A foreign exchange ______, which is between a bank and a customer (or another bank), specifies delivery, at a fixed future date, of a fixed amount of one currency against another currency.

A. contract
B. forward contract
C. futures contract

Correct Answer: B

Here is an example: A U.S. firm buys goods from Germany with a payment of euro 500,000 due in 90 days. The current price of the euro is $1.2000, yet it may rise against the dollar, which increases the dollar cost of the goods. The U.S. firm can protect itself against this exchange risk by entering into a 90-day forward contract with a bank at a price of $1.2050. Thus, according to the forward contract, the bank will give the U.S. firm euro 500,000 in 90 days to pay for the goods and the U.S. firm will give the bank $602,500 (500,000 x 1.2050).

If the spot rate in 90 days is less than $1.2050, the U.S. firm will experience a loss on the forward contract because it is buying marks for more than the current rate. On the other hand, if the spot rate is higher than $1.2050, the importer will implicitly profit.