Theoretical Pricing

FX Spot Contract

The spot price is the observable market price of unit of foeign currency. Let denote foreign currency and denote domestic currency:

A FX spot contract is an agreement where the buyer purchase units of foreign currency at a fixed rate at current time .

The contract value to the buyer is:

FX Forward Contract

Denote domestic interest rate = . The price of domestic zero-coupon bond

A FX forward contract is an agreement where the buyer agree to purchase units of foreign currency at a fixed rate at future time :

The time- value of a forward contract is:

We set to calculate the forward price at time . The equation is also called the covered interest parity, or CIP:

Non-Deliverable forward

Non-deliverable currency has restricted exchange by local regulations. CIP does not hold since covered interest arbitrage is not possible. For example:


  • CNY: China Yuan
  • TWD: New Taiwan Dollar
  • KRW: South Korean Won
  • INR: India Rupee
  • PHP: Philippine Piso
  • IDR: Indonesia Rupiah
  • MYR: Malaysian Ringgit

Latin America:

  • COP: Colombian Peso
  • VEB: Venezuelan Bolívar
  • BRL: Brazilian Real
  • PEN: Peru Sol
  • UYU: Uruguayan Peso
  • CLP: Chilean Peso
  • ARS: Argentine Peso

Europe, Middle East and Africa:

  • EGP: Egyptian Pound
  • KZT: Kazakhstani Tenge

Given CIP, we can calculate the implied yield, which is the foreign interest rate implied by the forward rate, domestic spot rate and domestic interest rate.

We know that the exponential function can be expressed as the sum of the Maclaurin series:

Applying this to the forward rate:

FX Swap Contract

A FX swap contract contains two FX forward contracts at time with opposite directions.

For example, a buy/sell swap contract:

The present value of the swap contract is the sum of the present value of the two sub-contracts:

Note that the value of a swap contract is fairly insensitive to spot rate changes, comparing to that of a forward contract.

FX Option

A FX option conveys the right, but not the obligation, to exchange units of foreign currency for units of domestic currency, at a future date .

For example, the buyer of a foreign currency call strike at , have the right at maturity to buy unit of at even if .

This is equivalent to the the buyer of units of domestic currency put strike at , which grants the buyer the right at maturity to sell unit of at a rate of , even if the exchange rate falls below .

In formula:

Visualizing the transactions on a foreign currency call:

Visualizing the transactions on a domestic currency put:

FX options also satisfy put-call parity:


To evaluate the price of the option:

  • Assumptions on the stochastic nature of St
  • Create a “risk-free” hedge portfolio, in order to find a governing PDE for the option value, which also leads to an equivalent risk-neutral probability measure
  • Solve the PDE directly, with appropriate boundary conditions

We know that if a tradable asset follows the geometric Brownian motion:

Applying Ito's formula any value of a derivative contract :

Setting the drift term to be zero as the derivative contract is tradeable, we can derive the Black-Scholes PDE equation characterize as such:

However, since the foreign exchange spot rate is not tradable, we need to tweak the B-S formula. Let and denote a bank account in domestic and foreign currencies, where and . Construct replicating portfolio and set the drift term to be , the Garman-Kohlhagen PDE equation can be derived:

Solving the PDF:

Using the Freynman-Kac equation with additional derivation, we can conclude that s.t. the arbitrage-free price of the contingent claim is unequivocally determined as the expected value of the discounted final payoff under , and obeys the stochastic differential equation:

Practical Pricing

FX Spot Contract

The trade date is when the terms of the transaction are agreed, and the value date is when transaction occurs, which is trade date for most currency pairs.

The spot rate quote means:

  • , i.e. higher the , stronger the .
  • is the base currency and is set to 1 unit, whereas is the numeraire currency which is used as the numeraire.

The bid-offer spread means:

  • The dealer is willing to buy for
  • The dealer is willing to sell for


  • The highest price YOU can sell is
  • The lowest price YOU can buy is

FX Forward Contract

The forward point is commonly expressed in the unit pip, or point in percentage, that is worth .

Example 1 When selling a forward for foreign currency , the bid side spot rate plus bid side forward points shall be equal to the bid side outright forward rate.

A market-maker would construct the short forward as follow. Note that borrowing and lending correspond to selling a forward and therefore the bid-side forward point.

Time Transactions
execute a short spot contract
execute a long spot contract

This is the same as selling an outright forward contract:

Time Transactions

FX Swap Contract

A FX swap contract intends to adjust the timing of cash flows from to and alter the value date on an existing trade. The near rate should be consistent with the market forward rate for the near date, and the same goes for the far rate. The swap point is equal to:

A buy/sell swap on means that it buys a forward on at and sells a forward on at . This correspond to borrowing and lending .

Example 2 A short outright forward position on can be thought of as a buy/sell swap on with a spot transaction at the near date and , similar to Example 1. Here :

Time Transactions
execute a short forward contract:
execute a long forward contract:

This is the same as a buy/sell swap:

Time Transactions

Example 3 From a market-maker perspective:

Contract Swap Point T1 T2
Buy/Sell offer-side swap point pay at bid-side points sell at offer-side points
Sell/Buy bid-side swap point sell at bid-side points pay at bid-side points

Note(): because a swap has less interest rate risk than an outright forward, the market-maker can easily construct a swap with bid-side points for both near and far dates.

Example 4 Say the swap point is , then a party that buy/sell the foreign currency is paying the swap point, because it is selling at a lower Far rate.

Conversely, a party that sell/buy is earning the swap point.

Risk Characteristics

Contract Transactions FX Risk IR Spread Risk
Spot 1 Yes No
Forward (Outright) 1 Yes Yes
Swap 1 No Yes

FX Option

There are four ways to express an option price:

Price in units in units
Notional as

Notional as


The meaning of can be different:

  • : at the spot rate
  • : at the forward rate (preferred by traders)
  • : delta-neutral

Risk Reversal

Where a -delta option is an option with a delta of . Risk reversal can also denote the difference in implied volatility:


Note that butterfly is vega () neutral, e.e. the strangle notional is usually larger than the straddle notional to create equal and offestting vega . BF can also denote the difference in implied volatility:

Under the Black-Scholes framework, delta-netural strike () options have the highest vega :

In addition, option gamma


  • FINM 37301 Foreign Exchange: Markets, Pricing and Products, Anthony Capozzoli, University of Chicago