Forward Points

Last Updated :

21 Aug, 2024

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Table Of Contents

What Are Forward Points?

Forward Points are basis points added or subtracted from the spot price of a currency pair to derive the futures price on a predetermined delivery date. It is commonly used in the foreign exchange market. These points are pips, also known as forward spread.

These basis points signify the interest rate differentials between two currencies. When added to the spot rate, they indicate a premium, while subtracting them yields discount points. A discount spread suggests that a currency holds more excellent value presently than it is anticipated to in the future.

What Are Forward Points?

Forward points, which are expressed in basis points, are utilized to adjust the spot rate of a currency pair, thus determining its forward price.
These are adjusted from the current market price of the currency pair to ascertain the future value of the forward contract.
When an investor trades a high-interest currency for a low-interest-rate currency, negative forward points are added to the forward contract.
The forward point varies based on how far the delivery date of the futures contract is, so for one year, the spread will be different compared to the 30-day forward.

Forward Points Explained

Forward points determine the currency forward rate in a binding contract, commonly used in the forex. The contract is set on a predetermined exchange rate for a particular currency pair trading (buying or selling) on a future date. These contracts do not involve upfront margins when used by big banks and financial institutions, and the terms are customizable for any maturity date or set price.

It helps calculate the forward spread or discount points depending on whether it is being added or subtracted from the spot rate of a currency. In essence, the higher-yield currency is discounted, and the lower-yield currency may have a premium. An investor with a forward contract in the foreign exchange market can use it to determine the future price of a forward contract.

Now, it readily depends on the currency pair, the exchange rate, and the length of the futures contract. The length plays a vital role in varying the price. When an investor purchases a high-interest-rate currency and rolls it over the next business day, they are entitled to receive pips. The calculation is simple, and the difference explains the varying price an investor must pay as the obligation of the binding contract. There is always a risk of parties defaulting on the delivery and not following the obligations of the forwards' contract; hence, better calculation and wise trading are advised while involved in such contracts.

Formula

These points represent the interest rate differentials between two currencies and are typically added or subtracted from the spot rate to derive the forward rate for a future delivery date.

The formula to calculate it is straightforward:

Forward points formula = 1/10,000 of the spot rate

It means that one forward point equals 1/10000 of the spot rate. It provides a precise method for determining the adjustment needed to arrive at the forward rate, considering the interest rate differentials between the currencies involved in the transaction.

Examples

Let us understand the concept with the help of some hypothetical and real-world examples below.

Example #1

Let's consider a forward contract with 45 forward points.

According to the formula,

one forward point = 1/10000 of a spot rate

Therefore, 45/10000 = 0.0045

If the forward rate is 1.899, then

1.899 + 0.0045 = 1.9035

Similarly, the same forward contract with the same forward rate of 1.899 is to be deducted from the spot price.

Then, 45/10000 = 0.0045

If forward points were subtracted from the forward rate

1.899 - 0.0045 = 1.8945

Example #2

State banks in China, known for their pivotal role in managing currency markets, have recently been active in acquiring offshore yuan. This move, according to industry insiders, is intended to tighten liquidity in the offshore yuan market and counteract downward pressure on the currency.

These state-owned banks, acting either on behalf of the central bank or for their trading purposes, play a significant role in influencing currency dynamics. In this instance, their actions have led to a notable increase in offshore yuan tomorrow-next forward points, a vital indicator of the cost associated with shorting the yuan in the near future.

Its increase indicates a higher cost for traders looking to short the yuan in the near future. This development aligns with recent efforts by Chinese authorities to maintain stability in the currency market amidst ongoing economic uncertainties. By tightening offshore yuan liquidity and increasing the cost of shorting the yuan through forward points, state-owned banks are contributing to the broader efforts to stabilize the currency amidst depreciating pressures.

Forward Points vs Swap Points

Below is a comparison highlighting the critical differences between forward and swap points, two concepts essential in understanding interest rate differentials and exchange rate calculations in the foreign exchange market.

Swap points represent the interest rate differential between two currencies and are used to adjust the exchange rate in a currency swap transaction. Forward points, on the other hand, represent the interest rate differential between two currencies and are used to determine the forward exchange rate in a forward contract.
Swap points are commonly used in currency swap transactions, where two parties exchange currencies for a specific period, typically to manage their interest rate exposure. Forward points are frequently used in forward contracts, where two parties agree to exchange currencies at a future date at a predetermined exchange rate.
Swap points are calculated based on the difference in interest rates between the two currencies involved in the swap transaction. Forward points are calculated based on the difference in interest rates between the two currencies involved in the forward contract, typically adjusted for the time to delivery.
Swap points are utilized in over-the-counter (OTC) currency swap agreements between institutions, allowing them to manage their currency and interest rate risks. Traders and investors use forward points in the foreign exchange market to hedge against future exchange rate movements or speculate on currency fluctuations.

Frequently Asked Questions (FAQs)

What affects forward points?

These are affected by the forex forward contract's length and the interest rate disparity between the two currencies of a single pair. Furthermore, the prevailing exchange rate between the currencies affects the derivation of forward points. Interest rate disparity is also established to showcase the economic equilibrium and remove arbitrage opportunities.

Are forward points positive or negative?

It can either be positive or negative in value. When the basis points are subtracted, it is referred to as a forward discount, and when they are added, they are called forward premium.

What is the difference between forward points and discount spread?

Forward points are the gap between the spot price of the currency and the forward rate of the same currency in the future. However, the significance lies in knowing whether the basis point values are positive or negative. Discount spread is when the basis points are subtracted from the spot rate of a currency to determine the future price.