Forward Premium
Candlefocus EditorThe forward premium is typically measured as the difference (in percentage points or absolute value) between the spot rate of a currency and the forward rate. When the forward premium is positive, the currency is said to be trading at a premium; when the forward premium is negative, the currency is said to be trading at a discount.
For example, if the current spot exchange rate of a currency is 1.1000 and the forward rate is 1.1020, the currency is trading in the forward market with a forward premium of 0.0020, which equates to a 2 basis-point premium (0.02%). If the current spot exchange rate of a currency is 1.1000 and the forward rate is 1.0980, the currency is trading with a forward premium of -0.0020, which equates to a 2 basis-point discount (or 2 basis-point forward discount).
The magnitude of the forward premium depends on a variety of macroeconomic factors, including, but not limited to, current and anticipated economic conditions, inflation levels, interest rate differentials between countries, and political or geopolitical risks. In general, a forward premium tends to rise when investors expect the future value of the currency to outperform the spot rate, and when there is high demand for the currency. A forward premium tends to decrease when the economic outlook of a country is uncertain or when the demand for the currency is low.
When the spot rate and the forward rate of a currency are in equilibrium, the currency is said to be trading at parity. In this case, there is no forward premium; rather, the spot rate and forward rate are the same.
In conclusion, a forward premium is a situation in which the forward or expected future price for a currency is greater than the spot rate. It is typically measured as the difference between the spot rate of a currency and the forward rate. The magnitude of the forward premium varies based on the macroeconomic outlook of a country, the demand for the currency, and other related factors. A currency is usually trading at a discount when the forward premium is negative and at a premium when the forward premium is positive. When the spot rate and the forward rate of a currency are at equilibrium, the currency is said to be trading at parity, with no forward premium.