What is the primary purpose of hedging in foreign exchange transactions?

Hedging in foreign exchange transactions primarily serves to mitigate risks associated with fluctuations in exchange rates. Businesses and investors engage in hedging strategies to protect themselves from potential losses that might arise due to adverse movements in currency values.

For example, a company that does significant business in a foreign country may face financial uncertainty if the value of that foreign currency declines against their home currency. By using financial instruments like forward contracts, options, or swaps, the company can lock in exchange rates, ensuring they know exactly how many dollars they will receive for their foreign currency sales, reducing exposure to sudden changes in the market.

This risk management strategy is essential for maintaining stable financial performance in a globalized economy, where currency volatility can greatly impact profit margins and operational budgets. Thus, the primary purpose of hedging is indeed to manage and reduce risks associated with unpredictable exchange rate fluctuations.