Final answer:
A hedge is a financial strategy used by firms to mitigate investment risks, such as currency fluctuation risk. The necessity of hedging depends on a firm's risk tolerance and potential market movements. It is distinguished from diversification, which is about spreading risks across various investments.
Step-by-step explanation:
A hedge is a financial transaction utilized by firms to protect themselves from various investment risks, such as currency risk due to exchange rate fluctuations. For example, a U.S. firm exporting to France may receive payment in euros but is concerned about a potential decrease in value against the U.S. dollar. The firm can enter a contract that locks in a specific exchange rate for euros to dollars for a set period, at the cost of a fee, thus ensuring they know the future financial value of their contract irrespective of market changes.Whether all firms should hedge their risks is debatable. While hedging can provide certainty and protection against adverse movements, it comes at a cost and sometimes it might turn out to be unnecessary if the market moves favorably.
Companies have to weigh the cost of hedging against the potential risks and their risk tolerance.Portfolio investment and diversification are related concepts but serve different purposes. Diversification is about spreading investments across various assets to reduce the impact of any single investment's poor performance, whereas hedging is about reducing specific risks through contractual agreements.