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Forward Points: Why Forwards Aren’t a Forecast

  • A forward rate is spot adjusted by the interest rate gap between the two currencies for the period. Arbitrage holds it there, a relationship called covered interest parity.
  • Because the forward is built from today’s spot and today’s interest rates, it contains no view on where the currency will trade. The higher-yielding currency always trades at a forward discount.
  • As a forecast it has been poor. For forwards set between January 2021 and September 2025, dollar-yen a year later finished above the one-year forward on about 94% of days.
  • Academic studies since the 1980s have found the same pattern across many currencies, and it is known as the forward premium puzzle. A 2021 meta-analysis finds it weaker than usually claimed, especially for emerging-market currencies.
  • The points are best read as a price: what a hedger pays or earns for the interest rate gap, fixed for the life of the hedge.

What are forward points?

The difference between the forward rate and the spot rate, quoted in the currency pair’s price units. They reflect the interest rate difference between the two currencies over the period.

What is covered interest parity?

The no-arbitrage rule that makes converting money now and investing it abroad, with the return locked in by a forward, worth the same as investing at home. It sets the forward rate from spot and the two interest rates.

Does a forward discount mean the market expects the currency to fall?

No. It means that currency has the higher interest rate. The forward would show the same discount whatever traders expected.

Is the forward rate a good predictor of the future spot rate?

Historically, no. Many studies find it has pointed the wrong way on average, though a 2021 review of 3,643 estimates finds the bias smaller than commonly thought.

What is the forward premium puzzle?

The finding that higher-interest-rate currencies have not, on average, depreciated by as much as their forward discount implied, and have sometimes appreciated. It is the empirical basis of the carry trade.

At the close on June 30, 2023, one dollar bought 144.47 yen. A one-year dollar-yen forward, the rate for exchanging currency a year later, stood at roughly 136.90. Taken as a prediction, the market was saying the yen would strengthen by about 5% over the year.

On June 28, 2024, the dollar bought 160.88 yen. The yen had weakened to its lowest level in almost 38 years, and anyone who had treated the forward as a forecast was 24 yen out.

Nobody who priced that forward was predicting anything. The 136.90 came out of arithmetic that has no room for an opinion.

The Forward Is Arithmetic

Start with the job a forward does. Suppose you hold $1 million and will need yen in a year. There are two ways to get there, and a forward exists to make them cost the same.

In the first, you keep the dollars and invest them for a year. In mid-2023 a one-year US Treasury yielded about 5.40%, so you would end with about $1,054,000, which you then convert at the forward rate. In the second, you convert today at 144.47 and invest the ¥144.47 million for a year in Japan, where one-year government yields were slightly negative (about −0.125%). You end with about ¥144.29 million.

Both routes are free of currency risk, so they must be worth the same at the end. The only rate that makes them equal is ¥144.29 million divided by $1,054,000, which is about 136.90. That gap below spot, roughly 7.57 yen, is the forward points. (Illustrative: these use government yields rather than the futures and overnight-index-swap rates dealers build curves from, and they ignore the extra cost of borrowing dollars through the swap market, which would have pushed the real forward lower still.)

What happens if a dealer quotes the forward at 144 instead? Then anyone can borrow yen, convert to dollars, earn the higher dollar rate, and sell the dollars forward at a price that returns more yen than they borrowed. It is a riskless profit, and it would be traded away almost at once. This rule, covered interest parity, is what fixes the forward. The currency with the higher interest rate always trades at a forward discount, because the forward has to hand back the extra interest.

So where would a forecast fit in? It doesn’t: the inputs are today’s spot rate and today’s two interest rates. A trader who is sure the yen will collapse still pays the same forward as one who is sure it will soar.

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