Foreign exchange is not just another asset class — it is the medium through which all other asset classes interact when they cross national boundaries. The FX market is the largest financial market in the world ($7+ trillion in daily spot turnover), and it operates almost entirely over the counter, around the clock. Its prices encode a simple but powerful no-arbitrage relationship: if you can borrow in one currency and lend in another at known rates, the forward exchange rate must be determined by those rates alone. This is covered interest rate parity (CIP), and it is the foundation for pricing all FX forwards, FX futures, FX swaps, and currency-linked derivatives.
The spot FX lesson also introduces the bid-ask spread, quotation conventions, and the distinction between spot and forward FX — concepts that appear throughout the derivatives chapters.
Learning objectives. By the end of this note you should be able to:
- describe the structure of the spot FX market: OTC, 24-hour, interdealer vs. bank-client;
- interpret direct and indirect FX quotations, and read a two-way bid-ask quote;
- state covered interest rate parity (CIP): , and prove it by no-arbitrage;
- execute the CIP arbitrage when the forward rate deviates from the no-arbitrage level;
- distinguish an FX swap (spot leg + forward leg) from an outright forward;
- explain why forward points (the forward premium or discount) depend on the interest-rate differential.
In this lesson
- The FX market structure
- Covered interest rate parity
- CIP arbitrage
- Forward points and the FX swap
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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