Forward Contracts and Outright Forwards
What a forward is
An outright forward is a single binding agreement to exchange a specified amount of two currencies on a future value date at a rate fixed today. It is a principal-to-principal OTC contract, creates no upfront premium, and carries counterparty credit exposure. Candidates must distinguish the forward rate from the spot rate and understand that the forward rate is driven by the interest rate differential between the two currencies, not by a forecast of the future spot rate.
Computing forward rates
Use covered interest parity: forward = spot times (1 + interest rate of quote currency times days/360) divided by (1 + interest rate of base currency times days/360). Adjust day-count conventions per currency. Forward points are the difference between forward and spot, quoted in pips; they are added to or subtracted from spot depending on which currency trades at a higher interest rate. A currency at a higher interest rate trades at a forward discount; the lower-rate currency trades at a forward premium.
Traps in questions
Classic traps: assuming forward points predict spot direction; forgetting to annualise interest rates correctly or to use the right day count; mixing up which currency's rate goes in the numerator; and ignoring that a forward can be closed out before maturity at a gain or loss, creating a cash flow but no delivery. Also watch for questions about non-deliverable forwards, which settle in a convertible currency against a fixing rather than delivering the restricted currency.
Rule of thumb
Higher interest rate currency trades at a forward discount. If your computed forward implies the opposite, you have inverted the interest rate ratio.
Worked example
Spot USD/JPY 150.00, 90-day USD rate 5.00%, JPY rate 0.10%. Forward = 150.00 times (1 + 0.001 times 90/360) / (1 + 0.05 times 90/360) = 150.00 times 1.00025 / 1.0125 = 148.18. JPY, the lower-rate currency, is at a forward premium.