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Spot vs Forward FX Contracts

Spot FX exchanges currencies now, settling in two business days for most pairs. Forward FX fixes a rate today for exchange on a future date.

The essential point, and the one most misunderstood: the forward rate is not a forecast. It is arithmetic on interest rates.

Covered interest parity

F=S×1+idT1+ifTF = S \times \frac{1 + i_d T}{1 + i_f T}

with SS spot, idi_d and ifi_f the domestic and foreign interest rates, and TT the time in years.

The logic is a no-arbitrage argument. You have two ways to hold domestic currency in one year:

  1. Deposit domestically at idi_d.
  2. Convert to foreign currency at SS, deposit at ifi_f, and lock in a forward to convert back.

Both are risk-free, so both must return the same, or there is free money. That equality is what fixes FF.

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