What is a Forward Premium?

John Lister
John Lister
Businessman with a briefcase
Businessman with a briefcase

The forward premium is the difference between the current exchange rate of a currency and the rate being used in forward currency exchange deals. In theory, it may indicate the way a market expects the exchange rate to move in the future. There is also a theory that the forward premium is linked to the difference between interest rates in the two countries concerned.

There are two types of exchange rate in currency markets. The spot rate is the current average rate at which traders are exchanging the currencies. The forward rate is the rate at which traders are agreeing to exchange currencies on a date in the future. Depending on what the spot rate is on that date, one of the traders in the deal will come out ahead. This is because they'll be able to exploit the disparity between the exchange rate they use in the completion of the deal, and the rate they can then get for the cash on the open market.

The forward rate is always stated in terms of a particular duration. For example, the 12-month forward rate will be for forward currency deals that are set to complete in 12 months. The difference between today's spot rate and the forward rate for a particular duration is known as the forward premium. It is stated in percentage terms and can be either a positive or negative number. If the number is negative, meaning the forward rate is lower than the spot rate, the difference is usually referred to as the forward discount.

The forward premium should give some indication of how the market expects currency rates to move. As the forward rate is decided by multiple forward currency exchange deals, it's effectively the average of forecasts by individual traders. In reality, human error, market confidence and unpredictability of events means there is often little relationship between the rates used in forward deals and the spot rates in effect when those deals come to completion.

A theory known as interest rate parity holds that there is a consistent relationship between the forward premium and the difference in interest rates available to investors in the two countries whose currencies make up the relevant exchange rate. The logic behind this theory is that whenever this relationship is distorted, the distortion will affect the most profitable tactics involving which country to invest in and whether to exchange currencies now or through a forward contract. The way investors react to this should itself distort the market back to the original position, making interest rate parity a self-correcting relationship.

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