Trading and Relative Value · Forwards Trading Guide

A gap from textbook interest parity can reflect scarce funding, balance sheet costs and market segmentation. It is not enough to compare two attractive screen rates.

Start with matched alternatives

Covered interest parity compares cash flows that are equivalent in currency, amount, date and risk. A calculation using a deposit rate in one market and a policy rate in another may not describe any executable strategy. For a real replication, identify who will lend, who will borrow, the available size and all settlement obligations.

Recognise the basis

Observed FX forwards can differ from a simple interest differential model. The difference can be expressed through a currency basis, although sign conventions depend on the quotation and market. Hedging demand, dealer balance sheet constraints and the availability of particular currencies can influence it. Treat a reported basis number as incomplete without its currency pair, tenor and convention.

Deduct the actual frictions

Suppose a hypothetical matched calculation suggests a $5,000 benefit. Executable exchange spreads cost $1,200, incremental funding costs $2,000, and collateral funding is estimated at $1,500. Only $300 remains before operational costs and model error. If one funding quote cannot be locked for the full interval, even that $300 is not a certain profit.

Test what cannot be traded

Restrictions on short sales, currency conversion, balance sheet capacity or access to the reference rate can prevent replication. An offshore NDF and a local deliverable forward can have different fixings or settlement risks. Do not call their price difference arbitrage without proving that all cash flows can be locked and transferred under the relevant rules.

Try it yourself

A pricing gap appears only because the worksheet assumes borrowing at a rate unavailable to the trader. Is the gap an executable arbitrage?

Show the worked answer

No. Replace the assumed rate with an executable funding quote and include all matched cash flows and costs before making that claim.

Further reading

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.

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