3.5 The Foreign Exchange Market & Interest Rate Parity

3.5 The Foreign Exchange Market & Interest Rate Parity

The foreign exchange market is the largest and most liquid financial market in the world, turning over trillions of US dollars every day across a decentralised, twenty-four-hour, over-the-counter network. For a wealth manager it is rarely an asset class in its own right; it is the unavoidable second exposure attached to every foreign asset a client owns. The syllabus therefore asks for two things: the basic structure of the market, and the ability to calculate a forward exchange rate using the interest rate parity formula.

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Quotation Conventions

Every FX price is a pair: the price of one currency expressed in units of another.

$\text{GBP/USD} = 1.2650$

• GBP is the base currency — the unit being bought or sold, always equal to 1.
• USD is the quote (or counter, or terms) currency — the number of units received.
• The quote reads: one pound buys 1.2650 US dollars.

If GBP/USD rises to 1.3000, sterling has appreciated and the dollar has depreciated. Candidates lose marks by reading the direction backwards; the rule is that the number always describes the base.

Majors (EUR, JPY, GBP, CHF, CAD, AUD, NZD against USD) carry the tightest spreads and deepest liquidity. Minors are crosses between majors without the dollar. Exotics involve an emerging or restricted currency, carry wide spreads, and may be subject to capital controls — in which case exposure is taken through a non-deliverable forward (NDF), cash-settled in dollars because the local currency cannot be delivered offshore.

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Market Structure, Participants and Settlement

The FX market has no central exchange. It is a tiered, dealer-based structure:

1. The interbank / interdealer core — a small number of global banks making prices to each other on electronic platforms.
2. Non-bank liquidity providers and principal trading firms — now a very large share of spot volume.
3. The client tier — asset managers, corporates, hedge funds, custodians and retail brokers, priced off the core with a spread.
4. Central banks — managing reserves and, occasionally, intervening.

Instruments range from spot and outright forwards through FX swaps (the largest segment by turnover, combining a spot and an offsetting forward leg to roll funding), to currency options and cross-currency swaps.

Settlement and CLS

Standard spot settlement is T+2 — two business days after trade date — with the notable exception of USD/CAD, which settles T+1. Because the two legs of an FX trade settle in different countries and different time zones, the market historically carried Herstatt risk: the danger that one party pays away its currency and the counterparty fails before paying the other side.

CLS Bank was created to eliminate it. CLS settles both legs simultaneously on a payment-versus-payment (PvP) basis across a large number of eligible currencies, so neither leg is released unless both are funded. This mirrors the delivery-versus-payment principle in securities settlement.

The T+2 spot convention also creates a live operational problem in equity settlement. Since North American equities moved to T+1 in May 2024, a European manager buying US shares must fund dollars one day before the standard FX spot date — forcing pre-funding, same-day FX execution, or a standing dollar balance. When the UK and EU migrate to T+1 in October 2027 the mismatch will move to the other side of the Atlantic.

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Forward Rates and Interest Rate Parity

A forward contract fixes today the rate at which two currencies will be exchanged on a specified future date. The forward rate is not a forecast. It is a purely arithmetical consequence of the two currencies' interest rates, enforced by arbitrage.

Covered interest rate parity

Consider an investor with sterling who wants dollars in one year. Two routes must produce an identical result, or a riskless profit exists:

• Route A: convert to dollars today at spot and deposit at the US rate.
• Route B: deposit sterling at the UK rate and simultaneously sell the maturing sterling forward for dollars.

Equating the two gives covered interest rate parity:

$F = S \times \frac{(1 + i_{quote})}{(1 + i_{base})}$

where $S$ is the spot rate quoted as base/quote, $i_{quote}$ is the interest rate of the quote currency and $i_{base}$ the interest rate of the base currency, each for the period of the contract.

Worked example

Spot GBP/USD is 1.2500. The one-year sterling interest rate is 5.00%; the one-year US dollar rate is 3.00%. What is the one-year forward GBP/USD rate?

Sterling is the base, so $i_{base} = 0.05$; the dollar is the quote, so $i_{quote} = 0.03$.

$F = 1.2500 \times \frac{1.03}{1.05} = 1.2500 \times 0.980952 = \mathbf{1.2262}$

Sterling trades at a forward discount of 238 pips. This is the invariable rule:

The currency with the higher interest rate always trades at a forward discount; the currency with the lower interest rate trades at a forward premium.

The logic is symmetry. If the higher-yielding currency did not fall on the forward curve, an investor could borrow the low-yield currency, deposit the high-yield currency, sell the proceeds forward, and lock in a riskless profit — the carry trade with the currency risk removed. Arbitrage closes that gap, which is why the forward discount almost exactly offsets the interest rate advantage.

Reading the result

• A forward premium or discount measures an interest rate differential, nothing more.
• The unhedged carry trade — borrowing yen to buy Brazilian real, for example — is profitable only if the spot rate does not move as far as the forward curve implies. It is a systematic short-volatility position that "goes up by the stairs and down by the lift".
• Uncovered interest rate parity, the proposition that the spot rate will in fact move to the forward rate, is not enforced by arbitrage and is empirically a poor predictor. This is the forward rate bias.

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Currency Risk in a Private Client Portfolio

A UK investor holding a US equity fund earns two returns: the fund's dollar return and the GBP/USD move. Over a single year the currency component frequently exceeds the asset component.

The hedge is implemented with rolling forwards or FX swaps. Its cost is not the bid-offer spread but the interest rate differential embedded in the forward points — hedging a higher-yielding foreign currency back into a lower-yielding base currency earns a positive carry, and vice versa. Advisers must also warn clients about the cash-flow risk of a hedge: a hedge that moves against the client requires cash to settle at each roll, even while the offsetting gain on the underlying asset remains unrealised.