Understanding forward point in Forex is especially important for anyone who is in the market or wants to get into it. There are diverse types of forward points, and it is also known as forward spread. In this article, we will look at what forward point is and how you can use it in trading. Let us dive in without further ado.
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What is a forward point?
Forward spread (forward point) refers to the difference in price between a security’s spot price and the forward price calculated at specific intervals. Depending on whether points are added or deducted from the spot price, it can be termed forward premium or forward discount. The basis of forward rate is the difference in the interest rates of any two currencies and the time remaining till its maturity.
What Is a Forward Point?
Forward points are the basis points that are either deducted from or added to the spot rate. The spot rate can also be understood as the commodity’s market price. Forward point comes into play when an investor must decide between buying a commodity now or in the future. If they decide to buy it now, they would do so according to the spot rate. If they decide to purchase it at a later point in time, they will have to do so at the forward rate (spot rate +/- forward rate). It is a valuable tool for Forex traders.
How Does a Forward Point Work?
Forward point is the difference between the spot price and the future price of a commodity, and it is calculated based on various external factors. We will get into the specific formula to calculator forward point in a while. It is used in both forward contracts and foreign currency swaps. The U.S. dollar, Euro, Yen, British pound, and Swiss franc are among the most widely traded forward currencies. In the next sections, we will look at how forward point works and what is the formula to calculate it. We will also look at the relationship between Forward Points, Interest Rates, and Forward Rates.
What Is the Forward Point Formula?
You must find out the forward rate first to calculate the forward point. Let us take the example of the U.S. dollar and the Namibian dollar for illustrative purposes. Let us assume that the USD (US Dollar) and NAD (Namibian Dollar) are quoted at USD/NAD = 12.47, and their annual interest rates are 4.25% and 7.00% respectively.
Now we can easily find out the forward rate using this formula:
Forward Rate: NAD/USD = spot * (1+ r_NAD)÷ (1+r_USD) = 12.4700 * (1 + 0.0700) ÷ (1+ 0.0400) = 12.80 (rounded)
Thereafter, you can calculate forward point with this formula:
Forward points: Forward rate - spot rate = 12.80 - 12.47 = 0.33
As you can see, calculating forward rate and forward point is not very difficult when you have the formula.
Examples of Forward Points
Forward points are usually expressed as numerical quantities. It could be something like +13.5 or -260.68, for example. These figures represent 1/10,000th. When a currency spot price is multiplied by +13.5, the result is 0.001325.
The future rate is 1.13632 (or 1.1350 + 0.00132) if the euro can be purchased against the dollar at a spot rate of 1.1350 and the forward points are +13.2.
Even with such limited data, we can deduce that the US interest rate is higher than that of the Eurozone. When buying the EUR/USD, the positive forward points signify the fact that the rate rises as we move forward into the future.
What Is the Relationship Between Forward Points, Interest Rates, and Forward Rates?
Understanding the relation between forward points, interest rates, and forward rates is crucial to understand the Forex market. Forward points, in most circumstances, are also a reflection of interest rate differentials and disparities between currency pairs. Depending on how low or high interest rates are, the points can be positive or negative. To express and account for interest rate differentials between currency pairings, you can alter the spot rate by adding or subtracting forward points. In other words, the currency with a higher yield will be depreciated, while the currency with a lower return will be rewarded. You will be considerably better off in the market if you understand the complex relationship between forward rates, forward points, and interest rates.
How to Calculate Forward Rate Using Forward Points?
Refer to the section where we discussed forward point formula to understand how you can calculate forward rate using forward points. While the calculations look complex, you can easily get into the mathematics underneath. Once you understand the maths, figuring out the forward rate using forward points will not be very difficult.
A forward point is 1/10000 of a spot rate. A forward contract, for instance, is thought to have 170 forward points. It is stated as 170/10,000, and it is multiplied by the spot price to provide a future rate projection. 0.017 units equals the ratio 170/10,000.
As a result, the forward rate will be calculated by multiplying the current spot rate by 0.017 units. The future rate would be 0.017 units less than the spot rate if the 170 forward points are deducted from the spot rate.
Difference Between a Forward Point and A Discount Spread
A discount spread, unlike a forward spread, is the currency forward points reduced from the spot rate. It is used to calculate a currency's forward rate. Forward spreads are given as two different quotes in the currency markets. They have a bid price and an offer price, which indicates they have an offer price and a bid. The bid price will be greater than the offer price in a discount spread. In a premium spread, however, the bid price is lower than the offer price.
What Are Forward Contracts?
A forward contract can be defined as a flexible derivative contract where two parties agree to buy or sell an asset at a predetermined price at a future date. They can be customized for a particular commodity, quantity, and delivery date. These contracts are considered over the counter (OTC) instruments because they are not traded on a centralized exchange. When opposed to contracts that are released to the market on a regular basis, financial institutions that launch forward contracts have a higher level of risk when it comes to settlements and defaulting.
Conclusion
We hope this glossary of terms will help you in your Forex trading endeavours.