Forward Rate

The forward rate is the rate at which an investor can purchase or sell a currency pair at some date in the future. The forward rate is made up of forward points which are added or subtracted from the spot rate. The spot rate is the standard rate which currency pairs is trade, for delivery within two business days.

Forward points are basis points that are either added or subtracted from the spot rate to derive the forward rate. A forward discount is when the forward rate of one currency relative to another currency is higher than the spot rate. A forward premium is when the forward rate of one currency relative to another currency is lower than the spot rate.

A forward rate agreement is an over-the-counter contract between two parties that determines the interest rate and exchange rate beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. A forward rate agreement is a customized, over-the-counter financial futures contract on short-term interest rate deposits.

When an investor purchases a currency pair he will either need to pay away interest to hold the pair or receive interest for holding the pair. If the interest rate of the currency he is long is greater than the interest rate of the short currency, the investor will earn a yield. If the reverse is true the investor will need to pay away a yield. For this reason higher yielding currencies are more attractive as the investor can earn a carry position by holding the higher yielding currency. If the spot exchange rate is stable, the investor can earn income from just holding the currency pair.

A carry trade is a trade in which an investor borrows money in one currency and uses that money to finance another risk position. For example if an investor purchases Australian dollars which currently have an overnight borrowing rate of 2.5% and sell the US dollar which has an overnight rate of 0.25% the investor will earn 2.25% (2.55% – 0.25%) if the AUD/USD remains unchanged for 1 year.