Currencies and FX

Core Concepts

Spot Rate

The price of one currency in terms of another for immediate delivery (T+2 settlement). Quoting convention: EUR/USD = 1.10 means 1 euro costs 1.10 US dollars. Some pairs are quoted as the number of foreign currency units per dollar (USD/JPY = 150), while others are quoted as dollars per foreign unit (EUR/USD = 1.10, GBP/USD = 1.27).

Forward Rate

The agreed exchange rate for a future currency transaction, determined by the interest rate differential between the two currencies. Forward rates are not forecasts of future spot rates — they are arbitrage-determined prices that reflect the cost of carry.

Covered Interest Rate Parity (CIP)

An arbitrage condition that must hold (and empirically does, closely):

F/S = (1 + r_d) / (1 + r_f)

where F = forward rate, S = spot rate, r_d = domestic interest rate, r_f = foreign interest rate (for the same period). If CIP were violated, riskless arbitrage would be possible by borrowing in one currency, converting, investing, and locking in the return with a forward.

Uncovered Interest Rate Parity (UIP)

A theoretical (not arbitrage-enforced) condition: