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Abstract
Measuring and managing exchange rate risk exposure is important for reducing a
firm’s vulnerabilities from major exchange rate movements, which could adverse-
ly affect profit margins and the value of assets. This paper reviews the traditional
types of exchange rate risk faced by firms, namely transaction, translation and
economic risks, presents the VaR approach as the currently predominant method
of measuring a firm’s exchange rate risk exposure, and examines the main ad-
vantages and disadvantages of various exchange rate risk management strate-
gies, including tactical vs. strategical and passive vs. active hedging. In addition,
it outlines a set of widely-accepted best practices in managing currency risk and
presents some of the main hedging instruments in the OTC and exchange-traded
markets. The paper also provides some data on the use of financial derivatives
instruments, and hedging practices by US firms.
This paper draws heavily on various presentations on risk management while the author was
the Director of Foreign Exchange Service of the WEFA Group. I thank Carlos Medeiros and a
referee for helpful comments. As customary, the views expressed are those of the author and do not
necessarily represent those of the I.M.F.
130 M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146
Introduction
Exchange rate risk management is an integral part of every firm’s decisions about for-
eign currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging
strategies entail eliminating or reducing this risk, and require understanding of both
the ways that the exchange rate risk could affect the operations of economic agents
and techniques to deal with the consequent risk implications (Barton, Shenkir, and
Walker, 2002). Selecting the appropriate hedging strategy is often a daunting task due
to the complexities involved in measuring accurately current risk exposure and decid-
ing on the appropriate degree of risk exposure that ought to be covered. The need for
currency risk management started to arise after the breakdown of the Bretton Woods
system and the end of the US dollar peg to gold in 1973 (Papaioannou, 2001).
The issue of currency risk management for non-financial firms is independent
from their core business and is usually dealt with by their corporate treasuries. Most
multinational firms also have risk committees to oversee the treasury’s strategy in
managing the exchange rate (and interest rate) risk (Lam, 2003). This shows the
importance that firms attach to risk management issues and techniques. Conversely,
international investors usually manage their exchange rate risk independently from
the underlying assets and/or liabilities. Since their currency exposure is related to
translation risks on assets and liabilities denominated in foreign currencies, they tend
to consider currencies as a separate asset class requiring a currency overlay mandate
(Allen, 2003).
This paper reviews the standard measures of exchange rate risk, examines best
practices on exchange rate risk management, and analyzes the advantages and dis-
advantages of various hedging approaches for firms. It concentrates on the major
types of risk affecting firms’ foreign currency exposure, and pays more attention to
techniques on hedging transaction and balance sheet currency risk. It is argued that
prudent management of multinational firms requires currency risk hedging for their
foreign transaction, translation and economic operations to avoid potentially adverse
currency effects on their profitability and market valuation. The paper also provides
some data on hedging practices by US firms.
The organization of the paper is as follows: In section I, we present a broad defini-
tion and the main types of exchange rate risk. In section II, we outline the main meas-
urement approach to exchange rate risk (VaR). In section III, we review the main
elements of exchange rate risk management, including hedging strategies, hedging
benchmarks and performance, and best practices for managing currency risk. In sec-
tion IV, we offer an overview of the main hedging instruments in the OTC and ex-
change-traded markets. In section V, we provide data on the use of various deriva-
tives instruments and hedging practices by US firms. In section VI, we conclude by
offering some general remarks on the need for hedging operations based on recent
currency-crisis experiences.
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 131
Value-at-Risk calculation
The VaR measure of exchange rate risk is used by firms to estimate the riskiness of
a foreign exchange position resulting from a firm’s activities, including the foreign
exchange position of its treasury, over a certain time period under normal conditions
(Holton, 2003). The VaR calculation depends on 3 parameters:
• The holding 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 confi-
dence levels are 99% and 95%.
• 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 meas-
ures 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% confidence level, the firm should
expect that, with a probability of 99%, the value of this position will decrease by
no more 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 simulation, which assumes that currency returns
on a firm’s foreign exchange position will have the same distribution as they had in
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 133
the past; (2) the variance-covariance model, which assumes that currency returns on
a firm’s 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 calculation. This involves run-
ning the firm’s 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 po-
sition, say 1,000, and then computing a percentile (the VaR). Thus, assuming a 99%
confidence level and a 1-day holding period, the VaR could be computed by sorting in
ascending order the 1,000 daily losses and taking 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 distribu-
tion 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
firm’s 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% confidence level, the VaR can be
calculated as:
where Vp is the initial value (in currency units) of the foreign exchange position
Mp is the mean of the currency return on the firm’s total foreign exchange po-
sition, which is a weighted average of individual foreign exchange positions
Sp is the standard deviation of the currency return on the firm’s total foreign
exchange position, which is the standard deviation of the weighted transfor-
mation of the variance-covariance matrix of individual foreign exchange po-
sitions (note that the latter includes the correlations of individual foreign ex-
change positions)
While the variance-covariance model allows for a quick calculation, its drawbacks
include 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 (Longin, 2001). When a non-normal distri-
bution is used instead, the computational cost would be higher due to the additional
estimation of the confidence interval for the loss exceeding the VaR.
134 M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146
the firm may use an optimization model to devise an optimal set of hedging strate-
gies 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 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 of 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 ex-
change rate deviation from the benchmark rate used to forecast a firm’s 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 inflation differentials (through PPP) 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 (Froot and Thaler, 1990). Under these
circumstances, the firm could best hedge its economic exposure by creating payables
(e.g., financing operations) in the currency in which the firm’s subsidiary experiences
the higher cost inflation (i.e., in the currency in which the firm’s value is vulner-
able).
Sophisticated corporate treasuries, however, are developing efficient frontiers of
hedging strategies as a more integrated approach to hedge currency risk than buying
a plain vanilla hedge to cover certain foreign exchange exposure (Kritzman, 1993).
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% unhedged strategies
with 100% hedged using vanilla forwards and option strategies in order to find the
optimal one. Although this approach to managing risk provides the least-cost hedg-
ing structure for a given risk profile, it critically depends on the corporate treasurer’s
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).
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 per-
formance 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 hedg-
ing 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 uncer-
tainty. In this way, when the firm’s currency view entails a perception of volatility,
options generate 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 percentage), the reporting period, especially for
firms that use forward hedging to limit the volatility of their net equity, (e.g., quar-
terly or 12-month benchmarks), and budget exchange rates, depending on the prevail-
ing accounting rules. Moreover, benchmarks enable the performance of individual
hedges to be measured against that of the firm.
1. The relative version of the PPP theory states that bilateral exchange rates would adjust to the rela-
tive price differentials of the same basket of goods traded in the two countries.
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 137
has a quarterly sales calendar, it may decide to hedge its next year’s quarterly foreign
currency cash flow in such a way that it does not differ by more than a certain per-
centage from the cash flow in the same quarter of the previous 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 (Barton, Shenkir, and Walker, 2002). In
such cases, 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 option structures available in the market.
This type of hedging strategy is fairly simple and easier to monitor.
Setting budget exchange rates is also crucial for a firm’s pricing strategy, in addi-
tion 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 ex-
change rate in order to avoid possible major changes in the firm’s pricing strategy or
to reconsider its hedging strategy. In this connection, it should be noted that forecast-
ing future exchange rates is a key aspect of a firm’s pricing strategy (Papaioannou,
1989). Since it has been well-documented that forward rates are poor predictors of
future spot rates, structural or time-series exchange rate models need to be employed
for such an endeavor (Bansal and Dahlquist, 2000; Fama, 1984). This becomes evi-
dent if we compare a firm’s 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.
fined 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 de-
livery 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 opposite direction are seri-
ous disadvantages.
The two most commonly used cross-currency swaps are the cross-currency cou-
pon swap and the cross-currency basis swaps. The cross-currency coupon swap is
defined as buying a currency swap and at the same time paying fixed and receiving
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 paying floating inter-
est in a currency and receiving 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 than
currency risk.
For exchange-traded currency hedging instruments, the main types are currency
options and currency futures. The development of various structures of currency op-
tions 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 (Allen, 2003). Its advantages
include its simplicity, lower cost than the forward, and the predicted maximum loss
- which 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 con-
tract 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 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-mar-
ket settlements. In terms of liquidation, while most forward contracts are settled by
140 M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146
actual delivery and only some by offset - at 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 market’s 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
identical futures contract. This, however, cannot be done with forward contracts.
Finally, since currency hedging is often costly, a firm may first consider “natural”
hedging (Madura, 1989), such as (1) matching, which involves pairing suitably a
multinational firm’s 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.
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
US firms do not attach high importance to 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 (Table 6).
The choice of derivative instruments for foreign exchange management by US
firms is concentrated in simple instruments, with OTC currency forwards being by
far the most popular instrument (over 50% of all foreign exchange derivatives instru-
ments), OTC currency options being the second most preferred hedging instrument
(around 20% of all foreign exchange derivative instruments ) and OTC swaps being
the third (around 10%) (Table7). Forward-type (volatility elimination) instruments
are used to hedge foreign exchange exposures arising from US firms’ contractual
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 143
The use of OTC instruments (forwards/swaps and options) is much more common
than that of exchange-traded hedging instruments, with currency futures being pre-
ferred by less than 10% of US 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 US firms with a set frequency for revaluing derivatives do so
144 M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146
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 (Table 8). Fi-
nally, the most common methods to evaluate the riskiness of their foreign exchange
positions are stress testing of derivatives and VaR techniques.
6. Concluding remarks
Measuring and managing currency risk exposure are important functions in reducing
a firm’s vulnerabilities from major exchange rate movements. These vulnerabilities
mainly arise from a firm’s 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 to accounting and balance sheet risks.
In managing currency risk, multinational firms utilize different hedging strate-
gies depending on the specific type of currency risk. These strategies have become
increasingly complicated as they try to address simultaneously transaction, transla-
tion 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 va-
riety of instruments has been generated by the ingenuity of the financial engineering
industry.
This paper presents some of the main issues in the measurement and manage-
ment of exchange rate risks faced by firms, with special attention to the traditional
types of exchange rate risk (transaction, translation, and economic), the currently pre-
dominant methodology in measuring exchange rate risk (VaR), and the advantages
M. PAPAIOANNOU, South-Eastern Europe Journal of Economics 2 (2006) 129-146 145
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 prac-
tices 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 US multinationals.
Based on the reported US 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 US 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 de-
rivatives 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 are preferred by less than 10
percent of US firms and currency options by around 2 percent.
Overall, it should be noted that the data on US firms are only representative of the
reporting period that they refer to and are indicative of the level of sophistication of
US 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 behaviors.
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