Hedging is measure usually taken by a firm or individual as a cover against future potential adverse events. It is like an insurance against economic or financial risk that may occur in future. The term hedging is thus usually used from an investor’s point of view. There are several types of hedging. An important one is the currency hedging where an entity or person dealing with foreign currencies takes safe measures against exchange rate fluctuations.
Currency hedging is covering the foreign exchange risk.
In the case of currencies, hedging is taken by exporters/importers, foreign investors etc. These groups need foreign currency or sells foreign currency in future to meet their trade and investment needs. For example, any depreciation of rupee becomes loss incurring for importers (as it raises the price of the imported commodity in terms of the domestic currency). Similarly, any appreciation of rupee will be loss making for exporters (as it reduces the export price of a commodity in domestic currency). Hence, to ensure that rupee into dollar and dollar into rupee are made at the fixed exchange rate; whatever happens to the market exchange rate in future, these people can resort to some measures where they can get their preferred currencies at an assured exchange rate.
Hedge funds are institutions who buy and sell foreign currency from the customers (traders and foreign investors) at a fixed rate on an agreed future date. Similarly, there are other facilities like currency futures ( a type of currency derivative) which gives opportunity for investors to hedge their currency.
Here is an illustration of currency hedging.
Imagine that an Indian exporter has made export worth $1000. If the prevailing exchange rate is 1$ = Rs 60, he can get Rs 60000 at the said date suppose after three months. Now, if the rupee appreciates to 1$=50, he can get only Rs 50000. Here, he may have incurred some losses because of the exchange rate fluctuations. To overcome the situation, the exporter can hedge his position by signing a contract with financial institutions providing hedging services. After payment of the hedge premium, like in the case of a life insurance premium, the exporter can convert his export earnings at the current exchange rate (1$ = Rs 60) even if the rupee appreciates at the time of reimbursement of his export earrings.
Similarly, in the currency future market (derivative), the exporter can take can take an option to sell $1000 at $1 = Rs 60 for the particular future date. All these are examples for currency hedging.