Read and explain quotes for spot and forward exchange rates
The idea
An exchange rate quote has a base currency and a price currency, and the convention is price/base: USD/EUR at 1.10 means one euro costs 1.10 dollars. Reading a quote backwards is a common error in this material, and it inverts every conclusion that follows. A forward rate is not a forecast — it is the spot rate adjusted for the interest rate differential, because otherwise borrowing in one currency and lending in the other would be free money. The currency with the higher interest rate trades at a forward discount. Quotes come in pairs, and a dealer buys the base currency at the bid and sells it at the ask.
Formulas
Covered interest rate parity
forward ÷ spot = (1 + rprice) ÷ (1 + rbase)
- forward
- the forward rate, price currency per unit of base currency
- spot
- the spot rate, quoted the same way round
- rprice
- the interest rate on the price currency, for the period
- rbase
- the interest rate on the base currency
An arbitrage relation, not a forecast: hedged, the two ways of holding money for a period must pay the same. The currency with the higher interest rate trades at a forward discount, which is exactly what cancels the rate advantage.
A practice question
In the quote USD/EUR 1.10, the base currency is the:
- euro — correct
- US dollarWhy not: The dollar is the price currency here: 1.10 is the number of dollars one euro costs.
- one with the higher interest rateWhy not: Interest rates determine the forward points, not which currency is written as the base.
The convention is price over base, so the quote gives the number of dollars needed to buy one euro.
A harder one
The currency with the higher interest rate trades at a forward:
- discount — correct
- premiumWhy not: A premium would allow a risk-free gain: earn the higher rate and sell the proceeds forward at a better rate than spot.
- rate equal to spotWhy not: Equal forward and spot rates would leave the interest differential uncovered, which is exactly the arbitrage parity rules out.
Its forward price is lower, which is what stops the interest advantage from being an arbitrage.
The hardest tier
Spot USD/EUR is 1.10, US rates are 5% and euro rates are 3%. The one-year forward USD/EUR is closest to:
- 1.08Why not: Applies the differential the wrong way round, multiplying by 1.03/1.05. The price currency's rate belongs on top.
- 1.10Why not: The spot rate unchanged, which would leave the two-point interest differential uncovered and open an arbitrage.
- 1.12 — correct
The lower-rate currency trades at a forward premium: 1.10 x 1.05 / 1.03 is about 1.121.
In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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