Forward Points

What Is Forward Points?

Forward points are the amount added to or subtracted from the spot exchange rate to arrive at a forward exchange rate. They are quoted in pip units, the smallest standard price increment for a currency pair. They show how much more or less one currency costs for delivery on a future date compared with delivery today.

Forward points are not a forecast of where a currency will move. They reflect the interest rates of the two currencies involved.

How Forward Points Work

When two parties agree today to exchange currencies at a future date, the price is the current spot rate plus or minus the forward points. The points reflect the interest rate differential between the two currencies over the period until delivery. The logic comes from covered interest parity, which holds that investing in either currency, with the exchange rate locked in by a forward contract, should produce the same return.

In simplified form:

Forward rate = Spot rate × (1 + quote currency rate × period) ÷ (1 + base currency rate × period)

Here the period is a day-count fraction of a year. The currency with the higher interest rate usually trades at a forward discount, which means its forward points are negative. The currency with the lower rate usually trades at a forward premium.

Example

This example is illustrative only. Suppose a currency pair has a spot rate of 1.1000, and the three-month forward points are +25 pips. Each pip for this pair is 0.0001, so the three-month forward rate is 1.1025. Whether the points are positive or negative depends on which currency carries the higher interest rate.

Why Forward Points Matter

Forward points help investors and businesses understand the cost or benefit of currency hedge|hedging foreign-currency exposure. A hedge can add or subtract the points from the outcome, so a rate gap that favors one currency can make a hedge cost money or earn money. Forward points also show what the market implies about interest rate differences, but they do not guarantee the future spot rate. In practice, supply and demand, credit conditions, and transaction costs can move points away from what interest rate parity alone would predict.