A U.S. importer agrees today to pay €10 million in 90 days. Spot is 1.10 USD/EUR; the 90-day forward is 1.105. The importer locks in $11.05 million on the forward and sleeps soundly. The treasurer who reads only spot and projects spot-times-amount books $11.0 million in the budget, a $50,000 miss when the forward settles. Covered interest rate parity says forwards are not just spot guesses; they are tied to the interest rate differential, and FRM Part I tests whether you can compute the implied no-arbitrage forward correctly.
Three FX instruments, three quote conventions.
- Spot trades for settlement two business days forward (T+2) for most currency pairs. Quotes show the price of one currency in another, so a EUR/USD spot of 1.10 means $1.10...
- Forward trades for any future settlement date, most commonly 1 month, 3 months, 6 months, 12 months.
- Futures trade on exchanges (CME EUR/USD futures, JPY/USD futures, etc.) with standardized maturities and central clearing. Liquid for major pairs; thinner for crosses.
Common mistakes
- Inverting the CIP formula. puts domestic in the numerator. Reversing produces the wrong forward. Trap: with EUR/USD spot 1.10, USD rate 5%, EUR rate 3%, the right one-year forward is . Reversed gives 1.079, which appears as a wrong-answer choice.
- Confusing transaction with translation risk. A €10M payable due in 90 days is transaction risk; consolidating a German subsidiary's quarterly P&L is translation risk. Trap: question describes a U.S. parent's German subsidiary recording a €5M operating profit and asks "what type of FX risk?" The answer is translation, not transaction.
- Treating UIRP as an empirical regularity. UIRP says high-rate currencies should depreciate to equalize expected returns. They don't, high-rate currencies often appreciate, and the carry trade exploits that failure. Trap: question asks "what does UIRP predict for next year's spot of a 6%-rate currency vs. a 2%-rate currency?" The textbook answer is depreciation.
Bottom line
- Spot quotes settle T+2; forward quotes lock a future rate; futures trade on exchanges (CME) with standardized maturities.
- Bid-ask spread = ask − bid; spreads widen for thinner pairs and longer-dated forwards.
- Three FX risks: transaction (contracted future cash flow at uncertain rate), translation (consolidating foreign-subsidiary financials), economic (long-run competitive position), each needing a different hedge.
- Covered interest rate parity: . A no-arbitrage condition making hedged borrowing in either currency pay the same; violations create riskless profit.
Exam shortcut
When a question gives spot, two interest rates, and asks for the forward, the answer chain is fixed: with rates matched to the horizon. The high-rate currency trades at a forward DISCOUNT, useful as a directional check on the answer. For risk-type questions, ask "is this a contracted cash flow, a consolidation entry, or a long-run competitive shift?" That triage maps to transaction, translation, economic.
The full lesson (about 3,277 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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