In finance and investing, the word 'hedge' means to minimize risk. When it comes to currency hedging, many different types of investors, traders, and corporations will want to minimize the risk that comes with dealing with different foreign currencies and exchange rates.

The people that are most concerned with exchange rate-related risks are those that manage international corporations, because there are certain risks that come with exchanging large amounts of foreign currency.

International corporations, depending on the size, can sometimes have entire branches of their company that are devoted to exchanging currencies and minimizing the risks associated with this kind of activity. This is especially true for the corporations that do business in many different countries, since it is necessary to use local currency if you want to do business in a foreign country. If you don't think this is true, try going to your local grocery store and paying with Swiss francs!

For the large, publicly traded companies that do international business to the tune of billions of dollars, the risks associated with exchange rate fluctuations can be very large. For example, if an American-based corporation does a lot of business in Europe, they will need to exchange US dollars for Euros. But if the EUR/USD exchange rate dramatically increases (meaning that they will need more dollars to buy the same amount of Euros), then this can be a very large increased cost for that corporation.

A popular way that these types of big corporations will minimize or hedge their exchange rate risk is to use currency derivatives such as futures or options. The concept behind a forex derivative is quite simple, so do not let this type of exotic financial terminology confuse you: A future or an option is simply an agreement between two parties to exchange money at a future date at a predetermined price.

Here is a simple example to illustrate this point: Let's continue with the example of an American-based company doing business in Europe, and let's say the current EUR/USD exchange rate is an even 1.00. This company might be afraid that over the next few months, the exchange rate could move to 1.15, meaning that they would need to spend more dollars to do the same amount of business.

The way that they might hedge against this risk is to use a currency option, which is an option to purchase currency at a selected exchange rate in the future. So what this company might do is obtain a 3-month option to exchange EUR/USD at 1.04 in three months. This means that if the exchange rate three months from now is at 1.15, they can use this option and still exchange their dollars at the much lower rate of 1.04. If the exchange rate is still 1.00, they will not want to use their 1.04 rate, and instead will only lose the small amount of money that it cost to set up the option.