What is exchange rate risk and how can a business hedge it?

• A. Risk from currency value fluctuations; hedge with forwards, options, or natural hedges like local sourcing.
• B. Risk from currency value fluctuations; hedging is not possible.
• C. Risk from domestic inflation; hedge with fixed-pricing.
• D. Risk only for importers; exporters are unaffected.

Answer: (A)

Exchange rate risk is the risk that changes in currency values will affect the value of money a business earns or spends in different currencies. To manage this risk, a company can use forward contracts to lock in a future exchange rate or options that set a price limit or floor, helping to protect margins against unfavorable moves. A natural hedge, such as sourcing locally or aligning costs and revenues in the same currency, reduces exposure without using derivatives. Hedging is a common and feasible way to stabilize cash flows and earnings across currencies. The other statements miss how hedging works or misstate who is affected: currency risk isn’t about domestic inflation, hedging isn’t impossible, and both importers and exporters can be affected by exchange rate fluctuations.