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South-Eastern Europe Journal of Economics 2 (2006) 129-146 EXCHANGE RATE RISK MEASUREMENT AND MANAGEMENT: ISSUES AND APPROACHES FOR FIRMS MICHAEL G. PAPAIOANNOU, Ph.D. International Monetary Fund Abstract Measuring and managing exchange rate risk exposure is important for reducing a firm’s vulnerabilities from major exchange rate movements, which could adversely 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 advantages and disadvantages of various exchange rate risk…show more content…
The organization of the paper is as follows: In section I, we present a broad definition and the main types of exchange rate risk. In section II, we outline the main measurement 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 section IV, we offer an overview of the main hedging instruments in the OTC and exchange-traded markets. In section V, we provide data on the use of various derivatives 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 1. Definition and types of exchange rate risk A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 1989). In particular, it is defined as the possible direct loss (as a result of an unhedged exposure) or indirect loss in the firm’s cash flows, assets and liabilities, net profit and, in turn, its stock market value from an exchange rate move. To manage the exchange rate risk inherent in every multinational firm’s operations, a firm needs to determine the specific type of current risk exposure, the hedging strategy

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