In currency trading, forward points are the number of basis points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date. When points are added to the spot rate, this is called a forward premium; when points are subtracted, it is referred to as a forward discount. The forward rate is determined based on the difference in interest rates between the two currencies and the time until the maturity of the trade.
Forward points are also known as the forward spread.
Basis points can be either added or taken away from the spot rate. If they are added, they are forward points. If subtracted, they are discount points.
Key Takeaways
- In currency trading, forward points are the number of basis points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date.
- A discount spread is the subtraction of forward points from the spot rate to derive the forward rate for a currency.
- When points are added to the spot rate, it is called a forward premium; when points are subtracted, it is a forward discount.
Mastering the Basics of Forward Points
Forward points are essential for pricing both outright forward contracts and foreign currency swaps. Transactions can be executed for any valid business day in both currencies. Some of the most commonly traded forward currencies include the U.S. dollar, the euro, the Japanese yen, the British pound, and the Swiss franc.
Forwards are generally executed for periods of up to one year, though longer-term contracts are available with lower liquidity. In an outright forward foreign exchange contract, one currency is bought against another for delivery beyond the spot date. The forward price is the spot rate plus or minus forward points to the value date. No money changes hands until the value date.
In a foreign exchange swap, one currency is bought for a near date (typically spot) against another currency, and the same amount is sold back for a forward date. The rate for the forward leg of the swap is the near-date rate plus or minus the forward points to the far date. Money changes hands on both value dates.
Understanding Discount Spreads
In contrast to the forward spread, a discount spread subtracts currency forward points from the spot rate to obtain a forward rate for a currency. In currency markets, forward spreads are presented as two-way quotes, featuring a bid price and an offer price. In a discount spread, the bid price is higher than the offer price, while in a premium spread, the bid price is lower than the offer price.
Examples of Forward Points
Forward points are often quoted in numbers, such as +13.2 or -270.68, which represent 1/10,000th of the rate value. For instance, +13.2 converts to 0.00132 when added to a currency spot price.
To illustrate, if the euro can be bought versus the dollar at the rate of 1.1350 for spot, and the forward points are +13.2, the forward rate becomes 1.13632 (1.1350 + 0.00132).
By analyzing this information, we can infer that the U.S. interest rate is higher than that of the Eurozone. Positive forward points when buying EUR/USD signify that the rate increases the further out you go. This adjustment reflects the interest rate differential between the two currencies.
For example, if the euro interest rate is 1% and the U.S. interest rate is 2%, holding U.S. dollars instead of euros provides a 1% interest rate advantage. Currency exchange rates for the future must consider these differentials, which is why forward points play a significant role in future rate calculations.
Related Terms: basis points, spot rate, forward rate, forward contract, foreign currency swap, liquidity, value date, discount spread.
