Final answer:
Financial contracts tied to the value of an underlying asset are known as derivative instruments. They enable businesses to secure a real price that factors in inflation or to hedge against fluctuations in currency exchange rates. These strategies help in managing portfolio investment risks.
Step-by-step explanation:
Financial contracts whose fair value is based on the price of an underlying asset or obligation are called derivative instruments. These contracts, like the ones adjusting prices according to inflation, allow businesses to agree on a real price that reflects the actual purchasing power, rather than just a fixed nominal price. Similarly, companies may use hedging contracts to protect against uncertain changes in currency values. For instance, a U.S. firm exporting to France might use a hedging contract to lock in a specific exchange rate for euros received in the future, thus mitigating the risk of exchange rate fluctuations and ensuring a known value for the euros when converted back to U.S. dollars.
Hedging is a key concept in managing portfolio investment decisions and can involve using derivative financial instruments to offset potential losses due to risks associated with the investment. Financial institutions or brokerage companies often facilitate these hedging arrangements for a fee or by creating a spread in the exchange rate.