Forward points are used for quotation in forward currency contract. They are added to or subtracted from the spot rate. The forward points are calculated based on prevailing rates in the two currencies used in the contract as well as the length of this contract. They are usually quoted in fractions of 1/10000, so +100 points means +0,01 to the spot rate. If the points are greater than zero, the value is forward premium, otherwise it is a forward discount.
Forward points is in relation to cross-currency basis swap. They should be very similar or the same to limit possibility of making seemingly riskless profit on currency operations. It is regulated by covered interest parity (CIP). But CIP sometimes doesn't work as it should and difference can be spotted.
The Basics of Forward Points
Forward points are used to calculate the price for both an outright forward contract and a foreign currency swap. Points can be calculated and transactions executed for any date that is a valid business day in both currencies. The most commonly traded forward currencies are the U.S. dollar, the euro, Japanese yen, British pound and Swiss franc. Forwards are most commonly done for periods of up to 1 year. Prices for further out dates are accessible, but liquidity is generally lower. In an outright forward foreign exchange contract, one currency is bought against another for supply on any date beyond spot.
In a foreign exchange swap, a currency is bought for the near date against another currency, and the same number is sold back for the 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 (S. Shamah 2006).
In contrast to the forward spread, a discount spread is the currency forward points that are subtracted from the spot rate, to achieve a forward rate for a currency. In the currency markets, forward spreads, or points, are presented as two-way quotes; that is, they have a bid price and an offer price. In a discount spread, the bid price will be higher than the offer price, while in a premium spread, the bid price will be lower than the offer price.
The calculation of the forward points
In forward contracts, forward points are the basis points that are deducted from, or added to, the current spot rate to evaluate exactly what the forward rate will be on the supply date (M. Connolly 2007):
- Forward points are counted according to the disp in the interest rates for the two currencies used in the forward contract, at the contract lapse, or in the case of flexible forwards, at every partial settlement.
- Buying a currency with a higher interest rate using a lower yield currency produces positive forward points, which will make the forward rate higher than the spot rate. This is common as a forward premium.
- Nevertheless, buying a currency with a lower interest rate using a higher yield currency generates a negative interest, which creates a forward rate lower than the spot. This is referred to as a forward discount.
- A common misunderstanding we frequently encounter relates to the calculation of foreign exchange forward points. Foreign exchange forward points are the time value adjustment made to the spot rate to express a future date. The forward foreign exchange market is very deep and liquid and is used by an array of participants for trading and hedging purposes. In the corporate world many importers and exporters hedge future foreign currency commitments or forecasts using forward exchange contracts.
- Despite the calculation of the forward points is mathematically descendent from the interest rate market, interest rates themselves are the market’s expectation of the outlook for an economy’s fundamentals i.e. subjective. Therefore the fx forward points are derived from barters positioning on interest rate differentials.
- Exporters from countries with higher interest rate environments such as New Zealand and Australia advantage from the negative forward points, while it is a cost to importers. An exporter wants a weak base currency so large negative forward points are an economic advantage. With an upward sloping interest rate yield curve (or more correctly positive interest rate differential) forward points will be more negative the longer the time horizon.
- An importer wants a strong currency therefore negative forward points are detrimental to the hedged conversion rate. The impact of negative forward points is a reason that exporters frequently have longer term hedging horizons compared to importers because the impact of forward points are not penal.
- Forward exchange contracts are therefore a ductile, and relatively simply to apprehend, hedging tool that is widely used to bring certainty to those grappling with foreign exchange exposures and the volatility of the financial markets.
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Author: Beata Furmanek