What Drives The Structure of the FX Forward Curve?
I was looking at the forward curve for USD/EUR today for a model I am building for work and was curious, what drives it? In commodity markets it is interest rates, free storage space at certain locations, supply/demand balance, etc. but I am not familiar with FX.
Short answer is interest rate differentials between EUR and USD. Think about it this way, FX forward curve basically reflects non-arbitrage forward exchange rate on the prevailing interest rate curves in EUR and USD. Ex. Selling EUR for USD spot aka borrowing EUR and lending USD for a certain amount of time should reflect what that forward exchange rate is, otherwise you would be able to arbitrage. It's the same idea in commodities just with storage + base interest rate.
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