How can you quantify currency risk in a floating exchange rate system?

What will be an ideal response?

To characterize the risk of a currency position, you must try to characterize the conditional distribution of the future exchange rate changes. With floating exchange rates, historical information provides useful information about this distribution. For example, you can use data to measure the average historical dispersion (standard deviation or volatility) of the distribution. The higher this volatility, the riskier are positions in this currency. It is also possible to rely on more forward-looking information using the options markets (see Chapter 20). Finally, we should point out that volatility is an adequate indicator of risk when exchange rate changes are approximately normally distributed. In reality, the distribution of exchange rate changes displays fat tails, even in floating exchange rate systems, and this increases the risk of currency positions.