If the CAPM explains deviations of the forward exchange rate from the expected future spot exchange rate, explain why one party involved in a forward contract would be willing to enter into a contract with an expected loss

What will be an ideal response?

If the party that is long in the forward market has an expected profit, the party that is short in the forward market has an expected loss. The CAPM explains this seeming dilemma because the party that is long would have a risky asset. The covariance of the profit on the long position with the return on the market portfolio would be positive, and this positive covariance is what makes the contract risky. The person who is on the short side of the forward contract would have an asset whose covariance with the world market portfolio was negative. They would receive profit when the market portfolio was doing poorly, and they would be willing to take an expected loss because of the desirable property of the negative covariance, which is like having portfolio insurance.