Final answer:
The fair value of a foreign currency firm commitment hedged by a foreign currency option is determined by the fluctuations in the exchange rate. Hedging allows firms to manage risk associated with currency fluctuations by locking in a specific exchange rate through financial contracts.
Step-by-step explanation:
The fair value of a foreign currency firm commitment that is being hedged by a foreign currency option is determined by referring to changes in the exchange rate between the two currencies involved. Firms engage in hedging to protect themselves from the risk that comes from currency value fluctuations.
If a U.S. firm expects to receive payment in euros in the future but wants to ensure a known dollar value today, it might use a foreign currency option to hedge the risk of the euro depreciating against the dollar.
A commonly used hedging technique is signing a financial contract, often facilitated by financial institutions or brokerage companies, which guarantees a specific exchange rate at a future date regardless of the market exchange rate at that time.
The fair value of the firm commitment follows the fluctuations in the market exchange rate, and the corresponding change in value of the hedge is what helps the firm manage the risk associated with currency volatility.