How does a forward contract hedge currency risk?

How does a forward contract hedge currency risk?

• A. Locks in a fixed exchange rate for a future date, eliminating uncertainty for that cash flow.
• B. Predicts future spot rate movements to profit.
• C. Changes the exchange rate immediately.
• D. Eliminates currency risk for all future transactions.

Answer: (A)

Forward contracts hedge currency risk by locking in a fixed exchange rate for a specific amount on a future date. Entering a forward commits you to convert that amount at the agreed rate when the future date arrives, so the exact cash flow is known regardless of how spot rates move in between. This eliminates uncertainty for that particular transaction and aids budgeting and planning. It’s a protective tool, not a bet on future currency movements, so it won’t try to profit from rate moves. It also doesn’t remove all currency risk for every future transaction—only the exposure covered by the contract.

Forward contracts hedge currency risk by locking in a fixed exchange rate for a specific amount on a future date. Entering a forward commits you to convert that amount at the agreed rate when the future date arrives, so the exact cash flow is known regardless of how spot rates move in between. This eliminates uncertainty for that particular transaction and aids budgeting and planning. It’s a protective tool, not a bet on future currency movements, so it won’t try to profit from rate moves. It also doesn’t remove all currency risk for every future transaction—only the exposure covered by the contract.