# What Is the Underlying in a Foreign Currency Forward Contract

Under the terms of the contract, the counterparty must compensate the exporter by making a payment to the exporter equal to the difference between the fixed rate and the current exchange rate. In this case, the exporter will receive \$0.2 million from the consideration as cash compensation. If the spot price for USD/EUR = 0.7395, it means that 1 USD = 0.7395 EUR. The interest rate in Europe is currently 3.75% and the current interest rate in the US is 5.25%. In 1 year, 1 dollar earning US interest will be worth 1.0525 US dollar and earn 0.7395 euros, which brings the European interest rate of 3.75%, will be worth 0.7672 euros. Thus, the 1-year spot forward rate is equal to 0.7672/1.0525 or, using the equation above (note, however, that rounding errors between the 2 different methods used to calculate the forward rate result in slight differences): How does a currency term work as a hedging mechanism? Suppose a Canadian exporter sells goods worth \$1 million to a U.S. company and expects to receive export products in a year. The exporter is concerned that the Canadian dollar has risen from its current rate (1.0500) in one year, meaning it would receive fewer Canadian dollars per U.S. dollar. The Canadian exporter therefore enters into a futures contract to sell \$1 million per year in the future at a forward rate of \$1 = C\$1.0655. The value of a term position at maturity depends on the ratio between the delivery price ( K {displaystyle K} ) and the underlying price ( S T {displaystyle S_{T}} ) at that time.