What Is a Forward Premium?

A forward premium results when the forward or expected future price for a currency is greater than the spot price (the price for immediate del✃ivery). It is an indication that the market believes the current domestic exchange rate is going to increase relative to the other currency.

This circumstance can be confusing because an increasing exchange rate means the currency is depreciating in value.

Understanding Forward Premiums

A forward premium is measured as the difference between the current 澳洲幸运5官方开奖结果体彩网:spot rate and the 澳洲幸运5官方开奖结果体彩网:forward rate, so it is reas𒁃onable to assume that the future spot rate will be equal to the current futures rate.

According to the forward expectation theory of exchange rates, the current spot futures rate will be the future spot rate. This theory is rooted in 澳洲幸运5官方开奖结果体彩网:empirical studies and is a reasonable ꦕassumption over a long-term time horizon.

Forward currency 澳洲幸运5官方开奖结果体彩网:exchange rates are often different from the spot exchange rate for the currency. If the forward exchange rate for a currency is mor🥂e than the spot rate, a premium exists for that currency. If the forward exchange rate is less than the spot rate, a discount exists.

Forward Premium Calculation

The calculation of a forward rate require𒀰s both the current spot price of the currency pair an🌳d the interest rates in the two countries:

Forward Premium/Discount (as a Percentage) = (Forward Rate - Spot Rate) ÷ Spot Rate x 100

Consider this example of an exchange 🍸between the Japanese yen and the U.S. dollar:

• The ninety-day yen to dollar (¥ / $) forward exchange rate is 109.50.
• The spot ¥ / $ rate is = 109.38.
• For an annualized forward premium: ((109.50-109.38) ÷ 109.38) x (360 ÷ 90) x 100% = 0.44%

In this case, the dollar is strong relative to the yen since the dollar's expected forward value exceeds the spot value by a premium of 0.12 yen per dollar. The yen would trade at a discount because its forward value relative to dollars is less than its spot rate.

To calculate the forward discount for the yen, you first need to calculate the forward and spot exchange rates for the yen in the relationship of doll⭕ars per yen.

• ¥ / $ forward exchange rate is (1÷109.50 = 0.0091324).
• ¥ / $ spot rate is (1÷109.38 = 0.0091424).
• Annualized forward discount for the yen, in terms of dollars = ((0.0091324 - 0.0091424) ÷ 0.0091424) × (360 ÷ 90) × 100% = -0.44%

Forward Rates for Periods Other Than One Year

To calculate for periods other th🌳an a year, onღe needs to input the number of days as shown in the following calculation:

Forward Rate = Spot Rate × (1 + Interest Rate of Currency A)^T / (1 + Interest Rate of Currency B)^T

where Currency A is the base cur🃏rency, Currency B is the quote currency, and T is the time꧃ period.

So, a three-month forward rate is equal to the spot rate multiplied by (1 + the domestic rate x 90/360 / 1 + foreign rate x 90/360).

As an example, assume the current U.S. dollar-to-euro exchange rate is $1.1365. The domestic interest rate, or U.S. interes𝕴t rate, is 5%, and the foreign interest rate is 4.75▨%.

Forward Rate = $1.1365 x (1.05 / 1.0475) = $1.1392

ꩲ In this case, the result reflects a forward prไemium.

The Bottom Line

Forward premium represents a higher forward exchange rate for ꦬa currency relative to the spot, or current, exchange♏ rate. The opposite is called a forward discount.

It's important for businesses engaged in international transactions not only to monitor forward premiums and discounts but also to understand the factors that affect them. That can inform their decision-making about timing transactions to manage currency exposure to their advantage.