Final answer:
To avoid exchange rate risk, the U.S. firm should purchase a 90-day forward contract on Canadian dollars, which allows the firm to lock in a future exchange rate.
Step-by-step explanation:
If a U.S. firm will need C$200,000 in 90 days to pay for imports from Canada and wants to avoid the risk from exchange rate fluctuations, it could purchase a 90-day forward contract on Canadian dollars. This is the correct option because a forward contract allows the firm to lock in the exchange rate at which it will exchange U.S. dollars for Canadian dollars in the future, thus hedging against any potential adverse movement in the exchange rates.
The forward contract would specify the amount of Canadian dollars the firm will receive and the rate at which it will exchange its U.S. dollars. If the firm were to choose the second option, selling a 90-day forward contract on Canadian dollars, it would not be meeting its need to acquire Canadian dollars in the future. The third and fourth options, which involve transacting at the spot rate in 90 days, would expose the firm to exchange rate risk, as the rate could be less favorable at that time.
Arbitrage is the process of buying and selling goods or currencies across international borders to profit from price discrepancies. Over time, arbitrage activities tend to align prices and exchange rates for internationally traded goods in different countries. However, when dealing with immediate financial obligations, such as the need for Canadian dollars for imports, companies often use financial instruments like forward contracts to manage exchange rate risks.