This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving "nonlinear" instruments like options.CORPORATIONS TAKE RISK MANAGEMENT very seriously-recent surveys find that risk management is ranked by financial executives as one of their most important objectives.^ Given its real-world prominence, one might guess that the topic of risk management would command a great deal of attention from researchers in finance, and that practitioners would therefore have a welldeveloped body of wisdom from which to draw in formulating hedging strategies.Such a guess would, however, be at best only partially correct. Finance theory does do a good job of instructing firms on the implementation of hedges. For example, if a refining company decides that it wants to use options to reduce its exposure to oil prices by a certain amount, a BlackScholes type model can help the company calculate the number of contracts needed. Indeed, there is an extensive literature that covers numerous practical aspects of what might be termed "hedging mechanics," from the computation of hedge ratios to the institutional peculiarities of individual contracts.Unfortunately, finance theory has had much less clear cut guidance to offer on the logically prior questions of hedging strategy: What sorts of risks * Froot is from Harvard and NBER, Scharfstein is from MIT and NBER, and Stein is from MIT and NBER. We thank

This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving "nonlinear" instruments like options. CORPORATIONS TAKE RISK MANAGEMENT very seriously-recent surveys findthat risk management is ranked by financial executives as one of their most important objectives.' Given its real-world prominence, one might guess that the topic of risk management would command a great deal of attention from researchers in finance, and that practitioners would therefore have a welldeveloped body of wisdom from which to draw in formulating hedging strategies. Such a guess would, however, be at best only partially correct. Finance theory does do a good job of instructing firms on the implementation of hedges. For example, if a refining company decides that it wants to use options to reduce its exposure to oil prices by a certain amount, a BlackScholes type model can help the company calculate the number of contracts needed. Indeed, there is an extensive literature that covers numerous practical aspects of what might be termed "hedging mechanics," from the computation of hedge ratios to the institutional peculiarities of individual contracts.Unfortunately, finance theory has had much less clear cut guidance to offer on the logically prior questions of hedging strategy: What sorts of risks * Froot is from Harvard and NBER, Scharfstein is from MIT and NBER, and Stein is from MIT and NBER. We thank

This paper reviews the large and growing literature which tests PPP and other models of the long-run real exchange rate. We distinguish three different stages of PPP testing and focus on what has been learned from each. The most important overall lesson has been that the real exchange rate appears stationary over sufficiently long horizons. Simple, univariate random walk specifications can be rejected in favor of stationary alternatives. However, we argue that multjvaj-ja tests, which ask whether any linear combination of prices and exchange rates are stationary, have not necessarily provided meaningful rejections of nonstationarity. We also review a number of other theories of the long run real exchange rate --including the Balassa Sarnuelson hypothesis --as well as the evidence supporting them. We argue that the persistence of real exchange rate movements can be generated by a number of sensible models and that Balassa-Samuelson effects seem important, but mainly for countries with widely disparate levels of income of growth. Finally, this paper presents new evidence testing the law of one price on 200 years of historical commodity price data for England and France, and uses a century of data from Argentina to test the possibility of sample-selection bias in tests of long-nm PPP.

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