Forward Premium and Forward Discount

If the difference between forward exchange rate and spot exchange rate of one currency is a positive value, it is known as forward premium and if it is a negative value it is known as forward discount. In other words if the spot ‘futures exchange rate’ is higher than the spot exchange rate then it is known as forward premium and if it is lower than spot exchange rate then it is known as forward discount.

Forward exchange rate of domestic currency (DC) with regard to a foreign currency (FC) for one year is derived by the formula,

Forward Rate = Spot Rate of FC x

(1 + Interest Rate of FC) (1+ Interest Rate of DC)

If the sport rate of Canadian dollar (CAD) is 0.7870, one year interest rate of Canada is 3.5% and that of US is 3% then the forward rate of USD with regard to CAD will be,
1 USD = 0.7870 x (1 + 3.5) / (1 + 3) = 0.8853
Which is 0.0983 (98.3 swap points) higher than the current spot price of CAD, thus USD trades at a forward premium against CAD and CAD trades at a forward discount against USD.

If the exchange rate after one year is still at or around 0.7870 in the above example, a trader can benefit from the arbitrate opportunity of converting low interest rate currency to high interest rate currency and depositing it for one year, and simultaneously buying an one year forward contract for low interest rate currency to hedge risk.

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