk focussin gFor their currency risk management decisions, firms with significant exchange rate exposure often need to establish an working(a) 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. instruction 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 allege the firms currency hedging objectiveswhether and why the firm should richly or partially hedge its currency exposures. Furthermore, a detailed currency hedging approach should be established. It is imperative that a firm enlarge 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 mechanisms, 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 chief dealer.)4. Development of a set of controls to monitor a firms exchange rate risk and ensure approp riate position taking. 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 periodic 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 ten, 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 new international attention on both accou nting and balance sheet risks. hedge 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 youthful firm. These instruments include both over-the-counter and exchange-traded products. Among the most common nonprescription(a) currency hedging instruments are currency transport and cross-currency merchandises. Currency forwards are defined as buying a currency contract for future lurch 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 ra te moving in the opposite 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 receives 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 the 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 capture 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 resolution 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 rat es, 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 tailored to individual needs in the forward market (i.e., determined between a firm and a bank), as opposed to currency futures contracts that are standardized and guaranteed by some create 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 prediction of the future spot rate. If a firm holding a currency futures contract decides before the settlement date that it no longer wants to represent such a position, it can close out its position by selling an identical futures contract. This, however, cannot be done with forward contracts.Finally, since currency hedging is often costly, a firm may first consider intrinsic hedging, such as (1) matching, which involves pairing 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 transnational Swap and Derivatives Association, the OTC deriveds market has experienced an exponential growth. Ev en with the recent slowdown due to the special disclosure requirements of FAS 133, deriveds continue to be the main hedging instrument for most firms. However, the increased availability of derivative instruments, pair 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 larger the size of sales of U.S. non-financial firms, the more likely is to use derivatives 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 power 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 renewing 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 instruments), OTC currency options being the second most preferred 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 than 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 valuin g 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. finishingMeasuring 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 inputs, 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 compound 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 unequivocal 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 penning presents 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 to 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 exch ange-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 deputy of the reporting period that they refer to and are indicative of the level of mundanity of U.S. corporate treasurers and the level of development of local derivatives markets. By no meaning 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.