Forward points and covered interest parity, briefly

[Shadow Trader]

A forward exchange rate is the spot rate adjusted by forward points, which reflect the interest rate difference between the two currencies over the period. If a currency has higher interest rates, its forward trades at a discount. This relationship is called covered interest parity, and it has held reasonably well, with deviations during stress.

Swap rates on retail platforms come from the same arithmetic. The swap credit or debit on holding a position is essentially a share of the forward points, plus the broker's markup.

Why care? Because it explains why carry exists and why swap rates move when central banks change rates. A rise in one country's rates widens the differential and shifts the swap in favour of long positions in that currency, all else equal.

It also explains the cost structure of longer positions. A scalper holding briefly pays nothing, but anyone thinking of holding for days should compute the swap in advance.

Deviations from covered interest parity, the cross-currency basis from an earlier thread, signal funding stress.

The formulas are simple enough for a spreadsheet, and checking a broker's swap against the theoretical value reveals the markup.

For a worked example, take a long AUDUSD position held through the Wednesday rollover. Suppose the swap is +0.5 points per day. On Wednesday, the credit is tripled to +1.5. Over a quarter, the difference between a position held across Wednesday and one closed before is visible on the statement as a recurring bump.

The more extreme cases arise around holidays. If a US bank holiday falls on a Monday, rolling a Friday position can affect the value date, and swap points reflect an extra day. Brokers usually publish a holiday swap schedule, and reading it takes two minutes.

How does the broker's swap compare with the theoretical figure derived from interest rates?