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Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
Forward contracts are the most common means of hedging transactions in foreign currencies. The trouble with forward contracts, however, is that they require future performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable.
Hedging employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and future markets). Hedging is used also in protecting one's capital against effects of inflation through investing in high-yield financial instuments, real estates or precious metals.
