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What is a Forward Discount?

Jim B.
Jim B.

A forward discount occurs when the spot exchange rate of a foreign currency exceeds that same country's forward exchange rate in a futures contract. This type of situation comes into play when forward trades of currencies are made, which means that no currency changes hands until the maturity date of the futures contract is reached. The concept is the opposite of a forward premium, in which the forward rate exceeds the current rate. Although a forward discount may be predicted by current rates, there is no guarantee that the future rates will live up to this prediction.

Foreign exchange trades are dependent on the interest rates of the countries involved in these trades. Discrepancies between these rates are often a way for traders in the foreign exchange market to get in and out of trades and make a quick profit. When these trades involving foreign exchange rates are made via future contracts, then the current rate of exchange is irrelevant and the future rate becomes all-important. These future trades are where the concept of a forward discount takes place.

Man climbing a rope
Man climbing a rope

When a future trade is made, there is no currency exchange when the contract for the trade is made. Instead, the trade actually takes place as determined by the contract at some time in the future. The forward rate is therefore the rate at the time that the contract stipulates the future trade will be made. For instance, if the future contract is set up for a period of one month, then the applicable rate will be the rate of exchange one month in the future.

What occurs then is that the current rate of exchange will either rise or fall in the span of time that the contract takes place. If the future rate falls below the current rate, then a forward discount is the result. When the opposite occurs, then a forward premium is said to take place. These results are important to those traders who are hedging investments by making a trade with a current rate and then following that up with a futures contract to protect against losses.

The problem with trying to anticipate a forward discount is that the predicted future rates don't always come to fruition. For example, if there is a 1-percent rate difference in the interest rates of two countries at the time of the trade, the prevailing theory is that those rates will even out at the time of the future contract's maturation, with the lower rate appreciating and the higher rate depreciating. But future rates, as determined at the time the futures contract is enacted, often vary from what actually takes place. This conundrum is known to investors as the forward discount puzzle.

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