Jargon: “forward-points” are bid/ask quotes. These are added on top of spot quotes

Jargon: full-forward-rates are the bid/ask quotes after the adjustments.

Sound byte: if my currency “drops”, then my interest rate should compensate that.

Q1: Suppose AUD (or USD…) spot interest rate is 200 bps [1] for a 1-year term. Yen spot rate is 150 bps. Suppose spot USDJPY = 100. What can you say about today’s AUDJPY forward rate with far date a year from now?

A1: this is ~~Covered-Interest-Rate-Parity ~~in action. Formula below gives F = 100*1.015/1.02 = 99.5098.

A more basic question is

Q2: will AUDJPY rate rise or fall?

We need to be thoroughly familiar with Q2 — AUD must WEAKEN (to 99.***) to reduce the high AUD return of 200bps!

[1] don’t care about Libor or treasury rate. Just consider it a measurable interest-rate

In practice, the 2 IR, the spot and forward fx rates always follow the equation. convert-deposit == deposit-convert. Otherwise, there will be arbitrage. This is described in both my bank online learning and [[complete guide]]

——textbook eg—–

USD 1 mth IR = 418 bps/year

GBP 1 mth IR = 480 bps/year

Spot cable = 1.7249

Number of days in the month = 31

Days basis GBP = 365

Days basis USD = 360

Let’s calculate 1-mth GBPUSD forward rate.

418 * 31/360 = 35.99444 bps of interest in USD

480 * 31/365 = 40.76712 bps of interest in GBP

Option A: 1 GBP invested today becomes #1.004076712 in a month

Option B: 1 GBP converted to USD and invested today becomes $1.7249 * 1.003599444 = $1.731109. Formula is S*(1+IR)

To make these 2 investments equally appealing to an investor, forward GBPUSD rate must be

1.731109/1.004076712 = 1-mth forward GBP/USD = 1.72408, which represents a depreciation of 8.2 pips.

Intuitively, GBP pays more interest, so GBP must depreciate. If GBP were to appreciate, then it’s too good to be true.

Textbook answer — Forward points = -0.00082

[ Formula is Spot-GBPUSD * (1 + IR-on-USD) == Forward-GBPUSD * (1 + IR-on-GBP)]

[ GBP convert to USD then deposit =========== GBP deposit then convert to USD ]

[ convert then deposit ==================== deposit then convert ]

—– a similar textbook example —–

AUD 3-mth 550 bps (high-yielder)

USD 3-mth 425 bps

Spot AUD/USD = 0.7326

Days = 92

Days basis AUD = 365

Days basis USD = 360

Forward AUD/USD = 0.7626 * (1 + 425 bps/360*92)/(1 + 550 bps/365*92) = 0.730431

Textbook answer — Forward points = -0.002169