Spot and Forward Transactions
Spot and forward mechanics
A spot transaction is an agreement to exchange currencies for near-date settlement, normally T+2. A forward outright fixes an exchange rate today for a value date beyond spot, often 1, 3, 6 or 12 months. The forward rate is driven by the interest rate differential between the two currencies, not by a forecast.
- Forward points: the difference between forward and spot rates, quoted in pips. Points are added to or subtracted from spot depending on which currency has the higher interest rate.
- Premium and discount: the higher-yielding currency trades at a forward discount; the lower-yielding currency trades at a forward premium.
- Interest rate parity: F = S × (1 + i_quote × days/basis) / (1 + i_base × days/basis), using the correct day-count convention.
- NDFs: non-deliverable forwards are cash-settled in a convertible currency where one leg is restricted or non-deliverable.
Worked example
Spot EUR/USD is 1.1000. EUR interest is 3% and USD interest is 5%, with 90/360 day count. Forward = 1.1000 × (1 + 0.05 × 90/360) / (1 + 0.03 × 90/360) = 1.1000 × 1.0125 / 1.0075 = 1.10546. The forward points are about +54.6 pips. Because USD has the higher interest rate, USD is at a forward discount and EUR is at a forward premium. Buyers of EUR forward pay more USD than at spot.
Traps
- Using 365 days when the market convention is 360 for the pair.
- Treating forward points as a prediction of spot.
- Forgetting that bid and ask forward points can have different signs and magnitudes.
- Missing holiday-adjusted value dates and NDF cash-settlement details.