FX Spot, Forward, and Covered Interest Parity¶

One-line definition¶

The FX forward rate is the spot rate adjusted for the interest-rate differential between the two currencies — no independent forecast of future spot is involved.

Formula (covered interest parity, CIP)¶

F = S * (1 + r_domestic*T) / (1 + r_foreign*T)

S quoted as domestic currency per unit of foreign currency (e.g. USD per EUR).

Why PMs care¶

CIP means the forward rate is a mechanical, no-arbitrage function of rates, not a market view on where spot is headed. A PM pricing a hedge or a cross-currency trade needs the forward, not a spot forecast.

Worked example¶

Spot = 1.10 (USD/EUR), r_USD = 5%, r_EUR = 3%, T = 1 year:

F = 1.10 * 1.05 / 1.03 ≈ 1.1214

The higher-rate currency (USD) trades forward at a discount relative to the lower-rate currency's spot advantage — EUR is "expensive forward."

Common mistakes¶

treating the forward rate as a spot forecast
getting the base/quote currency convention backwards (which rate goes in the numerator matters)