How is a forward exchange rate set?
Covered interest parity — no arbitrage.
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By the interest-rate differential, not by a forecast — otherwise there would be a risk-free arbitrage. The currency with the higher interest rate trades at a forward discount: forward = spot × (1 + rate of the quote currency) ÷ (1 + rate of the base currency).
The full answer
Forward (EUR/USD) = spot × (1 + USD rate × t) ÷ (1 + EUR rate × t)
Example
EUR/USD spot 1.1000, one-year USD rate 4%, EUR rate 2%: Forward = 1.1000 × 1.04 ÷ 1.02 = 1.1216.
The dollar has the higher rate, so it trades at a forward discount: one euro buys more dollars forward than spot. Holding dollars earns 2% more interest, which the forward gives back.
Uses
Companies hedge future receipts or payments by locking in the forward rate — budget certainty, at the cost of giving up favourable moves.
Mistakes to avoid
Reading the forward as the market's forecast of the future spot rate.
Follow-ups they may ask
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