Definition and Example of a Forward Premium
A forward premium exists when the forward exchange rate is higher than the current spot rate of forward contracts in the forex market. The forward rate is the future exchange rate of a forward contract for a specified asset. The spot rate is the current exchange rate for an asset.
A forward premium occurs when the forward exchange rate is higher than the spot rate. If the forward exchange rate is lower than the spot rate, then a forward discount occurs.
For example, if the US dollar-to-euro (USD/EUR) exchange rate is currently 0.8827 (aka the spot rate), and the calculated forward rate is 0.8885, a forward premium exists. Why? Because the spot rate for the USD/EUR is 0.8827 and the forward rate for the same currency pair is 0.8885, which is higher than the spot rate.
How Does a Forward Premium in Forex Trading Work?
In a forward contract, you settle on a price to pay now to acquire the underlying asset at a future date. When the expectation is that a currency will rise in the future, investors would pay a premium now to settle on a price to acquire it in the future. Simply put, this is the forward premium. The investment will work if the currency rises more than the premium paid.
Forward premiums and discounts are stated as annual percentage rates and calculated using the formula below:
Forward Premium = ((Forward Rate – Spot Rate) / Spot Rate) *100
Many economists and researchers also express forward premiums or discounts in annual terms. Annualized forward premiums are calculated by multiplying the formula above by the duration of the contract.
Annualized Forward Premium = ((Forward Rate – Spot Rate) / Spot Rate) * (360/ Duration of the forward contract) *100
Knowing whether a forward premium exists in forex trading can be a helpful indicator for investors to determine market trends and make investment decisions accordingly.
For example, when a forward premium exists, this may indicate that the domestic currency has a lower interest rate. Conversely, when a forward discount exists, this may indicate that the domestic currency faces higher interest rates.
A forward premium or discount does not guarantee the future movement of currency exchange rates parallel to the premium or discount.
To determine whether a forward premium exists, we need to know the spot and forward rates. The spot rate is the current exchange rate for a given currency and is already calculated for us. So first, we need to calculate the forward rate. This is calculated by dividing the domestic exchange rate by the foreign exchange rate and multiplying that by the current spot rate. See the formula below:
Forward exchange rate = spot rate x ((1 + domestic interest rate) / (1 + foreign interest rate))
Using the hypothetical example of the USD/EUR above, let’s say that the spot rate is currently 0.8827, and we’re looking at the forward rate for six months from today. The domestic interest rate is 4% and the foreign interest rate is 3%. Using these numbers, the forward rate formula would look as follows:
Forward exchange rate = 0.8827 x ((1 + 0.04) / (1 + 0.03)) = 0.8913
Now that we have the forward exchange rate, we can determine whether a forward premium exists by subtracting the spot rate from the forward rate and dividing that by the spot rate.
Forward premium = ((0.8913 – 0.8827) / 0.8827) *100 = 0.97%
The forward exchange rate is approximately 0.97% higher than the spot rate, indicating that there is a forward premium.
Calculating whether there is a forward premium or discount in most cases is much quicker than the above process because most forex brokers provide you with the forward exchange rate and the spot rate. In that case, all you need to do is plug the spot rate and the forward rate into the equations above and discover whether a forward premium exists.
What It Means for Individual Investors
Investors who trade forward contracts in the forex market can use the forward premium/discount formula to help gauge the future price movements of a given currency pair.
Simply put, a forward forex contract determines how much you would pay today to acquire the currency in the future. Your forward premium or discount helps factor in the direction of currency movement that might help inform your trade.
Keep in mind that the forward rate, whether a forward premium or discount, does not guarantee that the currency pair price will move in a parallel fashion. Nevertheless, it’s an indicator that should be used along with other technical analysis indicators to aid investors in making investment decisions in the forex market.
- A forward premium is when a currency’s forward price is higher than its current spot price.
- A forward discount exists when the currency’s forward price is lower than the spot price.
- To calculate a forward premium/discount, find the difference between the forward price and spot price and divide it by the spot price.
- A forward premium often indicates that the future domestic exchange rate may increase.
Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!