Final answer:
Hedging through financial contracts helps firms mitigate currency risk from contracts denominated in foreign currencies. When international financial investors demand more U.S. dollars.
Step-by-step explanation:
Many portfolio investment decisions involve hedging to protect against movements in exchange rates. For example, a U.S. firm with a contract to receive 1 million euros in the future may not know the contract's worth in U.S. dollars due to potential fluctuations in the dollar/euro exchange rate.
To mitigate this uncertainty, the firm can enter into a financial contract (such as a forward exchange contract), guaranteeing a certain exchange rate at a set date in the future.
Financial institutions or brokerage companies often handle the logistics of hedging, where they earn revenue through service fees or by creating a spread in the exchange rate.
When international financial investors demand more U.S. dollars to purchase U.S. government bonds, the supply of U.S. dollars in foreign exchange markets decreases.
This shift in demand and supply can lead to an appreciation of the U.S. dollar against other currencies. Understanding these dynamics is crucial for businesses and investors navigating the complications of international trade and foreign exchange markets.