Financial Institute

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Forward Premium Vs Discount:

If the interest rate differential is positive and to be added to spot rate, then the difference is called forward premium. Likewise, if the interest rate differential is negative and the same is to be deducted to the spot rate then the difference is called discount.

In the above illustration of USD INR 6 months Forward Rate calculation, we have observed that USD INR 6 Months forward rate at 76.7922 which is higher than the USD INR Spot rate of 75.00. Thus, USD is at premium for 6 months forward date against INR.

Thumb Rule: Low interest rate Currencies will be at a premium for forward dates and High Interest Rate currencies will be at discount for forward dates.

Interest rates on currencies some times drastically move up and down with the changes to demand and supply of currencies. Thus, forward rates for currencies depend on the operating money market rates instead of bench mark rates.
Forward rates move away from interest rate differentials due to spurt in demand and supply for currencies. Such a situation gives arbitrage opportunities to the businesses having access to both Money Market and Forward Markets.

2 Way Forward Rate Calculation: Forward Rates are calculated by adding premium to spot rate or deducting discount to spot rate. Premium or Discount are denoted with + or – Sign and are in ascending or descending order for 2 way quotes. Premium is Quoted in ascending order and Discount is quoted in descending order. The below table shows the forward points for various maturities.