Hedging is a type of investment intended to nullify potential losses that may be incurred by another investment. In simple terms, when you hedge, you insure yourself in case of a negative event. Hedging is widely used in Forex.
Here is an example, suppose you want to do business with company based in Australia and your base currency is USD, so in order to make transactions you will need to have Australian dollars, so suppose you enter in a business contract which says, you will pay AU$ 200,000 amount to the counter party after three months. The amount of money described in the contract is based on current exchange rate (say AUD/USD = 1.0200), so the amount in USD that you will pay is US$ 204,000. What if after three months the exchange rate rises to 1.0500, so now in order to pay AU$200,000, you will have to give US$ 210,000.
In order to avoid this loss due to fluctuation in exchange rate, your company will buy 2 future contracts of AUD/USD each worth AU$100,000. So what this will do is, if the exchange rate rises your loss in transaction will be nullified by the profit in the future contracts and if the rate drops the loss in future contract will be nullified by the profits in transaction. This is called as Hedging.
