What is a ‘forward Premium’
The forward premium is a situation in which the forward or expected future currency price more than spot price. This means that the market that the current domestic exchange rate is going to increase against other currencies.
This may be misleading, because the increase in the exchange rate means that the Currency depreciates in value.
The penetration of the forward Premium’
The forward premium is frequently measured as the difference between the current spot rate and the forward rate, so it is reasonable to assume that the future spot rate will be equal to the current rate on the futures. According to the theory of direct expectations from currency exchange rates, the current spot rate futures future spot rate. This theory is rooted in empirical studies and constitutes a reasonable assumption to make longer-term time horizon.
As a rule, it reflects the possible changes that occur due to the difference in interest rate between the two currencies of the two countries.
Forward exchange rates are often different from spot rate of the currency. If the forward rate of the currency exceeds the spot rate, there is a premium for that currency. The discount is, if the forward rate less the spot rate. Negative premium equivalent to the discount.
Forward Rate Calculation Of The Award
The basis of calculation of forward rate require the current spot price of the currency pairs and interest rates in the two countries (see below). Consider the example of exchange between the Japanese yen and the U.S. dollar.
Ninety days yen to the dollar (¥ / $) forward rate is 109.50.
- Rate ¥ / $ rate = 109.38.
The calculation of the annual forward premium = ((109.50-109.38÷109.38) x (360 ÷ 90) x 100% = 0.44%
In this case, the dollar will be “strong” against the yen, as forward the dollar’s value exceeds the spot value at the premium of 0.12 yen per dollar. The yen will trade at a discount because its forward value of the dollar is less than the spot rate.
To calculate the forward discount for the yen, it is first necessary to calculate the forward and spot rates for the yen in the relationship of the dollar over the yen.
- ¥ / $ forward rate is (1÷109.50 = 0.0091324).
- ¥ / $ spot rate is equal to (1÷109.38 = 0.0091424).
The annualized forward discount for the yen in terms of dollars = ((0.0091324 – 0.0091424) ÷ 0.0091424) × (÷ 360 90) × 100% = -0.44%
For calculating periods other than a year, you would enter the number of days as shown in the following example. Three-month forward rate equal to the rate of “spot” multiplied by (1 + 90/360 domestic rate / 1 + exchange times 90/360).
To calculate the forward rate, multiply the rate by the ratio of interest rates and to adjust the time before the deadline. So, forward rate is the rate of spot x (1 + rate) / (1 + interest rate).
As an example, suppose that the current exchange rate of U.S. dollar to Euro exchange rate is $1.1365. Inside bets, or betting in the US is 5% and the foreign interest rate amounts to 4.75%. Plug the values into the equation results In: f = $1.1365 x (1.05 / 1.0475) = $1.1392. In this case, it reflects the forward premium.