Reducing a risk by entering into a contract that will serve to counter all or part of the potential loss.
For example, consider the following scenario: You make a sale to a foreign company and specify the price in the buyer's currency. The nature of the sale is such that you won't receive most of the purchase price for some months, but you must begin to incur costs today, in your local currency, in order to fulfill the terms of the contract. If the rate of exchange between your local currency and the foreign currency suddenly drops dramatically and unexpectedly, then when you convert the payment you receive into your local currency it may no longer cover the costs you incurred, resulting in you taking a loss on the sale when you thought you would make a good profit. You can hedge against this risk by buying, from a currency trader, a forward contract that gives you the right to sell a specified amount of that foreign at a price (in your local currency) set in the contract and on a specified date (preferably the date you will receive payment) in the future.
Contributed by: Managerwise Staff