FX Forward Rates and Covered Interest Rate Parity
Summary
The note asks why GBP/USD forward quotes rise above spot despite the apparent expectation that the higher-yielding US currency should strengthen. The explanation is covered interest rate parity: forward points reflect the interest-rate differential so that borrowing in one currency, investing in the other, and hedging the exchange back does not create a risk-free profit. With GBP/USD quoted as dollars per pound, the relative rates can produce a forward rate above spot when US rates exceed UK rates.
The answer also separates forward pricing from forecasting. A forward quote is the rate that balances hedged currency returns under the parity relationship; it is not a promise or reliable prediction of the future spot rate. Actual exchange-rate movements can differ, and the document recommends understanding both covered and uncovered interest rate parity. It does not quantify market frictions, basis effects, or deviations from parity.
Key ideas
- FX forward rates incorporate the interest-rate differential between the two currencies.
- Covered interest rate parity links spot, forward, and investable interest rates to prevent hedged arbitrage.
- The direction of forward points depends on the exchange-rate quote convention.
- A forward rate is a hedging price, not a guaranteed forecast of future spot.
Tags
Full text
# FX forward rates # FX forward rates FX forward rate should reflect the difference in the interate in the two currencies. At the moment GBP USD is trading near 1.29. The 5 year yield for US treasuries is about 1.87% and the UK 5 year gilt is currently yielding about 0.5%. This we would expect this is reflected in the GBP USD forward rate. We should expect the 5 year GBP USD rate to be lower than the current rate. However, the current GBPUSD forward quotes I am seeing is: Period GBPUSD SPOT 1.2848 M12 1.299483 Y2 1.3175 Y3 1.336775 Y4 1.356516 Y5 1.3755 Y6 1.3933 Why is there a discrepancy? Why is there no arbitrage? Is my reference rate wrong? ## Answer by MH.Q (score 3, accepted) https://quant.stackexchange.com/a/33935 I am assuming you are confused because you expect the USD to be stronger with the higher interest rates. I had the exact same issue as you just a few months ago. The simplest way to clarify this is that the forward market is created on a NO arbitrage basis. By logic, we assume that the country with the higher interest rates attracts more foreign investments and thereby appreciating that country's currency. The forward market is there to prevent arbitrage opportunities like this where you can invest in the higher interest rate country and simultaneously hedge your exchange exposure by going into a forward contract that allows you to exchange back into your own currency for higher interest profits. By arbitrageurs who look to do this, the forward market should have high demand for GBP/USD (they are trying to lock in rates) and therefore GBP/USD increases instead of lowers. The calculation of forward prices takes this into account and that is why you have forward rates that do not align with your expectations. Note also that forward rates are by no means an indication of future prices. They are simply there mostly as a hedging tool. The currency with the higher interest rates can most definitely end up appreciating against against the lower interest rate currency even though the forward markets says otherwise. For more information on this you can do a google search on Japaneses Yen against USD which is an interesting read. The issue you question here can be found here -http://www.investopedia.com/terms/u/uncoveredinterestrateparity.asp I suggest you read through BOTH covered and uncovered interest rate parities to fully understand.
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