Forward Premium

What it is

A forward premium exists when a currency’s forward (future) exchange rate is higher than its current spot rate. It signals that the market expects the currency’s quoted value to rise relative to the other currency. When the forward rate is lower than the spot rate, the condition is called a forward discount.

Note: an increasing exchange rate can mean depreciation or appreciation depending on how the currency pair is quoted (e.g., $/¥ vs ¥/$). Always check which currency is the base and which is the quote.

Key formulae

• Forward premium/discount (percentage)
  (Forward Rate − Spot Rate) ÷ Spot Rate × 100

• Forward rate using interest-rate relationship (for period T days)
  Forward Rate = Spot Rate × (1 + i_dom × T/360) ÷ (1 + i_for × T/360)
  where i_dom is the domestic interest rate, i_for is the foreign interest rate, and T is the number of days (360-day convention often used).

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To annualize a short-period premium or discount, multiply the period result by (360 ÷ T).

Examples

1. Yen/dollar 90-day example (base: ¥ per $)
2. Spot: 109.38 ¥/$
3. 90-day forward: 109.50 ¥/$
4. 90-day premium = (109.50 − 109.38) ÷ 109.38 = 0.001098 ≈ 0.1098%
5. Annualized (360/90 = 4): 0.1098% × 4 ≈ 0.44%
   Interpretation: The dollar trades at a forward premium relative to the yen; the yen trades at a forward discount.

To express the yen’s discount in $ per ¥, invert rates:
– Forward ¥/$ = 1 ÷ 109.50 = 0.0091324 $/¥
– Spot ¥/$ = 1 ÷ 109.38 = 0.0091424 $/¥
Annualized discount ≈ ((0.0091324 − 0.0091424) ÷ 0.0091424) × 4 × 100% ≈ −0.44%.

1. Interest-rate based forward rate (USD/EUR example)
2. Spot: $1.1365 per €
3. Domestic (USD) rate: 5.00%
4. Foreign (EUR) rate: 4.75%
   Assuming a one‑year horizon:
   Forward ≈ 1.1365 × (1.05 ÷ 1.0475) = 1.1392
   This implies a forward premium for the dollar against the euro under these interest-rate differentials.

Why it matters

• Hedging: Businesses use forward contracts to lock in exchange rates for future cash flows, reducing currency risk.
• Pricing and planning: Forward premiums/discounts help firms budget for foreign receipts/payments and set prices for cross-border contracts.
• Market signal: They reflect expectations driven primarily by interest-rate differentials and can indicate where the market expects exchange rates to move.
• Trading: Speculators use forward rates to capture expected movements or arbitrage interest-rate differentials.

Main drivers

• Interest rate differentials between two currencies (primary driver under covered interest parity)
• Relative inflation expectations
• Economic and political stability
• Market speculation and capital flows

Quick takeaways

• Forward premium = forward rate > spot rate; forward discount = forward rate < spot rate.
• Interest-rate differences largely determine forward rates via interest parity relationships.
• Companies and traders monitor forward premiums/discounts to hedge, plan, and speculate on currency movements.