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What does a foreign currency hedge protect against?
Changes in interest rates
Variability in foreign currency transactions
Market fluctuations
Credit risks from counterparties
The correct answer is: Variability in foreign currency transactions
A foreign currency hedge primarily protects against variability in foreign currency transactions. This type of hedge is used by businesses and investors engaged in international operations or investments, where fluctuations in exchange rates can lead to significant gains or losses. Such variability may occur due to changes in economic conditions, political stability, or market sentiment, affecting the value of currencies and the cost of transactions in those currencies. By utilizing hedging instruments, such as forward contracts or options, companies can lock in exchange rates for future transactions or manage potential losses from adverse currency movements. This is crucial for maintaining predictable costs and revenues when dealing with foreign markets. Understanding that a foreign currency hedge does not protect against changes in interest rates, market fluctuations unrelated to currency, or credit risks is essential. Those risks relate to other aspects of financial management, but the primary focus of a foreign currency hedge is to mitigate the impact of fluctuations in exchange rates on cross-border transactions.