Forward Premium

What Is a Forward Premium?

A forward premium is a situation where the forward or expected future price for a currency is greater than the spot price. It is an indication by the market that the current domestic exchange rate will increase against the other currency.

This situation can be confounding on the grounds that a rising exchange rate means the currency is depreciating in value.

Understanding Forward Premiums

A forward premium is much of the time estimated as the difference between the current spot rate and the forward rate, so it is reasonable to expect that the future spot rate will be equivalent to the current futures rate. As per the forward assumption's theory of exchange rates, the current spot futures rate will be the future spot rate. This theory is established in empirical studies and is a reasonable assumption over a long-term time horizon.

Regularly, a forward premium reflects potential changes emerging from differences in the interest rate between the two currencies of the two countries included.

Forward currency exchange rates are frequently not quite the same as the spot exchange rate for the currency. Assuming the forward exchange rate for a currency is more than the spot rate, a premium exists for that currency. A discount happens when the forward exchange rate is not exactly the spot rate.

Forward Rate Premium Calculation

The nuts and bolts of computing a forward rate require both the current spot price of the currency pair and the interest rates in the two countries (see below). Think about this illustration of an exchange between the Japanese yen and the U.S. dollar:

• The ninety-day yen to dollar (\u00a5/$) forward exchange rate is 109.50.
• The spot rate \u00a5/$ rate is = 109.38.
• Calculation for annualized forward premium = ((109.50-109.38\u00f7109.38) x (360 \u00f7 90) x 100% = 0.44%

In this case, the dollar is "solid" relative to the yen since the dollar's forward value surpasses the spot value by a premium of 0.12 yen per dollar. The yen would trade at a discount in light of the fact that its forward value in regards to dollars is not exactly its spot rate.

To ascertain the forward discount for the yen, you first need to compute the forward exchange and spot rates for the yen in the relationship of dollars per yen.

• \u00a5 / $ forward exchange rate is (1\u00f7109.50 = 0.0091324).
• \u00a5 / $ spot rate is (1\u00f7109.38 = 0.0091424).
• Annualized forward discount for the yen, in terms of dollars = ((0.0091324 - 0.0091424) \u00f7 0.0091424) \u00d7 (360 \u00f7 90) \u00d7 100% = - 0.44%

For the calculation of periods other than a year, you would enter the number of days as displayed in the accompanying model. A three-month forward rate is equivalent to the spot rate duplicated by (1 + the domestic rate times 90/360/1 + foreign rate times 90/360).

To compute the forward rate, increase the spot rate by the ratio of interest rates and adapt to the time until expiration. In this way, the forward rate is equivalent to the spot rate x (1 + domestic interest rate)/(1 + foreign interest rate).

For instance, accept the current U.S. dollar-to-euro exchange rate is $1.1365. The domestic interest rate, or the U.S. rate is 5%, and the foreign interest rate is 4.75%. Connecting the values to the equation brings about: F = $1.1365 x (1.05/1.0475) = $1.1392. In this case, it mirrors a forward premium.

Features

• A forward premium is oftentimes estimated as the difference between the current spot rate and the forward rate.
• A forward premium is a situation where the forward or expected future price for a currency is greater than the spot price.
• At the point when a forward premium is negative, is it is equivalent to a discount.