Currency hedging is an important part of international investing. If an investor ships manufacturing to a third-world state, fluctuations in that nation's currency could spell the life or death of the investment. Hence, to take advantage of outsourcing, hedging has become an important tool to make certain that all investments--in effect--are done on the investor's home currency, There are many ways that this can be done.

Foreign Exchange Forward

This hedge is the most direct. It simply stipulates that all payments on the investment will be paid in the target currency at the present rate of value. In other words, all payments on an investment will be done at the home currency at the pre-specified rate of interest. Change is impossible.

Currency Options

In this case, a contract is drawn up at the time of the investment that gives the owner the option (though not the obligation) to either take (the call), or receive (the put) payments on the investment at a specified amount of currency, decided at the time of the contract. In this case, the hedger is giving himself the right to opt out of native currency payments in favor of his home currency payments depending on what is worth more. This is a sort of a bet based on which currency will appreciate, and which will depreciate.

Interest Rate Parity

This is a more sophisticated form of hedging that assumes that, over time, differences in floating exchange rates will average themselves out to zero, hence equalizing the value of the currencies (and the value of the payment from the investment). This form of hedge assumes that there will be no major shocks in the system in that, all other things being equal, the two invested currencies will even out over time. In general, the investor will borrow money from the currency with the lower interest rate, immediately convert it to a higher interest rate currency and invest over time to receive the higher interest rate. This can also be used in tandem with an exchange forward as a further hedge.

Source:

"Hedging -- In Finance"

"Using Interest Rate Parity To Trade Forex"