8-minute read
FX Spot prices are widely available: a quick internet search will reveal the current interbank rate for any currency pair, but forward rates are less easy to come by.
In this article, we explain what forward rates are, how they're calculated, and lift the lid on the tricks that some brokers use to bamboozle and increase spreads.
What is a forward rate?
Very simply, it is the exchange rate to convert one currency to another at a future date. You agree to a future exchange using a trade called a 'Forward Contract'.
Forwards are quoted in one of two ways:
- Outright Rate: this is the exchange rate for the future-dated deal
- Forward Points: the points adjustment to Spot to give the Outright forward rate
💡The outright rate = Spot + Forward Points. Forward points give the interest rate differential between the two currencies. If you've ever produced compounding interest rate calculations, then you'll recognise the formula!
The outright forward rate is sensitive to the spot rate, moving almost exactly 1:1, it's therefore common to quote the forward points only, although most Corporates will trade from the Outright Rate
Harry Mills, Founder & CEO Oku Markets
A dealer might quote "+50 points"; you then know if the spot rate moves from say, 1.2500 to 1.2520, that the forward rate will move from 1.2550 to 1.2570.
Forward Points can be positive or negative:
- A positive number means the rate increases with longer maturity dates. In this instance the base currency (e.g. "GBP" in GBPUSD) is at a Premium. It costs more of the counter-currency (dollars) to buy the base currency (a pound).
- A negative number means the rate decreases with longer maturity dates. In this instance the base currency is at a Discount. It costs less of the counter-currency to buy the base currency.
You can therefore see how the forward rate might be better or worse for you depending on which currency you're buying or selling, and whether the points are positive or negative. Oku Markets will help you understand this.
If you want to exchange one currency for another right now, you will use the current "spot" exchange rate. But if you want to exchange one currency for another in the future, how do you do that?
- You could wait until the future date comes about, but the exchange rate might have changed by then, and you could make a loss (or a gain) impacting your business
- You could exchange now and hold the currency until the future date, but this means tying up cash in a currency you don't yet need; an inefficient use of capital
A better solution is to agree to exchange on a future date using a Forward Contract, but with a rate that is derived from the current spot rate. What is that rate, and how do we calculate it?
It's not guess-work
The forward rate isn't a guess at the future spot rate, it is a precise calculation using the principle of covered interest parity (and risk-free arbitrage).
⚠️ If you don't like or aren't interested in the maths, just skip this bit...
Assume the GBPUSD spot rate is 1.30 and interest rates are 0.5% in the UK and 0.25% in the US. What is the correct rate for a 1-year forward, converting GBP to USD? Let's use an example to explain, and don't worry it's pretty easy to follow:
- To borrow £1million for one year, the cost would be £5K (£1m*0.5%)
- Converting £1m to USD at $1.30, the spot rate, would return $1.3m
- $1.3m deposited for one year would earn 0.25% interest ($1.3m*0.25% = $3.25K)
- The achieved rate is therefore equal to $1,303,250 / £1,005,000 = 1.2967
- So £1m at the forward rate of 1.2967 buys $1,296,766 (not $1.3m)
By factoring the relevant interest rates into the equation, arbitrage between the spot and forward rates is effectively nullified.
So how do I calculate it myself?
Here's the formula...
Where:
- F... Forward Rate
- S... Spot Rate
- it... Interest rate of the Terms currency (e.g. "USD" in GBPUSD)
- ib... Interest rate of the Base currency (e.g. "GBP" in GBPUSD)
- Days... Number of days from spot to the forward date
- Basis... Day count convention for the base/term currency (b / t ), 360 is the norm
Example: GBPUSD 1.30 spot, 0.5% UK, 0.25% US, 1-year (360 days)
⚠️ Mathphobes can re-join here...
Useful to note...
- Fully-flexible forward contracts (AKA "open" forwards or "time options") don't exist per se, rather the rate you receive is the worst-case rate for the date window. So if the forward rate worsens for you with longer-dated contracts, your rate will be based on the farthest date. Similarly, if the forward rate improves for you with longer-dated contracts, your open/window forward rate will be based from the nearest date.
- However, fully-flexible forward contracts are a valuable and simple tool for businesses to utilise. By agreeing the rate for the window period up-front, you are avoiding any extra costs down the line for early-delivery and you can drawdown as much as you wish without penalty.
- The interest rates used in the calculation aren't simply the central bank base rates, but the prevailing market deposit rates. In this sense the forward rate captures the curve and, to a degree, market expectations of future rates.
- Forward points, whilst relatively stable compared to spot rates, do still move over time. It's not uncommon to see large swings over time as economic fundamentals and interest rates change
- You may be required to pay an up-front deposit, or hold collateral known as "margin", to enter a forward contract
- The mark-to-market value of a forward contract changes as time passes and the underlying spot rate (and the forward points) moves. You may be required to post additional collateral known as variation margin in a process called a "margin call" if your forward position moves negatively beyond a threshold
Trip Hazards
Dealing forwards is a way brokers can squeeze a little more margin by being creative with the pricing. Here are a few things to watch out for:
- Misquoting forward points to add extra mark-up (spread) is very common
- Suggesting to use fixed-date or window forwards in order that the broker can "capture" more forward points as margin, without passing the benefit to the client
- Encouraging early-delivery against a forward contract in order to capture a forward points gain (by trading an FX Swap), without passing the benefit to the client
- Offering to close a position "at no loss" likely means there is a profit that's not being given to you
- Taking a wide margin on a trade close-out to maximise dealer profit, knowing you might not be able to unwind it elsewhere
At Oku Markets, we're proud to do business with integrity and provide accurate and fair prices at all times.
How can we help you?
Oku Markets provides live forward contract trading to clients online and via our telephone dealing desk. We always give our customers fixed, consistent, fair, and transparent FX prices, so you can trust us to work with you, not against you!
Contact us at [email protected] or 0203 838 0250 to discuss your needs!
Here's a quick video of our online platform showing the few clicks to trade:
