Final answer:
Currency risk from international transactions can be mitigated through hedging, where firms use financial contracts to secure exchange rates and protect against unfavorable movements, influencing their aggregate demand and trade incentives.
Step-by-step explanation:
Many portfolio investment decisions by firms involve hedging to protect themselves from movements in exchange rates. For example, a U.S. firm exporting to France and set to receive payments in euros would be exposed to the risk that the euro may depreciate against the dollar. To mitigate this uncertainty, the firm can enter into a hedging contract with a financial institution, which guarantees a certain exchange rate at a future date for a fee, thereby securing the value of future revenue in U.S. dollars.
Firms that participate in international trade measure their costs in the local currency but often receive revenues in a foreign currency. This situation can make their financial outcomes highly susceptible to fluctuations in exchange rates.
For instance, a stronger euro can result in a French firm's costs being higher relative to their sales revenue in U.S. dollars, potentially causing a loss when converting revenues back to euros, and vice versa. Thus, exchange rate movements can significantly impact a firm's aggregate demand and incentives to export or import, which in turn influences the overall economy's aggregate demand and supply.