What are Forward Points?
In currency trading, forward points are the number of base points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date. When points are added to the spot rate, this is called a term premium; when points are subtracted from the spot rate, it is a term discount. The forward rate is based on the difference between the interest rates of the two currencies (currency transactions always involve two currencies) and the time to maturity of the transaction.
Futures points are also known as futures spreads.
Base points can be added to or removed from the spot rate. If added, these are advanced points. If they are removed, they are discount points.
The basics of Forward points
Futures points are used to calculate the price of a firm futures contract and a currency swap. Points can be calculated and transactions executed for any date that is a valid business day in both currencies. The most commonly traded forward currencies are the US dollar, the euro, the Japanese yen, the British pound and the Swiss franc.
Transfers are most often made for periods of up to a year. Prices for other dates are available, but liquidity is generally lower. In a forward exchange contract, one currency is bought against another for delivery on any date beyond the spot. The price is the spot rate plus or minus the forward points on the value date. No money changes hands until the value date.
In a currency exchange, one currency is purchased for the near date (usually spot) for another currency, and the same amount is resold for the future date. The rate for the front part of the swap is the rate close to the date plus or minus the point before towards the distant date. Money changes hands on two value dates.
Unlike the forward spread, a discount spread corresponds to forward exchange points which are subtracted from the spot rate, to obtain a forward rate for a currency. On the currency markets, forward spreads, or points, are presented in the form of bidirectional quotes; that is, they have a price offered and a price offered. In a discount gap, the offer price will be higher than the offer price, while in a premium gap, the offer price will be lower than the offer price.
Key points to remember
- In currency trading, forward points are the number of base points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date.
- A discount difference corresponds to the forward exchange points which are subtracted from the spot rate, to obtain a forward rate for a currency.
- When points are added to the spot rate, this is called a term premium; when points are subtracted from the spot rate, it is a term discount.
Examples of Forward Points
Futures are often cited in numbers, such as +13.2 or less -270.68. These represent 1 / 10,000, so +13.2 means 0.00132 when added to a spot price in currency.
For example, if the euro can be bought against the dollar at the rate of 1.1350 for the spot and the futures points are +13.2, the futures rate is 1.13632 (or 1.1350 + 0 , 00132).
Based on this information, we can determine that the interest rate in the United States is higher than in the euro area. The positive points over time when buying EUR / USD indicate that the rate will rise further in the future. Indeed, futures points compensate for the difference in interest rates between the two currencies.
If you think about it differently if the euro interest rate is 1% and the US interest rate is 2%, you could make the difference of 1% by holding US dollars instead of euros. Thus, when exchanging or locking exchange rates for the future (forward rates), this must be taken into account.