Forward Pricing – Interest Rate Parity and the Forward Curve

Why does a three-month EUR/USD forward trade at 1.0825 when spot is 1.0850? The answer isn't a forecast. It's mathematics.

Episode 10 takes on the pricing engine behind every forward contract in the FX market. David Axtell walks through Covered Interest Rate Parity — the no-arbitrage relationship linking currency markets with money markets — and explains why forward rates are determined by interest rate differentials, not by anyone's view on where the exchange rate is heading.

He starts with the intuition: two investment strategies — a direct dollar deposit versus converting to euros, investing at euro rates, and selling euros forward — must produce identical returns. If they don't, arbitrage exists and banks eliminate it instantly. That equilibrium condition sets the forward rate.

David then works through a complete EUR/USD calculation step by step: spot rate, dollar and euro interest rates, day-count conventions, and the resulting forward points. He explains why EUR/USD forward points are typically negative (USD rates above EUR rates), what "premium" and "discount" mean in practice, and why traders quote in points rather than outright rates — because points are driven by relatively stable interest differentials while outright rates move with every spot tick.

The episode covers the post-2008 reality where CIP breaks down. Basel III capital requirements, leverage ratio constraints, and structural demand imbalances mean that the cross-currency basis — the deviation from theoretical parity — persists at 20 to 40 basis points and widens dramatically during stress. David explains why this matters for pricing, hedging costs, and funding strategy.

He closes with the forward curve: how the term structure of forward points reflects market expectations about interest rate paths, and how practitioners extract implied interest rates and relative value from the curve.

Next Episode: Hedging in Practice — building a corporate hedging programme with graduated ratios, rolling programmes, and performance measurement.

Based on: Chapter 8 of FX Cash Products by Luigi Rondanini and David Axtell, forthcoming from Rondanini Publishing.