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When trading currencies on the foreign exchange market, a forward contract is said to have a forward premium if the forward exchange rate of the contract is greater than the current spot exchange rate. During transactions on the foreign exchange markets, you could apply it as an indicator.
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An explanation of a forward premium, along with an example
A forward premium is created in the foreign exchange market whenever the forward exchange rate of forward contracts is greater than the current spot rate of forward contracts. The exchange rate that will be applied to a forward contract for a particular asset is referred to as the forward rate. The current exchange rate for an asset is referred to as the spot rate.
As an illustration, if the current exchange rate for the US dollar to the euro (USD/EUR) is 0.8827 (also known as the spot rate), and the projected forward rate is 0.8885, then there is a forward premium. Why? The reason for this is that the spot rate for USD/EUR is currently at 0.8827, while the forward rate for the same currency pair is currently at 0.8885, which is higher than the spot rate.
The Forward Premium in Foreign Exchange Trading: What Is It and How Does It Work?
When you enter into a forward contract, you and the other party agree on a price that you will pay now in order to acquire the underlying asset at some point in the future. When investors believe that the value of a currency will increase in the future, they may be willing to pay a premium for it now in order to lock in a price at which they can purchase it in the future. To put it another way, this would be the forward premium. If the value of the currency increases by an amount more than the premium that was paid, the investment will be successful.
Premiums and discounts on forward coverage are expressed as annual percentage rates and are computed using the formula that is presented below:
The forward premium can be calculated as follows: Forward Premium = ((Forward Rate – Spot Rate) / Spot Rate) *100
The expression of forward premiums or discounts in annual terms is common practice among economists and scholars. To determine the annualized forward premiums, simply multiply the calculation presented above by the number of years remaining on the contract. 3
The annualized forward premium can be calculated as follows: annualized forward premium = ((forward rate – spot rate) / spot rate) * (360 / duration of the forward contract) * 100
When it comes to foreign exchange trading, knowing whether or not a forward premium exists can be a helpful signal for investors looking to understand market trends and make investment decisions in accordance with those trends.
For instance, the presence of a forward premium may be taken as an indication that the interest rate associated with the domestic currency is lower. On the other hand, the presence of a forward discount may be an indication that higher interest rates are in store for the native currency.
We need to be aware of both the spot rate and the future rate in order to establish whether or not there is a forward premium. The current exchange rate for a particular currency is referred to as the spot rate, and it has already been determined for us. Therefore, our first order of business is to compute the forward rate. In order to determine this, first the domestic exchange rate is multiplied by the international exchange rate, and then the result is divided by the current spot rate. Take note of the formula that follows: 4
The forward exchange rate is calculated by multiplying the spot rate by the ratio of the domestic interest rate to the international interest rate.
Using the hypothetical example of the USD/EUR exchange rate from earlier, let’s pretend that the spot rate at the moment is 0.8827, and we’re interested in the forward rate for six months from the present day. The interest rate on loans taken out within the country is 4%, whereas loans taken out abroad have a 3% interest rate. The following is how the formula for the forward rate would look if we used these numbers:
The forward exchange rate is equal to 0.8827 times (1 + 0.04) divided by (1 + 0.03), which is 0.8913.
Since we now have the forward exchange rate, we are able to calculate whether or not there is a forward premium by first subtracting the spot rate from the forward rate, and then dividing the result by the spot rate.
The forward premium can be calculated as follows: forward premium = ((0.8913 -0.8827) /0.8827) *100 = 0.97%
It can be seen that there is a forward premium because the forward exchange rate is approximately 0.97 percentage points higher than the spot exchange rate.
Because most forex brokers will give you both the spot exchange rate and the forward exchange rate, it is considerably simpler and more expedient to determine whether there is a forward premium or discount than it was to go through the method described above. If this is the case, all that is required of you to determine whether or not there is a forward premium is to insert the spot rate and the forward rate into the calculations presented above.
What It Implies for Those Who Invest on Their Own
In the foreign exchange market, investors that trade forward contracts have access to a calculation known as the forward premium/discount formula, which can assist them in estimating the potential future price fluctuations of a particular currency pair.
To put it another way, the cost of acquiring a currency at some point in the future is factored into the price of a forward FX transaction today. Your forward premium or discount contributes to factoring in the direction of currency movement, which may help inform the decisions you make regarding your deal.
Bear in mind that the forward rate, regardless of whether it is a forward premium or discount, does not guarantee that the price of the currency pair will move in a manner that is parallel to the forward rate. In spite of this, it is an indicator that traders should use in conjunction with other technical analysis indicators when trying to assist them in making decisions regarding investments in the foreign exchange market.
