Question : Which of the following is a method used to manage exchange rate fluctuations?

Option 1: Currency arbitrage
 

Option 2: Hedging
  

Option 3: Currency speculation

  

Option 4: Currency manipulation

Correct Answer: Hedging

Solution : The correct answer is b) Hedging.

Hedging is a method used to manage exchange rate fluctuations. It involves taking actions to offset the potential losses or risks associated with adverse movements in exchange rates. By hedging, individuals, companies, or investors aim to protect themselves against the negative impact of currency fluctuations on their investments, assets, or liabilities.

There are various hedging techniques and instruments available to manage exchange rate risk. Some common hedging strategies include:

1. Forward contracts: These are agreements to buy or sell currencies at a predetermined exchange rate on a future date. Forward contracts allow participants to lock in an exchange rate, mitigating the risk of adverse currency movements.

2. Options contracts: Options provide the holder with the right but not the obligation to buy (call option) or sell (put option) currencies at a predetermined price within a specified time period. Options offer flexibility and can protect against unfavorable exchange rate movements while allowing participation in favorable movements.

3. Currency swaps: Swaps involve the exchange of currencies between two parties, usually at the spot rate, with an agreement to reverse the transaction at a future date. Currency swaps can be used to hedge both principal and interest payments denominated in different currencies.

Currency arbitrage and currency speculation, mentioned in options a) and c), are not methods used to manage exchange rate fluctuations but rather activities involving taking advantage of exchange rate differences for profit. Currency arbitrage refers to the practice of exploiting price discrepancies between different markets or exchanges, while currency speculation involves speculating on the future direction of exchange rates to make profits.

Currency manipulation, mentioned in option d), refers to the deliberate actions taken by a country's government or central bank to influence its currency's value in the foreign exchange market. It is not a method used by individuals or companies to manage exchange rate fluctuations but rather a policy undertaken by authorities to achieve specific economic objectives.