Forward points

Forward points
See also
Interest rate differential Alternative futures Net Volume Gold-silver ratio Interest Rate Collar Gamma hedging Outright Forward Bear steepener After the bell

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).

Discount Spreads

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):

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.

Examples of Forward points

• A company needs to purchase Japanese Yen to pay for a shipment of parts from Japan. The current spot rate is ¥122.25 / $1.00. The forward rate for a 3-month contract is ¥122.50 / $1.00. This means that the forward points are +25 points, or +0.0025 to the spot rate.
• A company is looking to buy Euros to pay for a shipment of goods from Europe. The current spot rate is €1.10 / $1.00. The forward rate for a 6-month contract is €1.12 / $1.00. This means that the forward points are +20 points, or +0.0020 to the spot rate.

Advantages of Forward points

Forward points offer many advantages to traders and investors, including:

• Price certainty: when a forward contract is entered, the price of the underlying asset is agreed upon and locked in, reducing the risk of price fluctuations.
• Flexibility: forward contracts can be tailored to suit specific needs, such as the length of the contract and the delivery date.
• Price protection: forward contracts can help protect against adverse price movements, allowing traders to hedge their exposure to price risks.
• Liquidity: forward contracts are highly liquid, allowing for easy trading and exit strategies.
• Cost savings: forward contracts can offer cost savings by allowing traders to avoid costly transaction fees.

Limitations of Forward points

Forward points have several limitations. These include:

• The points are only an estimate of future exchange rates and do not guarantee that the two currencies will be exchanged at the stated rate.
• Forward points are based on the current spot rate which can change throughout the life of the contract.
• Forward points are not transferable. They are only applicable to the two currencies specified in the contract.
• Forward points can vary depending on the amount of currency being exchanged in the contract.
• The forward points are only valid for the duration of the contract and cannot be used to exchange the two currencies after the contract has expired.

Other approaches related to Forward points

Introduction: Apart from being used for quotation in forward contracts, forward points can be used in other approaches as well.

• Forward points can be used as a measure of interest rate differentials between two countries. It is expressed as the difference between the spot rate and the forward rate.
• Another method is to use forward points as a measure of currency risk. Forward points are used to assess the cost of hedging currency risk and the cost of a potential currency mismatch in a portfolio.
• Forward points can also be used to determine the cost of capital, as the cost of borrowing in one currency and lending in another, taking into account the forward points difference.
• Forward points can also be used to estimate the potential gains or losses from a currency transaction.

Summary: In summary, forward points can be used as a measure of interest rate differentials, currency risk, cost of capital and to estimate potential gains or losses from a currency transaction.

References

• Collis J., Holt A., Hussey R., (2017). Business Accounting, Macmillan Education UK, London.
• Connolly M., (2007). International Business Finance, Routledge New York.
• Debelle, G., Gyntelberg, J., & Plumb, M. (2006). Forward currency markets in Asia: lessons from the Australian experience , Forward currency markets in Asia: lessons from the Australian experience.
• Grath A., (2005). The Handbook of International Trade and Finance, The Complete Guide to Risk Management, International Payments and Currency Management, Bonds and Guarantees, Credit Insurance and Trade Finance, Kogan Page Publishers.
• Ramirez J., (2011). Accounting for Derivatives: Advanced Hedging under IFRS Advanced Hedging under IFR.
• Salih N., (2011). Principles of Financial Engineering Academic Press.
• Scott W. R., (2015). Financial accounting theory (Vol. 2, No. 0). Prentice Hall.
• Shamah S., (2006). Foreign Exchange Primer, Foreign Exchange Primer, Willey.

Author: Beata Furmanek