Pricing and Valuation · Forwards Trading Guide
A currency forward links two funding markets. Covered interest parity describes an ideal relationship, not a rule that every retail quote must match exactly.
Specify the quotation first
Let EUR/USD mean dollars per euro. In a simple model, the forward rate equals spot multiplied by the dollar growth factor and divided by the euro growth factor for the same interval. The interest rate attached to the quote currency belongs in the numerator. Reversing the currency quotation requires reversing the rates as well.
Calculate a hypothetical price
Assume spot EUR/USD is 1.1000, the dollar annual rate is 5%, the euro rate is 3%, and both use simple interest with a half year fraction. The forward is 1.1000 × 1.025 ÷ 1.015, approximately 1.110837. The difference is about 108.37 pips. The euro trades at a forward premium in this quotation even though its assumed interest rate is lower.
Follow the matching cash flows
To secure EUR 100,000 in six months through a cash replication, acquire and deposit approximately EUR 98,522.17 today. That deposit grows to EUR 100,000 at the assumed euro rate. Its spot dollar cost is about $108,374.38. Financing that dollar cost at 5% for half a year produces about $111,083.74 due at maturity, matching the model forward amount.
Recognise market adjustments
Actual forward pricing reflects relevant discount factors, currency basis, bid and ask spreads, credit and collateral terms. Different day count conventions require separate accrual fractions. Policy rates are not automatically the rates at which a customer can borrow and lend. A theoretical parity worksheet is useful for understanding a quote, but it cannot establish a free trading opportunity without executable funding and exchange transactions.
Try it yourself
Using the same simple rate assumptions, spot is 1.2000, the dollar rate is 4%, the euro rate is 2%, and the interval is one year. What is the forward?
Show the worked answer
Approximately 1.223529 dollars per euro, calculated as 1.2000 × 1.04 ÷ 1.02. It is a theoretical price under those assumptions.
Further reading
- BIS: Covered interest parity and currency basis
- CFA Institute: Currency exchange rates and equilibrium value
Educational material. Numerical examples are hypothetical and exclude costs unless stated. Forward contracts create binding obligations and may require collateral or credit approval. Actual terms, access and risks depend on the agreement and jurisdiction.
