Hedging in the context of foreign exchange (FX) refers to the use of financial strategies or instruments to protect against the risk of losses caused by unfavorable movements in currency exchange rates.

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Businesses, investors, and traders use FX hedging to lock in exchange rates or set boundaries on potential losses, ensuring greater certainty over future cash flows and financial results.

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Common methods for FX hedging include forward contracts, options, and futures. For example, a company expecting to receive or pay foreign currency in the future can use a forward contract to lock in today’s exchange rate, eliminating the risk of adverse currency movements before the transaction settles. The primary purpose of FX hedging is not to make a profit, but to minimize or eliminate the risk of loss from exchange rate fluctuations.

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Example:

A U.S.-based company expects to receive a payment in euros from a European customer several months in the future. The company is concerned that the value of the euro might fall against the U.S. dollar before the payment is made, which would reduce the amount of dollars they ultimately receive.

To protect itself from this risk, the company enters into a forward contract with a bank. This contract locks in the current exchange rate for converting euros to dollars on the future payment date. As a result, even if the euro’s value drops, the company is guaranteed to receive the agreed-upon amount in dollars, ensuring stable cash flow and protecting its profit margin from adverse currency movements.

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