Forwards & Spots

FX forwards, or forward points, represent the difference between the spot FX rate and the FX rate for some future date.  (A future FX rate is known as outright FX to avoid confusion with forward points). Forward points are usually scaled up by some power of 10 for ease of market quotation.  Market conventions govern the amount of scaling up, which is usually dictated by the magnitude of the Spot FX rate.  For example GBPUSD forward points are the difference between the outright and the spot rates multiplied by 10,000.FX forwards can be thought of as a measure of the relative depreciation of one currency to another.

In some currencies the issuing country imposes some degree of cross-border currency control.  In those cases it is not always possible or easy to take or make delivery of the currency outside that territory. NDFs provide a way of hedging currency exposure without physically delivering exchanged amounts of currency.  Instead, a future FX rate is agreed and the differential of that and some published reference FX rate fixing is paid in US dollars.  The NDFs are quoted as forward points, as if for physical exchange, but the contract settlement is that differential payment.

Given the ability to borrow money in one currency, convert to another, then lend in that currency and convert the proceeds back into the initial currency to pay back the original loan, there is an arbitrage-driven relationship between forward FX rates and interest rate differentials.  This arbitrage strategy is known as covered arbitrage, but given the credit risks and transaction costs associated with such a strategy, actual arbitrage opportunities are rare.  Nevertheless, the mathematical relationship between forward FX and rates is fundamental to fair value pricing for a range of cross-currency instruments and securities.