FX Forwards and Forward Points

An importer has signed a contract to pay EUR 5,000,000 in six months. His costs are in dollars, his budget was approved today, and he has no idea what EURUSD will be in June. He does not want a view on the euro; he wants the number in his spreadsheet to be true. So he calls his bank and agrees, now, the rate at which he will buy those euros in six months. That agreement is an FX forward.

A forward is the plainest derivative there is: two parties fix an amount, a rate and a future settlement date, and nothing changes hands until that date arrives. No premium, no option, no choice at maturity — you will exchange at the agreed rate whatever the market does.

Why dealers quote points, not prices

The forward rate for any given date moves all day long, but almost all of that movement is spot moving. The gap between spot and forward is driven by interest rates, which barely twitch. So the market quotes the gap and lets you add your own spot. That gap, expressed in pips, is the forward points (or swap points).

$$F = S + \frac{\text{points}}{10{,}000}$$

In words: take spot, then shift it by however many pips the points say. For most pairs a pip is the fourth decimal, so you divide by 10,000; for yen pairs a pip is the second decimal, so you divide by 100 instead. Positive points mean the base currency is at a forward premium, negative points a forward discount.

Worked example: hedging the importer

EURUSD spot is 1.0800, dollar rates are 5.00 percent and euro rates 3.00 percent, and the six-month points are quoted at +106.

1. Build the outright. $F = 1.0800 + 106/10{,}000 = 1.0906$.
2. Price the hedge. Buying EUR 5,000,000 forward costs $5{,}000{,}000 \times 1.0906 = 5{,}453{,}000$, so USD 5,453,000 in six months.
3. Compare with spot. At today's rate the same euros would cost USD 5,400,000. The forward costs USD 53,000 more, which is simply 106 pips at $500 a pip.

That USD 53,000 is not a bank fee. It is the six months of extra interest his dollars would have earned had he kept them, handed back through the exchange rate. Nothing was paid up front.

Now check what the hedge actually did. If EURUSD is 1.1200 in June, the unhedged importer pays USD 5,600,000 and the hedge saved him USD 147,000. If it is 1.0500, the unhedged importer pays USD 5,250,000 and the hedge cost him USD 203,000. Hedging removes uncertainty, not cost — he traded a range of outcomes for one known number, which was the whole point.

Worked example: deriving the points yourself

USDJPY spot is 150.00, three-month dollar rates are 5.40 percent and yen rates 0.60 percent. Here the dollar is the base currency and the yen the quote, and $T = 0.25$.

$$F = 150.00 \times \frac{1 + 0.006 \times 0.25}{1 + 0.054 \times 0.25} = 150.00 \times 0.98816 = 148.224$$

The forward sits 1.776 yen below spot, and since a yen pip is 0.01 that is −177.6 points. There is a mental shortcut worth keeping:

$$\text{points} \approx S \times (r_q - r_b) \times T$$

which reads as "spot times the rate gap times the fraction of a year". Here $150 \times (0.006 - 0.054) \times 0.25 = -1.80$ yen, or −180 points, within a couple of pips of the exact answer. Good enough to sanity-check a dealer's quote in your head.

Where it shows up

Corporates use forwards to fix receivables and payables. Fund managers use them to hedge the currency exposure inside a foreign portfolio, rolling short-dated contracts and paying or earning the points as forward point drag. Dealers use them as funding instruments, since a spot trade plus an offsetting forward is an FX Swaps deal and therefore a collateralised loan in two currencies. Where a currency is not deliverable, the same economics are settled in dollars as a Non-Deliverable Forwards contract.

Key terms

• Outright forward — a single exchange at an agreed rate on a future date.
• Forward points — the forward minus spot, quoted in pips.
• Forward premium / discount — base currency stronger or weaker forward than spot.
• Value date — the settlement date the forward rate applies to.
• Broken date — any maturity that is not a standard tenor, priced by interpolating the points.