For firms buying and selling in global markets, exchange rate risk comes from working in multiple currencies that fluctuation in value against one another largely because of time separation - time between which a debt is incurred and paid, or when income is earned and received. If the currency could be exchanged today (on what is called the spot market), we would know what everything costs and is worth. But because the transaction won't be completed until the future, the exchange rate is uncertain, which puts in question the profitability of the transaction.
A company could simply set aside the money to make the exchange now, trading at the spot rate, making the exchange rate certain and waiting until the transaction date arrives. Most companies do not have idle funds in bank accounts denominated in multiple currencies just hanging around until needed. If a bill isn't due for 90 days, the money to pay that bill will be available then, not necessarily now. This is where a forward market for foreign exchange becomes a useful tool for managing exchange rate risk.
If I am a business with a bill to pay in the future that is denominated in a different currency, I want to know how much that bill is in today's local currency. By entering into a forward contract to buy the foreign exchange I need, I know exactly what it will cost and can make decisions based on that information about whether to proceed. The same is true if I'm going to receive foreign currency in payment at some point in the future. What is that worth to me in local currency today? I can lock in that amount with a forward contract and again make a decision about whether I want to make the sale.
A forward contract locks in today an exchange rate a specified number of days in the future. No money changes hands in the present, but the participants are contractually obligated to make the currency exchange at the specified price upon maturity. Usually small or medium sized businesses work with their local bankers to execute this kind of agreement. Banks and their networks do have access to deposits denominated in multiple currencies so the future exchange rate agreed to is largely going to be set based on differences in interest rates paid on various types of deposits.
A simple, hypothetical example: Suppose I were to win the Nobel Prize in Economics. The prize is announced in the fall, but not awarded until early winter. As a U.S. person, I am interested in U.S. dollars but the prize is awarded in Swedish kronor. Kronor are not spendable at my local shops so I'm going to want to exchange them for U.S. dollars. However, I don't have the kronor yet to exchange so I can't use the spot market. If the kronor strengthens (appreciates) against the U.S. dollar between the time the prize is announced and paid, I get more U.S. dollars on the future spot market. But if the kronor weakens (depreciates) against the U.S. dollar, my payout is reduced. I am taking a risk over time of potentially winning or losing U.S. dollars depending on the future spot exchange rate with the kronor. I could be certain today about the size of my future prize if I lock in the future exchange rate with a forward contract.
In the above example, if I enter into a forward contract I have hedged my exchange rate risk. Hedging always reduces risk. In this case, I give up the possibility of gain (the kronor appreciates, more U.S. dollars) to avoid the possibility of loss (the kronor depreciates, less U.S. dollars). I have locked in my future payment and know how everything is going to turn out. Speculation on the other hand, embraces risk. If I could win or lose depending on what happens, I'm speculating. In this case, knowing I need U.S. dollars, knowing the kronor could change favorably or unfavorably against the U.S. dollar over time, and doing nothing would be speculating with the future value of my hypothetical Nobel Prize.
In the mid 1990s, Nobel recipients (even the economics' one) operating in U.S. dollars saw the value of the prizes awarded in Swedish kronor fall in value between the time the prizes were announced and awarded due to currency instability surrounding the development of the euro. Given that experience, today recipients know they can and should hedge against exchange rate risk. Since 2010, the Nobel Foundation itself has been hedging currency risk in the portfolio it manages to support the prize payouts. Stabilizing returns over time, the directors felt, was increasingly important to ensure the portfolio would still be around to award prizes in 100 years.
Doing business requires speculation. Firms count on products to sell, venders to ship, customers to pay bills, and many things to come together for success. If any of these go wrong, losses could result. But businesses don't have to speculate on the value of future transactions due to uncertain exchange rates. Relatively simple and low cost, forward contracts are a risk mitigation tool international businesses need to utilize.