Final answer:
Hedging is a financial strategy used by businesses to protect against investment risks like foreign exchange fluctuations, ensuring a known future revenue by locking in a specific exchange rate through a contract.
Step-by-step explanation:
In the context of commodities and the foreign exchange market, hedging is defined as using a financial transaction to protect oneself against risk from an investment. For example, a U.S. firm exporting to France and receiving payments in euros may wish to hedge against currency risk due to the volatile dollar/euro exchange rate. By entering a financial contract that guarantees a specific exchange rate one year from now, the firm can avoid the risk of the euro devaluing, ensuring they know exactly what their future revenue will be in U.S. dollars. Although hedging may come with a fee or result in an unnecessary cost if the currency instead appreciates, it offers protection against potential losses.
Hedging is a widespread practice among businesses dealing with international transactions, where fluctuations in currency values can significantly affect profits. To facilitate hedging, firms often rely on financial institutions or brokerage companies, which earn money through fees or by creating a spread in the exchange rate for their services.