Forward Points

 

What are FX forward points?

Forward points represent the difference between the spot exchange rate and the forward exchange rate for a given currency pair, typically measured in pips. They are used to calculate the forward rate — the agreed exchange rate for settlement on a specified future date.

 

How do forward points work?

Forward points are either added to or subtracted from the current spot rate, depending on the interest rate differential between the two currencies.

• Forward premium: Occurs when forward points are added, reflecting lower interest rates in the base currency relative to the quote currency.
• Forward discount: Occurs when forward points are subtracted, indicating higher interest rates in the base currency relative to the quote currency.

 

What influences forward points?

Tenor of the forward contract

The longer the tenor, the greater the difference between the spot and forward rates is likely to be. This is because interest rate differentials compound over time, creating a wider spread between the two rates. For example, a one-year forward contract typically shows larger forward points than a one-month forward contract for the same currency pair.

 

Interest rate gap between two currencies

Forward points are primarily driven by the interest gap between the currencies being exchanged.

• If the base currency offers a higher interest rate than the other, it will tend to trade at a forward discount.
• A currency with a lower interest rate will trade at a forward premium.

This relationship reflects the principle of Covered Interest Parity (CIP), which ensures the forward rate adjusts to eliminate arbitrage opportunities in the FX market.

 

Broader economic and market conditions

Macroeconomic factors such as inflation expectations, central bank policy, and geopolitical developments can indirectly impact forward points by influencing interest rates and market sentiment.

For instance, if investors expect the Bank of England to raise rates faster than the Federal Reserve, sterling forward points against the US dollar may shift accordingly.

 

Forward Premiums and Discounts

Forward points can be either positive or negative, depending on the interest rate differential between two currencies. This determines whether a currency trades at a forward premium or a forward discount.

• Forward Premium: Occurs when the forward rate exceeds the spot rate, indicating that the base currency is trading at a higher value in the forward market. This typically happens when the base currency has a lower interest rate compared to the quote currency. 
• Forward Discount: Occurs when the forward rate is below the spot rate, meaning the base currency is trading at a lower value in the forward market. This happens when the base currency has a higher interest rate, and the forward rate adjusts downward to reflect the interest rate advantage.

These forward spreads uphold the principle of Covered Interest Parity (CIP), ensuring that the forward rate accounts for interest rate differences and eliminates arbitrage opportunities. Essentially, the forward premium or discount reflects the cost or benefit of holding one currency over another during the forward period.

 

Forward point example

Let’s say the current spot rate for EURUSD is 1.1000. Forward points are used to adjust the spot rate to calculate the forward rate, reflecting the interest rate differential between the two currencies.

Scenario:

• USD interest rate: 2% per year
• EUR interest rate: 4% per year
• Forward tenor: 1 year

 

1. Calculate the Forward Points

The forward points are derived from the interest rate differential. Since the EUR has a higher interest rate than the USD, the forward points will be negative, meaning the forward rate will be lower than the spot rate.

Interest Rate Differential = (EUR rate - USD rate) = 4% & 2%

Forward Rate = 1.1000 x ((1+0.02)/(1+0.04)) = 1.1000 x 0.980769 = 1.078846

 

2: Calculate the Forward Points

Forward Points = Forward Rate − Spot Rate

Forward Points = 1.078846−1.1000=−0.021154

Forward Points =−211.54 points

The 1-year forward rate for EUR/USD is 1.078846, meaning 1 EUR will buy 1.078846 USD in one year. This reflects a forward discount on the EUR.