Firms that engage in international business through exportation or importation are faced with the risk of exchange rate fluctuation. Therefore, the financial performance of such firms may be adversely affected if effective financial management mechanisms are not adopted. Hedging is one of the strategies that such firms can adopt. Hedging is defined as the process of eliminating financial risks that emanate from exchange rate fluctuations.
The process of hedging is undertaken by setting the price at which a foreign currency will be purchased or sold today at a future date. Therefore, the parties to a particular international business transaction enter into a forward contract. The rate of exchange to be used at a future date is based on a predetermined spot rate. Moreover, interest rate differentials between the two countries involved are also taken into account in the process of setting the spot rate. As a result, an organization is in a position to avoid possible losses. International business transactions are characterized by a high degree of uncertainty, which arises from the fact that such transactions are subject to exchange rate fluctuations. The motive behind hedging is to enhance the element of certainty in international business commitments and transactions.
In summary, hedging enables businesses to manage risks that emanate from foreign exchange rate fluctuations. These fluctuations are becoming imminent in contemporary times due to the volatile international business arena. The strategy enables businesses to conduct international business by integrating the concept of forwarding contracting. Consequently, businesspersons can eliminate the element of uncertainty, which increases their likelihood of succeeding in the international market despite the existence of foreign exchange rate fluctuations.