Which financial instrument is commonly used to hedge foreign exchange risk?

Futures contracts are commonly used to hedge foreign exchange risk because they allow a party to lock in an exchange rate for a future date. This instrument is particularly useful for businesses and investors who need to protect themselves from unfavorable currency fluctuations that can impact their international transactions. By entering into a futures contract, they can agree to buy or sell a specific amount of currency at a predetermined rate at a future time, thus mitigating the risk associated with exchange rate volatility.

In contrast, dividend stocks primarily provide income from dividends and are not designed for hedging currency risk. Government bonds serve as fixed-income investments that offer stability and security but do not directly address foreign exchange exposure. Index funds typically track the performance of a specific market index and may be exposed to currency risk depending on the assets they hold, but they are not specifically structured as hedging instruments. This distinction highlights why futures contracts are the appropriate choice for hedging foreign exchange risk.