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Wednesday, February 16, 2011

Forward rate quotations

You are not alone if puzzled about how forward FX rates are quoted.  The mystery is very simple, they are expressed in points or pips

Given that exchange rates change by the second, It would be impractical to quote them in terms of currency prices. Forward prices are usually quoted as the difference in pips—forward points—from the current exchange rate. Since currency in the country with the higher interest rate will grow faster and because IRP (interest rate parity) must hold, it follows that the currency with a higher interest rate will trade at a discount in the FX forward market, and vice versa. So if the currency is at a discount in the forward market, then you subtract the quoted forward points in pips; otherwise the currency is trading at a premium in the forward market, so you add them.

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