Foreign Exchange Forward Points

Foreign exchange forward points are the adjustment, expressed in pips, that converts a spot exchange rate into the rate for an outright forward deal on a future value date. If EUR/USD trades at 1.0850 spot and three-month forward points are +54, the three-month forward rate is 1.0904. The points are not a forecast of where the exchange rate will be; they are set by the difference in interest rates between the two currencies over the period.

Forward points are used whenever a company, investor or bank prices a forward contract, such as an exporter locking in the rate for future receipts. The same figures, seen as the price of exchanging currencies now and reversing later, are called foreign exchange swap points. Forward points are therefore the language of hedging a future cash flow, while swap points are the language of funding and rolling positions.

Suppose you could put money in a savings account at 4.5 per cent in one country or 2.5 per cent in another. If you could also fix today the rate at which you will switch between the two currencies in three months, the market would not let you earn the extra 2 per cent for free. The fixed future rate is adjusted just enough to cancel out the interest advantage.

Forward points are that adjustment. They make the forward rate a little better or worse than today's rate, depending on which currency pays more interest. The currency with lower interest rates is worth a bit more in the forward market, and the currency with higher rates a bit less.

Under covered interest parity, the outright forward rate for a currency pair quoted as units of the quote currency per unit of the base currency is:

and the forward points are:

• $S$ is the spot rate and $F$ the outright forward rate.
• $r_{q}$ and $r_{b}$ are the interest rates of the quote and base currencies, as decimals.
• $d$ is the number of days from spot to the forward value date, and $B_{q}$ and $B_{b}$ are the day-count bases, 360 for the US dollar and euro and 365 for sterling.
• The multiplier 10,000 applies to pairs quoted to four decimal places; for yen pairs it is 100.

Take EUR/USD spot at 1.0850, US dollar rates at 4.5 per cent, euro rates at 2.5 per cent and a 90-day period. The forward rate is 1.0850 × (1 + 0.045 × 90/360) ÷ (1 + 0.025 × 90/360) = 1.0850 × 1.01125 ÷ 1.00625 ≈ 1.0904. The forward points are (1.0904 − 1.0850) × 10,000 ≈ +54. The euro, the lower-yielding currency, trades at a forward premium.

Dealers quote forward points as a two-way price, such as 53.5/54.5. When the first figure is smaller than the second, the points are added to spot, meaning the base currency is at a premium; when the first is larger, they are subtracted, meaning a discount. The client's all-in forward rate combines the spot bid or offer, the forward points bid or offer and any dealer margin, so the cost of a forward includes the bid-ask spread on both. Points are quoted for standard tenors, such as one week and one, three, six and twelve months, with broken dates interpolated.

• Hedging. Corporate treasurers use points to calculate the cost or benefit of hedging foreign exchange risk. An importer buying a high-interest currency forward obtains a better rate than spot, while one buying a low-interest currency pays more.
• Portfolio hedging. Investors running a currency overlay treat the annualised points as the carry earned or paid on their hedges.
• Non-deliverable markets. For currencies with capital controls, points on a non-deliverable forward reflect offshore supply and demand and can diverge widely from onshore interest rates.
• Market stress signal. When points differ from what interest rates imply, the gap shows up as cross-currency basis, often a sign of strong demand for dollar funding.

Forward points tell a hedger what the forward rate is, not what the spot rate will be. The forward rate has historically been a poor predictor of future spot rates, which is the basis of the carry trade. Points also embed counterparty credit and liquidity conditions, so quotes vary between banks, and for long tenors or less traded currencies they can be wide and volatile. Day-count conventions and value-date rules must be applied correctly, or small errors in the points calculation lead to mispriced hedges.