Lesson 4 of 6 · All lessons in this module
- Building a cross-rate from two quotesVideo lesson
- Triangular arbitrage and reading currency moves
- Forward points, premiums and discounts
- The no-arbitrage link between spot, forward and interest ratesVideo lesson
- Forward points, maturity and the rate differential
- Integrated cases: hedging a receivable and comparing dealers
Lesson 4 of 6 · 14 min
The no-arbitrage link between spot, forward and interest rates
Investing at home and investing abroad with the currency risk hedged forward are both riskless, so they must earn the same; that one condition fixes the forward rate.
In short
- Route 1: invest one unit of domestic currency at . Route 2: convert at spot, invest at , and sell the proceeds forward. Both are riskless, so they must pay the same.
- With quotes in foreign/domestic (f/d) form: , which gives .
- In price/base terms: the forward is above spot when the price currency's interest rate is higher. The higher-rate currency trades at a forward discount.
- A forward quote that breaks the equation creates riskless arbitrage: borrow in the route with the lower return, invest in the one with the higher return.
- Forwards are sometimes read as expected future spot rates, but they are poor predictors in practice; treat them as the output of the arbitrage equation.
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