In the companion article, "Why derivatives don't reduce FX risk," Tom Copeland and Yash Joshi argue from a macro perspective that FX risks are often swamped by other risks and that therefore using FX derivatives is not likely to substantially reduce a company's cash flow volatility. This article explores the topic from another angle. First, how should an individual company identify and measure its foreign exchange risk? Second, what can it do about it?

Few CFOs, even among the best, measure more than a small portion of their overall risk

Identifying and measuring FX risk is far from easy. Few CFOs, even among the best, measure more than a small portion of their overall risk. Many companies manage only visible and easily quantifiable risks, such as exposure to foreign currency liabilities. And CFOs seldom comprehend all the risks in their business. They may not understand, say, the relationship between exchange rates and the local prices in the markets where they sell their products.

Nor do many CFOs appreciate all the limitations of the tools they use to manage their risks. Swaps, for instance, require margin accounts to protect the counterparty from credit risk. These margin accounts may distort the...