What is Forward Premium?
Forward premium is when the future exchange rate is predicted to be more than that of the spot exchange rate. So if the notation of the Exchange Rate is given like Domestic/Foreign and there is a forward premium, then it means that Domestic currency will depreciate.
Forward Premium Formula
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 Rate
- Interest Rate prevailing in the Foreign Country
- Interest Rate prevailing in the Domestic Country
Step 3: The formula for Forward Exchange rate-
Step 4: For calculation of the forward premium we need:
- Spot Exchange Rate
- Forward Exchange Rate
Step 5: Apply the formula
John is a trader and he lives in Australia. He has sold some goods in London and is expecting to receive GBP 1000 after 3 months. John wants to do an estimation of how much more AUD he is expecting to receive, as he is receiving after 3 months instead of now.
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- Spot Rate (AUD/GBP) = 1.385
- Forward Rate after 3 months (AUD/GBP) = 1.40
The FP is 0.04332
- So as John is receiving the payment of GBP 1,000 after 3 months, so 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 would have received the payment now, he would have got AUD 1385, but as he is receiving the payment after 3 months. So by the AUD will depreciate and he will receive a payment of AUD 1400. So he is receiving AUD 15 more.
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:
This arbitrage is not possible because there will be forward premium whenever Interest Rate of a country 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
- So the Exchange Rate after the period will be 1.5144. So now after the period, the person will receive
- 150 units * 1.05 = 157.5 units of currency A. He will have to convert that in currency B with the new exchange rate of 1.5144
- So he will receive currency B of 157.5 / 1.5144 = 104 units of currency B.
- He will have to repay the 4% that was 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.
- = (1.5144 – 1.50) / 1.50 * 100
- = 0.96
Due to this, the arbitrage was not possible.
Forward Premium is a situation when the future exchange rate is more than the spot rate. So it is basically an indication of currency depreciation. 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 –