FX forwards and options
By SuperdayReps · Michigan Ross Undergrad | Wharton MBA · ex-Citi | ex-Greenhill · Former Head Mentor at a Leading IB Prep Service
14 min read · updated November 3, 2026
A corporate client rarely wants to trade currency today. It wants to know what it will pay or receive in six months, or it wants protection with the upside left open. Those two needs are the forward and the option, and between them they are most of what an FX sales desk sells to companies. Trading desks then live with the risk: a forward is hedged with spot and interest rates, and an option is hedged with spot, over and over, as the market moves.
In an interview, two things come up. First, price a forward from interest rates and say why it is not a forecast. Second, explain an FX option and how you would hedge one you sold. Both reward saying the direction slowly before you say the trade. This lesson assumes you can read an FX quote; if not, start with how the FX market works.
A forward is spot adjusted for the interest rate gap, because a dealer can build the same thing by borrowing one currency and depositing the other. The higher-yielding currency always trades at a forward discount that exactly cancels its extra interest. And every FX option is two options at once: the right to buy euros with dollars is also the right to sell dollars for euros.
Why a forward is priced off rates
A client wants to buy 1,000 euros for dollars in one year. The dealer does not need a view on the euro. It can lock the outcome in today:
- Borrow dollars now.
- Convert them into euros at spot.
- Deposit the euros for a year.
In a year the euro deposit has grown into exactly what the client needs, and the dealer owes back the dollar loan plus interest. The forward rate is whatever makes that break even. Any other price hands someone free money, and banks would trade until it disappeared.
That logic is covered interest parity:
Forward = Spot x (1 + quote currency rate x t) / (1 + base currency rate x t)
where t is the time to delivery in years. For EUR/USD the euro is the base, so the dollar rate goes on top.
Worked example
Illustrative numbers: EUR/USD spot 1.1000, one-year dollar rate 4%, one-year euro rate 2%.
- Forward = 1.1000 x 1.04 / 1.02 = 1.1216 (1.12157 before rounding).
- Check that it leaves no free money. Start with 1,100 dollars. Deposit them at 4% and in a year you have 1,144 dollars. Or convert them at spot into 1,000 euros, deposit those at 2% to get 1,020 euros, and sell the 1,020 euros forward at 1.12157. That is also 1,144 dollars. The two routes match, which is the whole point.
- Six months, using half of each annual rate: 1.1000 x 1.02 / 1.01 = 1.1109.
Notice which way it goes. The dollar pays more interest, and the dollar is at a forward discount: in the forward, a euro buys more dollars than it does today. You earn more holding the higher-yielding currency, and you give that extra interest back through the forward rate.
The same rule with the dollar as the base: USD/JPY spot 150, dollar rate 4.5%, yen rate 0.5%. The one-year forward is 150 x 1.005 / 1.045 = 144.26. The dollar, the higher yielder, again trades at a discount, this time about 574 yen pips below spot.
Putting the rates upside down and giving the high-yielding currency a forward premium. Test it: if the dollar paid more interest and could also be sold forward at a better price than spot, you would borrow euros, buy dollars, earn the higher rate and sell them forward for a riskless profit. The high yielder has to trade at a discount.
Keep reading
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Frequently asked
- How is an FX forward rate calculated?
- From spot and the two interest rates, not from anyone's forecast. Forward equals spot times one plus the quote currency's rate, divided by one plus the base currency's rate, each scaled for the time to delivery. With EUR/USD at 1.1000, a one-year dollar rate of 4% and a euro rate of 2%, the forward is about 1.1216.
- What are forward points?
- Forward points are the forward rate minus spot, written in pips. Dealers quote them separately because spot moves all day while the points move only when interest rates do. Spot 1.1000 plus 216 points gives a forward of 1.1216.
- Is the forward rate a prediction of the future exchange rate?
- No. It is arithmetic that removes a riskless profit between borrowing in one currency and lending in the other. The idea that the higher-yielding currency will actually fall by the rate gap is called uncovered interest parity, and on average it fails, which is why the carry trade has tended to make money.
- How does a bank hedge an FX option it sold?
- With spot, sized by the option's delta. If a client buys a euro call on 10 million euros with a delta of 0.5, the bank is short the call and acts as if it were short 5 million euros, so it buys 5 million euros in spot. As spot moves the delta changes, and the bank buys or sells more to stay hedged.
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