What are Forward Points?
Forward points are basis points that are added or subtracted to the spot rate, which is the price quote of a commodity. If an investor was interested in purchasing a particular commodity, he or she would purchase it at the price it is quoted at the time of purchase. The price is the spot rate.
Forward currency contracts tend to be quoted in forward points which are estimated with predominant interest rates of the two currencies and with the consideration of the contract length.
Also, forward points are added to or subtracted from the present spot rate of a commodity or a pair of currencies to derive an estimate for a forward rate on a specified future date. The addition of forward points to a spot rate is known as a forward premium and the opposite is true. The subtraction of forward points to a spot rate is known as a forward discount.
When it comes to currency trading, the currency with a higher yield tends to have negative points, whereas the currency with a lower yield tends to have positive points.
The concept behind the phenomenon is that lower-yielding currencies are more expensive than they would be in a forward market, and higher-yielding currencies are likely to be less expensive in a forward market. In instances where this may not be the case, an arbitrage may occur.
- Forward points are basis points that are added or subtracted to the spot rate which is the price quote of a commodity.
- A forward point is equivalent to 1/10,000 of a spot rate.
- Generally, forward points tend to mirror or reflect interest rate disparities between currency pairs. The points can either be positive or negative, in conjunction with lower or higher interest rates.
Using Forward Points to Compute the Forward Rate
A forward point is equivalent to 1/10,000 of a spot rate.
For example, a forward contract is believed to include 170 forward points. It is written as 170/10,000 and is added to the spot price to estimate the forward rate. The fraction 170/10,000 equates to 0.017 units.
Hence, the forward rate will be computed by adding the 0.017 units to the current spot rate. If the situation is reversed and the 170 forward points are to be subtracted from the spot rate, the future rate will be 0.017 units fewer than the spot rate.
Forward Points, Interest Rates, and Forward Rates
Generally, forward points tend to mirror or reflect interest rate disparities between currency pairs. The points can either be positive or negative, in conjunction with lower or higher interest rates.
The adjustment of a spot rate through the addition or subtraction of forward points is done to represent and account for the interest rate differentials between currency pairs. In essence, the currency with a higher yield will be discounted and the currency with a lower yield may have a premium.
The U.S. dollar and the Namibian dollar are currently quoted at USD/NAD = 12.47, with annual interest rates of 4.25% and 7.00%, respectively.
The forward rate can be determined as follows:
The forward point can be determined by subtracting the spot rate from the forward rate:
The points, 0.33, are known as pips, and 0.33 is equivalent to 33 pips.
Pros and Cons of Forward Contracts
The pros of entering into forward contracts include – but may not be limited to – zero or very limited upfront costs and/or the ability to fix or “lock-in” the exchange rate for a predetermined future date.
The cons of entering into forward contracts include – but may not be limited to – the risk of a counterparty not being able to meet the financial obligations outlined in the forward contract once the predetermined date is reached and/or the opportunity costs associated with potential benefits that may result from exchange rate fluctuations.
In general, forward exchange contracts are widely used as a relatively straightforward and flexible hedging method for individuals and businesses who are involved or may be susceptible to foreign exchange exposure and fluctuations.
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