## 1. Notional Amounts Outstanding of OTC Derivatives by Instrument

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### III. Introduction and paper scope
- Reviews standard measures of exchange rate risk, examines best practices on exchange rate risk management, and analyzes advantages and disadvantages of various hedging approaches for firms.
- Concentrates on major types of risk affecting firms’ foreign currency exposure, with emphasis on hedging transaction and balance sheet currency risk.
- Argues that prudent management of multinational firms requires currency risk hedging for foreign transaction, translation and economic operations to avoid adverse effects on profitability and market valuation.
- Provides data on hedging practices by U.S. firms.
- Paper organization:
  - Section I: definition and main types of exchange rate risk.
  - Section II: measurement approach to exchange rate risk (VaR).
  - Section III: main elements of exchange rate risk management, including hedging strategies, benchmarks, performance, and best practices.
  - Section IV: overview of main hedging instruments in the OTC and exchange-traded markets.
  - Section V: data on use of derivatives instruments and hedging practices by U.S. firms.
  - Section VI: conclusions on need for hedging based on recent currency-crisis experiences.

### II. Definition and types of exchange rate risk
- Common definition: effect of unexpected exchange rate changes on the value of the firm (Madura, 1989).
- Exchange rate risk can cause direct or indirect loss in cash flows, assets, liabilities, net profit, and stock market value.
- Three main types of exchange rate risk (Shapiro, 1996; Madura, 1989):
  - 1. Transaction risk: cash flow risk from receivables (exports), payables (imports), or repatriation of dividends; direct transaction exchange rate risk.
  - 2. Translation risk: balance sheet exchange rate risk measured by exposure of net assets (assets less liabilities) of foreign subsidiaries; translation may use end-of-period or average exchange rates depending on accounting rules.
  - 3. Economic risk: risk to present value of future operating cash flows from exchange rate movements; affects revenues and operating expenses across products and markets.

### III. Measurement of exchange rate risk — Value-at-Risk (VaR)
- VaR broadly defined as the maximum loss for a given exposure over a given time horizon with z% confidence.
- VaR does not define worst-case beyond the (100 – z)% tail; firms often set operational limits (nominal amounts or stop loss orders) in addition to VaR limits.
- VaR calculation depends on 3 parameters:
  - The holding period (typical holding period is 1 day).
  - The confidence level (usual confidence levels are 99 percent and 95 percent).
  - The unit of currency for denomination.
- Example interpretation:
  - If 1-day VaR = $10 million at the 99 percent confidence level, the firm should expect with probability 99 percent that the position will decrease by no more than $10 million during 1 day.
  - Equivalently: 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.
- Common VaR calculation methods:
  - Historical simulation:
    - Runs current position across historical exchange rate changes to yield a distribution (e.g., 1,000 losses) and computes a percentile (the VaR).
    - Example: with 99 percent confidence and 1-day holding period, take the 11th largest loss out of the 1,000.
    - Benefits: does not assume normality; recognizes leptokurtosis of currency returns.
    - Drawbacks: requires a large database and is computationally intensive.
  - Variance–covariance model:
    - Assumes change in total foreign exchange position is linear combination of individual changes and that currency returns are jointly normally distributed.
    - VaR formula:
      - VaR= -Vp (Mp + 2.33 Sp)
      - 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 position;
        Sp is the standard deviation of the currency return on the firm’s total foreign exchange position.
    - Advantages: quick calculation.
    - Drawbacks: restrictive normality and linearity assumptions (normality assumption can be relaxed; Longin, 2001).
  - Monte Carlo simulation:
    - Often involves principal components analysis of the variance–covariance model, followed by random simulation.
    - Advantages: can handle any underlying distribution; better captures non-linear currency factors (e.g., options).
    - Drawback: computationally intensive.

### IV. Management of exchange rate risk — Hedging approaches and frameworks
- Decision to hedge depends on type of exposure and firm characteristics; no settled universal strategy (Jacque, 1996).

A. Hedging strategies
- Transaction risk:
  - Often hedged tactically (selectively) or strategically.
  - Tactical hedging used for short-term receivables/payables; strategic hedging for longer-period transactions.
  - Passive hedging: maintain same hedging structure over regular hedging periods irrespective of currency expectations.
- Translation (balance sheet) risk:
  - Hedged infrequently and non-systematically; focus on net balance sheet exposures (net assets).
  - Hedging translation risk may introduce cash flow or earnings volatility if exchange rates move differently than expected; costs of hedging must be weighed against costs of not hedging.
- Economic risk:
  - Often hedged as a residual risk; difficult to quantify.
  - May be reduced via netting across product lines and markets.
  - Example strategy: create payables in the currency where a subsidiary experiences higher cost inflation to hedge economic exposure.
- Hedging optimization and efficient frontiers:
  - Sophisticated treasuries develop efficient frontiers measuring cost of hedge against degree of risk hedged.
  - Optimization compares 100 percent unhedged with 100 percent hedged using vanilla forwards and option strategies to find the optimal structure, conditional on the corporate treasurer’s currency view.
  - Optimization applicable to transaction, translation or economic risk if a specific currency view (forecast) exists.

B. Hedging benchmarks and performance
- Hedging performance measured as distance to a benchmark rate; risk expressed as a VaR consistent with performance measure.
- Optimization models find most efficient hedge for individual currency exposures but typically do not provide multi-currency hedging processes.
- Effective hedge rate and risk (confidence level) used to select a single optimal hedging strategy given acceptable level of uncertainty.
- Options may provide better or similar effective hedge rates at lower uncertainty than unhedged positions when a currency view exists.
- When local currency has relatively high yield and low volatility, options will almost always generate a better effective hedging rate than forward hedging.

C. Hedging and budget rates
- Budget exchange rates provide a reference level for forecasting and hedging; linked to firm sensitivities and benchmarking priorities.
- Practices in setting budget rates:
  - Many treasurers prefer PPP rates as budget exchange rates, recognizing tactical hedging may be needed in the short-term where PPP forecasting is poor.
  - Some firms set budget rates according to sales calendar (e.g., quarterly sales -> four hedges per year, each of one-year tenor, using end-of-period exchange rate).
  - Some set budget rate as daily average exchange rate over previous fiscal year, using one hedge via average-based instruments (options or synthetic forwards) executed on last day of previous fiscal year.
  - Passive currency hedging can target average value of a foreign currency cash flow over a specified period relative to a previous period through option structures.
- Budget rates influence pricing strategy and hedging tenor; budget rate used to forecast cash flows should be close to spot to avoid major pricing adjustments.
- Forward rates are poor predictors of future spot rates; structural or time-series models should be employed for forecasting.

D. Best practices for exchange rate risk management
- Firms with significant exchange rate exposure should establish an operational framework of best practices (Allen, 2003; Jacque, 1996).
- Identification and measurement:
  - Determine transaction, translation and economic risks, and identify the specific currencies related to each type of currency risk.
  - Measure currency risks using various models (e.g., VaR) to identify hedging positions.
- Strategy development and operationalization:
  - Specify currency hedging objectives: whether to fully or partially hedge exposures and why.
  - Establish a detailed currency hedging approach specifying:
    - Execution process of currency hedging.
    - Hedging instruments to be used.
    - Monitoring procedures of currency hedges.
  - Operational detail is imperative for strategy implementation.
- Centralized treasury entity (execution and responsibilities):
  - Create a centralized entity in the firm’s treasury (specialized team headed by the treasurer or, for large multinationals, by a chief dealer) to handle:
    - Exchange rate forecasting.
    - Hedging approach mechanisms.
    - Accounting procedures for currency risk.
    - Costs of currency hedging.
    - Establishment of benchmarks for measuring hedging performance.
- Controls and oversight:
  - Set position limits for each hedging instrument.
  - Position monitoring through mark-to-market valuations of all currency positions on a daily basis (or intraday).
  - Establish currency hedging benchmarks for periodic monitoring of hedging performance (usually monthly).
  - Establish a risk oversight committee to:
    - Approve limits on position taking.
    - Examine appropriateness of hedging instruments and associated VaR positions.
    - Review risk management policy regularly.

### Hedging instruments: OTC and exchange-traded
- OTC instruments (common):
  - Currency forwards:
    - Defined as buying a currency contract for future delivery at a price set today.
    - Two types: outright forwards (physical delivery) and non-deliverable forwards (net cash settlement).
    - With forwards, the firm is fully hedged; disadvantages include high cost and risk of adverse exchange rate moves.
  - Cross-currency coupon swaps:
    - Buy a currency swap and at the same time pay fixed and receive floating interest payments.
    - Allows simultaneous management of foreign exchange and interest rate risks; leaves firm exposed to both.
  - Cross-currency basis swaps:
    - Buy a currency swap and at the same time pay floating interest in one currency and receive floating in another.
    - Allows capture of prevailing interest rate differentials; primary risk is interest rate risk rather than currency risk.
- Exchange-traded instruments:
  - Currency options:
    - Plain vanilla call: buy an upside strike in an exchange rate with no obligation to exercise.
    - Advantages: simplicity, lower cost than the forward, predicted maximum loss equal to the premium.
    - More sophisticated option structures (e.g., call spreads) can be lower cost than plain vanilla calls.
  - Currency futures:
    - Exchange-traded contracts specifying a standard volume of a currency to be exchanged on a specific settlement date.
    - Similar to forwards in fixing future currency price; differ in traded currencies, standardized quarterly settlement dates, and clearing-house-backed daily mark-to-market.
    - Futures price typically similar to forward rate for a given currency and settlement date.
    - Futures positions can be closed out by offset prior to settlement; forwards cannot.

### Natural hedging alternatives
- Because currency hedging can be costly, consider natural hedging techniques:
  - Matching: pair foreign currency inflows and outflows by amount and timing.
  - Netting: consolidated settlement of receivables, payables and debt among subsidiaries.
  - Invoicing in a foreign currency: reduces transaction risk related to exports and imports.

### Hedging practices by U.S. firms (stylized facts and survey findings)
- Derivatives markets and usage:
  - OTC derivatives market experienced exponential growth (BIS; ISDA).
  - Derivatives remain the main hedging instrument for most firms despite disclosure requirements (FAS 133).
- Stylized facts:
  - Larger firms are more likely to use derivatives.
  - Foreign currency derivatives usage is most common, with almost three-fourths of reporting firms taking positions.
  - Primary goal of hedging: minimize variability in cash flow and accounting earnings (less emphasis on minimizing variation in market value of the firm).
- Choice of instruments by U.S. firms (concentration in simple instruments):
  - OTC currency forwards: over 50 percent of all foreign exchange derivatives instruments.
  - OTC currency options: around 20 percent of all foreign exchange derivative instruments.
  - OTC swaps: around 10 percent.
  - Exchange-traded currency futures: preferred by less than 10 percent of U.S. firms.
  - Exchange-traded currency options: preferred by around 2 percent of U.S. firms.
- Use by purpose:
  - Forward-type instruments commonly used to hedge contractual commitments (accounts receivable/payable, repatriations).
  - Option-type instruments commonly used to hedge uncertain foreign currency-denominated future cash flows (anticipated transactions beyond one year and economic exposures).
- Valuation and risk assessment practices:
  - Majority revalue derivatives monthly; a quarter value at least weekly; a very small percentage only annually.
  - Most common risk evaluation methods: stress testing of derivatives and VaR techniques.

### Key statistics from BIS and survey tables
- Table 1. Notional Amounts Outstanding of OTC Derivatives by Instrument (End of Year; In Billions of U.S. dollars):
  - Instrument 2002 2003 2004
  - Total contracts 141,665 197,167 248,288
  - Foreign exchange contracts 18,448 24,475 29,575
    - Forwards and swaps 15,222 18,758 23,460
    - Options 3,226 5,717 6,115
  - Interest rate contracts 101,658 141,991 187,340
  - Other contracts 21,559 30,701 31,373
- Table 2. Notional Amounts Outstanding of OTC Derivatives by Currency (End of Year; In Billions of U.S. dollars):
  - Currencies 2002 2003 2004
  - All currencies 18,448 24,475 29,575
    - U.S. dollar 16,500 21,429 25,998
    - Euro 7,794 10,145 11,936
    - Japanese yen 4,791 5,500 7,083
    - Pound sterling 2,462 4,286 4,349
- Table 3. Notional Amounts Outstanding of OTC Foreign Exchange Derivatives by Maturity (End of Year; in Billions of U.S. dollars):
  - Maturity 2002 2003 2004
  - Total contracts 18,448 24,475 29,575
    - Maturity of 1 year or less 14,522 18,840 23,115
    - Maturity over 1 year and up to 5 years 2,719 3,901 4,386
    - Maturity over 5 years 1,208 1,734 2,073
- Table 7 (choice of instrument by exposure type, in percent):
  - Contractual commitments (accounts receivable/payable and repatriations): Forwards 60, Options 29, Swaps 5
  - Anticipated transactions of < 1 year: Forwards 60, Options 29, Swaps 5
  - Anticipated transactions of > 1 year: Forwards 21, Options 31, Swaps 13
  - Economic exposures: Forwards 5, Options 16, Swaps 3
  - Translation of accounts: Forwards 13, Options 11, Swaps 6
- Table 8 (frequency of derivative valuations by U.S. non-financial firms, in percent):
  - Daily 17
  - Weekly 8
  - Monthly 36
  - Quarterly 18
  - Annually 4
  - As needed 17
  - Total 100

### Concluding observations and implications
- Measuring and managing currency risk reduces firm vulnerabilities from major exchange rate movements that affect inputs, output markets, debt, and asset values.
- Corporate treasurers are increasingly proactive in currency risk control; demand for hedging protection has increased and produced a greater variety of instruments.
- The paper emphasizes:
  - Traditional risk types (transaction, translation, economic).
  - VaR as the currently predominant measurement methodology.
  - Trade-offs among tactical vs. strategical and passive vs. active approaches.
  - A set of widely-accepted best practices in currency risk management.
- Stylized findings from U.S. data (not generalized to other times/countries):
  - Larger firms more likely to use derivatives.
  - Primary hedging goal is to minimize variability in cash flows and accounting earnings.
  - Concentration in OTC forwards (>50 percent), OTC options (around 20 percent), OTC swaps (around 10 percent); exchange-traded futures < 10 percent, exchange-traded options ~2 percent.
- Recommendation for further research: more empirical studies across countries and time periods to better understand global firms’ exchange rate risk measurement and hedging behaviors.

*Source: _wp06255 - 1. Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure (PDF).*

### 1. Notional Amounts Outstanding of OTC Derivatives by Instrument .................................. 15

### 1. Notional Amounts Outstanding of OTC Derivatives by Instrument .................................. 15

### III. Introduction and paper scope
- Reviews standard measures of exchange rate risk, examines best practices on exchange rate risk management, and analyzes advantages and disadvantages of various hedging approaches for firms.
- Concentrates on major types of risk affecting firms’ foreign currency exposure, with emphasis on hedging transaction and balance sheet currency risk.
- Argues that prudent management of multinational firms requires currency risk hedging for foreign transaction, translation and economic operations to avoid adverse effects on profitability and market valuation.
- Provides data on hedging practices by U.S. firms.
- Paper organization:
  - Section I: definition and main types of exchange rate risk.
  - Section II: measurement approach to exchange rate risk (VaR).
  - Section III: main elements of exchange rate risk management, including hedging strategies, benchmarks, performance, and best practices.
  - Section IV: overview of main hedging instruments in the OTC and exchange-traded markets.
  - Section V: data on use of derivatives instruments and hedging practices by U.S. firms.
  - Section VI: conclusions on need for hedging based on recent currency-crisis experiences.

### II. Definition and types of exchange rate risk
- Common definition: effect of unexpected exchange rate changes on the value of the firm (Madura, 1989).
- Exchange rate risk can cause direct or indirect loss in cash flows, assets, liabilities, net profit, and stock market value.
- Three main types of exchange rate risk (Shapiro, 1996; Madura, 1989):
  - 1. Transaction risk: cash flow risk from receivables (exports), payables (imports), or repatriation of dividends; direct transaction exchange rate risk.
  - 2. Translation risk: balance sheet exchange rate risk measured by exposure of net assets (assets less liabilities) of foreign subsidiaries; translation may use end-of-period or average exchange rates depending on accounting rules.
  - 3. Economic risk: risk to present value of future operating cash flows from exchange rate movements; affects revenues and operating expenses across products and markets.

### III. Measurement of exchange rate risk — Value-at-Risk (VaR)
- VaR broadly defined as the maximum loss for a given exposure over a given time horizon with z% confidence.
- VaR does not define worst-case beyond the (100 – z)% tail; firms often set operational limits (nominal amounts or stop loss orders) in addition to VaR limits.
- VaR calculation depends on 3 parameters:
  - The holding period (typical holding period is 1 day).
  - The confidence level (usual confidence levels are 99 percent and 95 percent).
  - The unit of currency for denomination.
- Example interpretation:
  - If 1-day VaR = $10 million at the 99 percent confidence level, the firm should expect with probability 99 percent that the position will decrease by no more than $10 million during 1 day.
  - Equivalently: 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.
- Common VaR calculation methods:
  - Historical simulation:
    - Runs current position across historical exchange rate changes to yield a distribution (e.g., 1,000 losses) and computes a percentile (the VaR).
    - Example: with 99 percent confidence and 1-day holding period, take the 11th largest loss out of the 1,000 (text states this procedure explicitly).
    - Benefits: does not assume normality; recognizes leptokurtosis of currency returns.
    - Drawbacks: requires a large database and is computationally intensive.
  - Variance–covariance model:
    - Assumes change in total foreign exchange position is linear combination of individual changes and that currency returns are jointly normally distributed.
    - VaR formula (as presented):
      - VaR= -Vp (Mp + 2.33 Sp)
      - 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 position;
        Sp is the standard deviation of the currency return on the firm’s total foreign exchange position.
    - Advantages: quick calculation.
    - Drawbacks: restrictive normality and linearity assumptions (normality assumption can be relaxed; Longin, 2001).
  - Monte Carlo simulation:
    - Often involves principal components analysis of the variance–covariance model, followed by random simulation.
    - Advantages: can handle any underlying distribution; better captures non-linear currency factors (e.g., options).
    - Drawback: computationally intensive.

### IV. Management of exchange rate risk — Hedging approaches and frameworks
- Decision to hedge depends on type of exposure and firm characteristics; no settled universal strategy (Jacque, 1996).

A. Hedging strategies
- Transaction risk:
  - Often hedged tactically (selectively) or strategically.
  - Tactical hedging used for short-term receivables/payables; strategic hedging for longer-period transactions.
  - Passive hedging: maintain same hedging structure over regular hedging periods irrespective of currency expectations.
- Translation (balance sheet) risk:
  - Hedged infrequently and non-systematically; focus on net balance sheet exposures (net assets).
  - Hedging translation risk may introduce cash flow or earnings volatility if exchange rates move differently than expected; costs of hedging must be weighed against costs of not hedging.
- Economic risk:
  - Often hedged as a residual risk; difficult to quantify.
  - May be reduced via netting across product lines and markets.
  - Example strategy: create payables in the currency where a subsidiary experiences higher cost inflation to hedge economic exposure.
- Hedging optimization and efficient frontiers:
  - Sophisticated treasuries develop efficient frontiers measuring cost of hedge against degree of risk hedged.
  - Optimization compares 100 percent unhedged with 100 percent hedged using vanilla forwards and option strategies to find the optimal structure, conditional on the corporate treasurer’s currency view.
  - Optimization applicable to transaction, translation or economic risk if a specific currency view (forecast) exists.

B. Hedging benchmarks and performance
- Hedging performance measured as distance to a benchmark rate; risk expressed as a VaR consistent with performance measure.
- Optimization models find most efficient hedge for individual currency exposures but typically do not provide multi-currency hedging processes.
- Effective hedge rate and risk (confidence level) used to select a single optimal hedging strategy given acceptable level of uncertainty.
- Options may provide better or similar effective hedge rates at lower uncertainty than unhedged positions when a currency view exists.
- When local currency has relatively high yield and low volatility, options will almost always generate a better effective hedging rate than forward hedging.

C. Hedging and budget rates
- Budget exchange rates provide a reference level for forecasting and hedging; linked to firm sensitivities and benchmarking priorities.
- Practices in setting budget rates:
  - Many treasurers prefer PPP rates as budget exchange rates, recognizing tactical hedging may be needed in the short-term where PPP forecasting is poor.
  - Some firms set budget rates according to sales calendar (e.g., quarterly sales -> four hedges per year, each of one-year tenor, using end-of-period exchange rate).
  - Some set budget rate as daily average exchange rate over previous fiscal year, using one hedge via average-based instruments (options or synthetic forwards) executed on last day of previous fiscal year.
  - Passive currency hedging can target average value of a foreign currency cash flow over a specified period relative to a previous period through option structures.
- Budget rates influence pricing strategy and hedging tenor; budget rate used to forecast cash flows should be close to spot to avoid major pricing adjustments.
- Forward rates are poor predictors of future spot rates; structural or time-series models should be employed for forecasting.

D. Best practices for exchange rate risk management
- Firms with significant exchange rate exposure should establish an operational framework of best practices (Allen, 2003; Jacque, 1996).
- Best practices (introduction to list in source): principles and operational procedures are recommended to guide treasury decisions and hedging implementation (full list of principles begins in the source text following this section).

*IMF working paper content unit: 1. Notional Amounts Outstanding of OTC Derivatives by Instrument, pages excerpted.*

### 1.   Identification of the types of exchange rate risk that a firm is exposed to and

### 1.   Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure

### Identification and measurement of exchange rate risks
- Determine transaction, translation and economic risks, and identify the specific currencies related to each type of currency risk.
- Measure currency risks using various models (e.g., VaR) to identify hedging positions.

### Exchange rate risk management strategy (development and operationalization)
- Specify currency hedging objectives: whether to fully or partially hedge exposures and why.
- Establish a detailed currency hedging approach specifying:
  - Execution process of currency hedging.
  - Hedging instruments to be used.
  - Monitoring procedures of currency hedges.
- Operational detail is imperative for strategy implementation.

### Centralized treasury entity (execution and responsibilities)
- Create a centralized entity in the firm’s treasury (specialized team headed by the treasurer or, for large multinationals, by a chief dealer) to handle:
  - Exchange rate forecasting.
  - Hedging approach mechanisms.
  - Accounting procedures for currency risk.
  - Costs of currency hedging.
  - Establishment of benchmarks for measuring hedging performance.

### Controls and oversight
- Develop controls to monitor exchange rate risk and ensure appropriate position taking:
  - Set position limits for each hedging instrument.
  - Position monitoring through mark-to-market valuations of all currency positions on a daily basis (or intraday).
  - Establish currency hedging benchmarks for periodic monitoring of hedging performance (usually monthly).
- Establish a risk oversight committee to:
  - Approve limits on position taking.
  - Examine appropriateness of hedging instruments and associated VaR positions.
  - Review risk management policy regularly.

### Hedging instruments: OTC and exchange-traded
- OTC instruments (common):
  - Currency forwards:
    - Defined as buying a currency contract for future delivery at a price set today.
    - Two types: outright forwards (physical delivery) and non-deliverable forwards (net cash settlement).
    - With forwards, the firm is fully hedged; disadvantages include high cost and risk of adverse exchange rate moves.
  - Cross-currency coupon swaps:
    - Buy a currency swap and at the same time pay fixed and receive floating interest payments.
    - Allows simultaneous management of foreign exchange and interest rate risks; leaves firm exposed to both.
  - Cross-currency basis swaps:
    - Buy a currency swap and at the same time pay floating interest in one currency and receive floating in another.
    - Allows capture of prevailing interest rate differentials; primary risk is interest rate risk rather than currency risk.
- Exchange-traded instruments:
  - Currency options:
    - Plain vanilla call: buy an upside strike in an exchange rate with no obligation to exercise.
    - Advantages: simplicity, lower cost than the forward, predicted maximum loss equal to the premium.
    - More sophisticated option structures (e.g., call spreads) can be lower cost than plain vanilla calls.
  - Currency futures:
    - Exchange-traded contracts specifying a standard volume of a currency to be exchanged on a specific settlement date.
    - Similar to forwards in fixing future currency price; differ in traded currencies, standardized quarterly settlement dates, and clearing-house-backed daily mark-to-market.
    - Futures price typically similar to forward rate for a given currency and settlement date.
    - Futures positions can be closed out by offset prior to settlement; forwards cannot.

### Natural hedging alternatives
- Because currency hedging can be costly, consider natural hedging techniques:
  - Matching: pair foreign currency inflows and outflows by amount and timing.
  - Netting: consolidated settlement of receivables, payables and debt among subsidiaries.
  - Invoicing in a foreign currency: reduces transaction risk related to exports and imports.

### Hedging practices by U.S. firms (stylized facts and survey findings)
- Derivatives markets and usage:
  - OTC derivatives market experienced exponential growth (BIS; ISDA).
  - Derivatives remain the main hedging instrument for most firms despite disclosure requirements (FAS 133).
- Survey-based stylized facts:
  - Larger firms are more likely to use derivatives.
  - Foreign currency derivatives usage is most common, with almost three-fourths of reporting firms taking positions.
  - Primary goal of hedging: minimize variability in cash flow and accounting earnings (less emphasis on minimizing variation in market value of the firm).
- Choice of instruments by U.S. firms (concentration in simple instruments):
  - OTC currency forwards: over 50 percent of all foreign exchange derivatives instruments.
  - OTC currency options: around 20 percent of all foreign exchange derivative instruments.
  - OTC swaps: around 10 percent.
  - Exchange-traded currency futures: preferred by less than 10 percent of U.S. firms.
  - Exchange-traded currency options: preferred by around 2 percent of U.S. firms.
- Use by purpose:
  - Forward-type instruments commonly used to hedge contractual commitments (accounts receivable/payable, repatriations).
  - Option-type instruments commonly used to hedge uncertain foreign currency-denominated future cash flows (anticipated transactions beyond one year and economic exposures).
- Valuation and risk assessment practices:
  - Majority revalue derivatives monthly; a quarter value at least weekly; a very small percentage only annually.
  - Most common risk evaluation methods: stress testing of derivatives and VaR techniques.

### Key statistics from BIS and survey tables (as reported)
- Table 1. Notional Amounts Outstanding of OTC Derivatives by Instrument (End of Year; In Billions of U.S. dollars):
  - Instrument 2002 2003 2004
  - Total contracts 141,665 197,167 248,288
  - Foreign exchange contracts 18,448 24,475 29,575
    - Forwards and swaps 15,222 18,758 23,460
    - Options 3,226 5,717 6,115
  - Interest rate contracts 101,658 141,991 187,340
  - Other contracts 21,559 30,701 31,373
- Table 2. Notional Amounts Outstanding of OTC Derivatives by Currency (End of Year; In Billions of U.S. dollars):
  - Currencies 2002 2003 2004
  - All currencies 18,448 24,475 29,575
    - U.S. dollar 16,500 21,429 25,998
    - Euro 7,794 10,145 11,936
    - Japanese yen 4,791 5,500 7,083
    - Pound sterling 2,462 4,286 4,349
- Table 3. Notional Amounts Outstanding of OTC Foreign Exchange Derivatives by Maturity (End of Year; in Billions of U.S. dollars):
  - Maturity 2002 2003 2004
  - Total contracts 18,448 24,475 29,575
    - Maturity of 1 year or less 14,522 18,840 23,115
    - Maturity over 1 year and up to 5 years 2,719 3,901 4,386
    - Maturity over 5 years 1,208 1,734 2,073
- Table 5 (survey use of derivatives by U.S. non-financial firms): summary statistics indicate higher usage among larger firms (table presents counts and percent-of-total by size categories).
- Table 7 (choice of instrument by exposure type, in percent):
  - Contractual commitments (accounts receivable/payable and repatriations): Forwards 60, Options 29, Swaps 5
  - Anticipated transactions of < 1 year: Forwards 60, Options 29, Swaps 5
  - Anticipated transactions of > 1 year: Forwards 21, Options 31, Swaps 13
  - Economic exposures: Forwards 5, Options 16, Swaps 3
  - Translation of accounts: Forwards 13, Options 11, Swaps 6
- Table 8 (frequency of derivative valuations by U.S. non-financial firms, in percent):
  - Daily 17
  - Weekly 8
  - Monthly 36
  - Quarterly 18
  - Annually 4
  - As needed 17
  - Total 100

### Concluding observations and implications
- Measuring and managing currency risk reduces firm vulnerabilities from major exchange rate movements that affect inputs, output markets, debt, and asset values.
- Corporate treasurers are increasingly proactive in currency risk control; demand for hedging protection has increased and produced a greater variety of instruments.
- The paper emphasizes:
  - Traditional risk types (transaction, translation, economic).
  - VaR as the currently predominant measurement methodology.
  - Trade-offs among tactical vs. strategical and passive vs. active approaches.
  - A set of widely-accepted best practices in currency risk management.
- Stylized findings from U.S. data (not generalized to other times/countries):
  - Larger firms more likely to use derivatives.
  - Primary hedging goal is to minimize variability in cash flows and accounting earnings.
  - Concentration in OTC forwards (>50 percent), OTC options (around 20 percent), OTC swaps (around 10 percent); exchange-traded futures < 10 percent, exchange-traded options ~2 percent.
- Recommendation for further research: more empirical studies across countries and time periods to better understand global firms’ exchange rate risk measurement and hedging behaviors.

*Source: _wp06255 - 1.   Identification of the types of exchange rate risk that a firm is exposed to and measurement of the associated risk exposure (PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06255.pdf_