A hedge is a type of protective investment designed to offset adverse price movements in a given asset. Typically, a hedge is an offsetting position taken in a related security.

As an example, assume a US firm has agreed to purchase 40,000,000 Yen worth of consumer electronics from a Japanese manufacturing firm. But the JPY 40,000,000 is due in one month. The US firm is now worried about changes in the value of Yen.

Should Yen increase in value between now and when payment is due, it will raise the price of the purchase in US dollars. What can this US firm do in the face of unstoppable foreign exchange market fluctuations?

Spot FX Hedge

For example, currently the USD/JPY exchange rate is positioned at 118.77. Thus, currently, the US firm owes $336,785.38. However, if the yen appreciates to 110.00, the US firm would owe $363,636.38, meaning its costs would have increased by over $27,000 in a month.

Cash Position	Today	In One Month
Amount Owed in Yen	JPY 40,000,000	JPY 40,000,000
USDJPY Rate	118.77	110.00
In Dollars	$ 336,785.38	$ 363,636.36
		$ 26,850.98	Loss

To hedge this risk, the US firm decides to short 40,000,000 Yen worth in dollars. In other words, the US firm sells $336,785.38 for 40,000,000 Yen. Thus, supposing the yen currency appreciates to 110.00 in a month (as it does in the previous example), the firm avoids the approximately $27,000 in loss. Essentially, profits from the spot position offset losses from the cost of the contract agreement with the Japanese manufacturer.

Spot FX Position	Today	In One Month
Size of Position	JPY 40,000,000	JPY 40,000,000
USDJPY Rate	118.77	110.00
In Dollars	$ 336,785.38	$ 363,636.36
		$ 26,850.98	Gain

Conclusion

In the end, the gains from the spot position offset any losses from the 'cash' or contracted position. Should the Spot FX position have resulted in a loss, profits from the contract would have offset the spot losses.

Hedges reduces risk associated with contracts to pay or receive. In this case hedging facilitated international trade, but hedging works in agriculture, manufacturing, raw materials and other industries.

Hedging allows business people to focus on their business, and not worry about unavoidable price fluctuations.