What is Forward Premium?

Forward Premium Formula

Formula = (The Future Exchange Rate – The Spot Exchange Rate) / The Spot Exchange Rate * 360 / No. of Days in the Period

How to Calculate Forward Premium?

Step 1: Here we need a forward exchange rate.

Step 2: For the calculation of forward exchange rate we need:

  • The Spot Exchange RateInterest Rate prevailing in the Foreign CountryInterest Rate prevailing in the Domestic Country

Step 3: The formula for Forward Exchange rate-

Forward Exchange Rate = Spot Exchange Rate * (1 + Interest Rate in Domestic Market) / (1 + Interest Rate in Foreign Market)

Step 4: For calculation of the forward premium we need:

  • Spot Exchange RateForward Exchange Rate

Step 5: Apply the formula

Premium = (Forward Rate * Spot Rate) / Spot Rate * 360/Period

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Examples

Example #1

John is a trader, and he lives in Australia. He has sold some goods in London and expects to receive GBP 1000 after three months. John wants to estimate how much more AUD he is expecting to receive, as he is receiving after three months instead of now.

  • Spot RateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more (AUD/GBP) = 1.385Forward Rate after 3 months (AUD/GBP) = 1.40

Annualised Premium = (Forward Rate – Spot Rate) / Spot Rate * (360/90)

The FP is 0.04332

  • So, as John is receiving the payment of GBP 1,000 after three months, he is getting more AUD as the AUD is depreciating in 3 months. The total gain, if annualized, is coming out to be 0.04332%.So if John had received the payment now, he would have got AUD 1385, but he is receiving the payment after three months. So the AUD will depreciate, and he will receive a payment of AUD 1400. So he is receiving AUD 15 more.

Example #2

Country A is providing more interest rate than country B. Then why isn’t everyone borrowing from Country B and investing in country A? Information is given below:

Solution:

This arbitrage is impossible because there will be a forward premium whenever the Interest Rate is more than others. Say a particular person did this transaction. He borrowed 100 units of currency from country B and invested that in Country A.

So he will get 1.5 * 100 = 150 units of currency in country A.

As we know that at the end of the period the exchange rate will be

Forward Rate = Spot Rate (A/B) * (1 + Interest Rate in Country A) / (1 + Interest Rate in country B)

  • So the Exchange Rate after the period will be 1.5144. So now, after the period, the person will receive150 units * 1.05 = 157.5 units of currency A. He will have to convert that in currency B with the new exchange rate of 1.5144So he will receive currency B of 157.5 / 1.5144 = 104 units of currency BHe will have to repay the 4% charged for borrowing 100 units of currency B. So 4 Units of currency B returned as Interest, and 100 units of currency B returned as principal. So the net is zero

Forward Premium = (Forward Rate – Spot Rate) / Spot Rate * 100

  • = (1.5144 – 1.50) / 1.50 * 100= 0.96

Due to this, the arbitrage was not possible.

Conclusion

Forward Premium is a situation when the future exchange rate is more than the spot rate. So it is an indication of currency depreciationCurrency DepreciationCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more. It determines where the currency of a particular currency is heading. So it is very important to check if currencies are trading at a premium or discount.

This has been a guide to what is Forward Premium & its definition. Here we discuss the formula to calculate the Premium along with examples. You can learn more about from the following articles –

  • Value Based PricingCurrency AppreciationFunctional CurrencyCurrency PegCurrency Options