Forward premium

derivatives

The forward premium is called the situation in which the forward exchange rate of a currency in relation to the base currency is higher / lower than the current spot exchange rate.

To understand the forward premium, two concepts must be clear. On the one hand the concept of spot and, on the other hand, the concept of forward. The spot is nothing more than the official price of the currency pair. Meanwhile, the forward is a financial derivative whose underlying asset is the currency pair.

Forward premium formula

Its formula would be the following:

Where:

F0 = Quote of the forward exchange rate of the currency

S0 = Quote of the spot exchange rate of the currency

Forward premium example

In the currency market commonly known as the forex market, forward exchange rates of currencies serve as expectations regarding the appreciation / depreciation of the exchange rate between them. To talk about appreciation or depreciation, we always have to talk in relation to the base currency. A little trick for this is to refer to the base currency as the one that is always in the denominator. See base currency and quote currency

Let's imagine that we have the following quote:

Forward EUR / USD = 1.1667

Spot EUR / USD = 1.1659

In this example, the base currency would be the euro and it would be the one that we would have as a reference when talking about appreciation or depreciation. It should be remembered that this quote determines the amount of dollars that we would have to pay to buy one euro.

Considering the forward exchange rate, to buy one euro we would have to spend 1.1667 dollars, while considering the spot exchange rate, to buy one euro we would have to spend 1.1659 dollars.

If we apply the previous formula we would have the following result:

Forward premium = 1.1667 - 1.1659 = 0.0008

Interpretation of the forward premium

As we can see from the result, the future exchange rate or forward exchange rate between the euro and the dollar is trading at a premium or discount.

This result, according to the theory of exchange rate expectations, would be telling us that in the future the spot exchange rate will be trading at 1.1667. This would lead the base currency to appreciate in the future. This is so because we would have to spend more dollars to get the same amount of euros.

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