The Problem with Traditional FX Forward Valuation
A seemingly logical approach is to value the two cash flows of an FX forward using the respective domestic deposit rates. However, these rates do not necessarily reflect the conditions implied by the FX forward market.
As a result, valuations based solely on domestic interest rates can diverge from observable market prices. During volatile market conditions, that difference can become particularly important.
Calculating the Currency Basis Spread
Our white paper, Quantifying Currency Basis Spreads for Accurate FX Valuation, presents a practical methodology for identifying this discrepancy.
The approach compares two equivalent strategies:
- Exchanging the currency at the current spot rate and investing it at the domestic deposit rate.
- Investing in the foreign currency and exchanging it at maturity using the agreed FX forward rate.
The implied domestic interest rate required to make these two strategies equivalent can then be calculated. The difference between this market-implied rate and the observable domestic deposit rate represents the currency basis spread.
A Practical USD/SEK FX Forward Example
The white paper demonstrates the method using a USD 1 million FX forward with a 33-day maturity.
In this example, traditional domestic discounting produces a valuation discrepancy of approximately SEK 1,170 compared with the FX market-implied valuation. A currency basis spread of approximately 14.5 basis points reconciles the difference.
More Accurate FX Pricing and Risk Management
Currency basis spreads are sensitive to maturity and can fluctuate throughout the trading day. Accurately quantifying them can therefore support:
- Consistent FX forward valuation
- More precise financial reporting
- Market-aligned pricing
- Robust and responsive risk management
The methodology is demonstrated in Quantlab, where FX and interest rate inputs can be reconciled within a consistent and transparent analytical framework.
Download the Currency Basis Spreads White Paper
Download the white paper to learn how implied rates and currency basis spreads can be calculated for more accurate FX forward valuation.
