Forward Premium and Discount
A forward rate is spot adjusted for the interest rate gap, not a forecast.
A forward rate is the spot rate adjusted for the interest rate difference between the two currencies over the forward period. When the foreign currency costs more for future delivery than for spot, it is at a premium; when it costs less, it is at a discount.
The adjustment is not a forecast of where the rupee will go. It is arithmetic: what a bank earns or loses by holding one currency instead of the other until the delivery date.
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The Terms
- Premium
- Forward rate above spot. Under direct quotation, premium is added to spot to get the forward rate.
- Discount
- Forward rate below spot. Discount is deducted from spot.
- Swap points
- The premium or discount expressed in points, as dealers quote it. A rising pair of points (for example 20/25) means premium; a falling pair (25/20) means discount.
- Interest rate parity
- The principle that the currency with the higher interest rate trades at a forward discount, and the lower-interest currency at a forward premium, so that no one earns a riskless profit by borrowing in one and lending in the other.
- Annualised premium
- Premium (or discount) divided by spot, scaled to a year and expressed as a percentage, so it can be compared with the interest rate differential.
Worked Example (Illustrative Figures)
- 1
Start with spot and the forward rate
Spot USD/INR 88.00; three-month forward 88.66.
- 2
Find the premium
88.66 minus 88.00 is a premium of 66 paise for three months.
- 3
Annualise it
0.66 ÷ 88.00 × 12/3 × 100 = 3.0% per year.
- 4
Check against parity
If three-month rupee interest is 6.5% and dollar interest 3.5% (illustrative), the 3% gap matches the annualised premium. When the two differ materially, arbitrage pressure pulls them back together.
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How CCFE Tests This
Expect calculations: compute a forward rate from spot and swap points, annualise a premium, or pick the premium period for an option contract. The classic trap is the option forward: candidates add premium for the full period on a purchase contract, when the bank passes on premium only to the start of the option. A second trap is reading 25/20 points as a premium; falling points mean discount and are deducted.
FAQs
What is forward premium and discount in forex?expand_more
Forward premium is the amount by which the forward rate exceeds spot; discount is the amount by which it falls short. Both reflect the interest rate difference between the two currencies.
How is a forward rate calculated?expand_more
Spot plus premium, or spot minus discount, for the forward period. Swap points quoted rising (bid lower than ask) are a premium and added; falling points are a discount and deducted.
How do you calculate the annualised forward premium?expand_more
Premium ÷ spot × (12 ÷ months in the forward period) × 100. The result is comparable with the annual interest rate differential.
Why is the US dollar at a forward premium against the rupee?expand_more
Because rupee interest rates have generally been higher than dollar rates. Under interest rate parity the higher-yielding currency trades at a forward discount, so the dollar sits at a premium.
Next steps
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