Final answer:
Hedging is the practice of using financial instruments to protect against the risk of future rate or price changes, particularly in the context of international trade and currency exchange rates.
Step-by-step explanation:
The use of financial instruments or contracts to reduce or eliminate risk from future changes in rates or prices is known as hedging. When companies engage in international trade, they are exposed to the risk of exchange rate fluctuations. For example, a U.S. company exporting to France and receiving payment in euros is at risk if the value of the euro decreases against the dollar. By entering into a hedging contract, the company can lock in an exchange rate for euros to dollars for a certain time in the future, thereby stabilizing its expected revenue in dollars. If the euro's value goes down, the hedge will protect the company's interests. Financial institutions or brokerage companies usually facilitate these contracts for a fee or by creating a spread in the exchange rate.
Entities utilize hedging as a form of financial protection to manage currency risk, and hedging can be an essential tool for making portfolio investment decisions in the volatile foreign exchange market.