Forward rate
What is Forward rate?
A forward rate is an exchange rate agreed today for exchanging currencies on a specified future value date.
Forward curves should be stored by trade date, maturity, value date, quote convention, points or outright format, and collateral basis. Using today's curve to reconstruct old hedged returns creates look-ahead bias and removes the carry and stress conditions investors actually faced.
Credit support, regulation, funding, and market segmentation can create deviations from simple textbook parity relationships.
Portfolio forecasts should model the full rolling hedge path rather than extrapolate one current forward rate indefinitely.
How forwards work
A forward contract specifies currencies, notional, rate, maturity, settlement, and counterparty. Deliverable forwards exchange principal; non-deliverable forwards settle a net amount against a fixing. Contracts are commonly over the counter and can be customized, though liquidity concentrates in standard dates. Closing early requires an offsetting value at current market terms.
Forward pricing
Under covered interest parity, the forward relationship reflects spot and interest rates in the two currencies for aligned periods. A higher-yielding currency commonly trades at a forward discount, not because the market necessarily forecasts depreciation but because otherwise hedged arbitrage could arise. Cross-currency basis, credit, funding, and market frictions affect observed pricing.
Points and outright quotes
Markets may quote forward points added to or subtracted from spot, or an outright future rate. Sign interpretation depends on pair convention. Annualized forward premium and discount require correct day count. Confusing points, pips, percentage changes, and outright rates can create large operational errors even when the economic hedge idea is sound.
Portfolio applications
Forwards hedge foreign assets, liabilities, subscriptions, distributions, and future purchases, or express active views and carry strategies. Rolling short contracts maintains exposure but realizes gains and losses and changes rate each period. Hedge return includes spot change, forward pricing, transaction cost, collateral, and mismatch from changing asset values.
Risks and controls
Counterparty, settlement, collateral, liquidity, basis, rollover, overhedging, and capital-control risks remain. Confirm legal agreement, netting, credit support, notional, direction, fixing, value date, and holidays. Stress large spot moves and asset declines. Do not present a forward rate as a consensus prediction of the future spot rate.
Sources and further reading
- Currency Management: An Introduction, CFA Institute
- Triennial Central Bank Survey of foreign exchange and Over-the-counter Derivatives Markets, Bank for International Settlements