Forex trading is a highly lucrative business, but it can be quite challenging for beginners. One of the most difficult concepts to understand is pip, which is an acronym for “percentage in point”. A pip is the smallest unit of measurement for the price of a currency pair. A pip is usually the fourth decimal place for most currency pairs, except for the Japanese yen.
Another essential concept in forex trading is a forward pip. Forward pips are the difference between the current spot rate and the forward rate that is agreed upon between two parties in a forward contract. In simpler terms, it is the number of pips that a currency pair is expected to move forward in the future.
Forward contracts are agreements between two parties to buy or sell a currency at a predetermined price and date in the future. Unlike spot contracts, which are settled immediately, forward contracts are settled at a future date. Forward contracts are used to hedge against currency risk and to lock in a future exchange rate.
The forward rate is determined by the interest rate differential between the two currencies in the pair. The interest rate differential is the difference between the interest rate of the currency being bought and the interest rate of the currency being sold. If the interest rate of the currency being bought is higher than the interest rate of the currency being sold, then the forward rate will be higher than the spot rate. If the interest rate of the currency being bought is lower than the interest rate of the currency being sold, then the forward rate will be lower than the spot rate.
For example, let’s say that the spot rate for the EUR/USD currency pair is 1.1200, and the forward rate for a one-year forward contract is 1.1400. The forward pips for this contract would be 200 pips (1.1400-1.1200). This means that the EUR/USD currency pair is expected to appreciate by 200 pips in the next year.
The calculation of forward pips is essential for forex traders who use forward contracts to mitigate currency risk. If a trader knows the forward pips for a currency pair, they can calculate the potential profit or loss of a forward contract. For example, if a trader enters a long forward contract for the EUR/USD currency pair with a forward pips of 200, they will make a profit if the currency pair appreciates by 200 pips or more.
Forward pips are also used in forex trading to predict future price movements. If a currency pair has a high forward pips value, it is expected to appreciate in the future. On the other hand, if a currency pair has a low forward pips value, it is expected to depreciate in the future.
In conclusion, forward pips are an essential concept in forex trading that allows traders to hedge against currency risk and predict future price movements. Forward contracts are agreements between two parties to buy or sell a currency at a predetermined price and date in the future. The forward pips are the difference between the current spot rate and the forward rate that is agreed upon in a forward contract. Forex traders use forward pips to calculate the potential profit or loss of a forward contract and to predict future price movements.
