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Forward points refer to the difference between the spot rate and the forward rate in a foreign currency forward trade. This difference is measured in the amount of percentage points, also known as basis points, either added to or subtracted from the spot rate of a currency pair trade. If there are points added to the spot rate, it is known as a forward points premium. When points are subtracted from the spot rate, this creates what is known as a forward discount.
Much of the trading done on the foreign exchange market, also known as the forex market, centers on the trading of currency pairs, which are two countries with different values attached to their currencies. For example, the United States Dollar (USD) and the European monetary unit known as the Euro (EUR) would be one currency pair. In some cases, the pairs are traded via forward trades, in which no money is exchanged between the parties involved until some date in the future, which is known as the maturity date. Forward points come into play when such forward trades are made.
When a forward trade is made, the forward points are determined at that time and are unchanged by any market fluctuations. This is one of the advantages of a forward trade to a trader, in that there is no uncertainty to the trade that can be caused by one or both of the currencies either rising or falling from their current value. The rate of the trade is locked in at the time of the trade.
How many forward points are involved in a trade is determined by current and forward interest rates, how much time will elapse between the time the trade is made and its maturity date, and other market factors. Basis points, which are essentially percentage points that represent the difference in worth between the two currencies in a currency pair, are the determining factor in measuring the trade. Either a forward premium, which is an increase in basis points, or a forward discount, which is a decrease, can occur.
For example, imagine that the current spot rate in a trade between the USD and the EUR is 0.7532 USD/EUR. This means that $1 USD is currently equal to 0.7532 EUR. The one-year forward rate for the pair is 0.7632 USD/EUR. In a one-year forward trade of the pair, the forward points would be 100, which is 0.7632 minus 0.7532, with the decimal then removed to clarify the amount. It would be an example of a forward premium because the basis points went up in the trade.
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