Forward points represent the difference in price between currency rates for two different delivery dates. Typically, they are expressed as the number of pips added to or subtracted from the current spot rate of a currency pair to obtain the forward rate for delivery on a specific value date in the future. They may also reflect the difference between two forward rates for two different dates in the future.
Forward points are mainly affected by the difference in interest rates between two currencies. This is because forward currency trades are contracts in which one party implicitly borrows one currency from, and simultaneously lends another to, the second party. For example, if someone is selling US dollars against euros for delivery in three months’ time and the US 3-month interest rate is higher than the euro interest rate, the forward rate will normally be lower than the spot rate to offset the interest differential that otherwise benefits the holder of dollars. This relationship is known as the Covered Interest Parity.
Forward points are also affected by the Cross-Currency Basis. The cross-currency basis indicates the amount by which the interest paid to borrow one currency by swapping it against another differs from the cost of directly borrowing this currency in the cash market. Prior to the Global Financial Crisis (GFC) the cross-currency basis was almost always very close to zero for developed currencies. After the GFC, the cross-currency basis has become much more volatile and has occasionally widened significantly. This is often a reflection of strains in global interbank markets. Specifically, heightened concerns about counterparty risk and constrained bank access to wholesale dollar funding inhibited arbitrage during the GFC, and again during subsequent crises. It is also believed to reflect regulatory constraints on arbitrage activity by market-makers such as banks.
Keywords: currency hedging, currency overlay, currency management, cross-currency basis, covered interest parity.