Definition and Example of Forward Premium
A forward premium occurs when the forward contract exchange rate is higher than the current spot exchange rate when trading currencies in the forex market. It can be used as an indicator during trading in forex markets.
How Does Forward Premium Work in Forex Trading?
In a forward contract, you agree on a price to pay now to acquire the underlying asset on a future date. When the expectation is that the currency will rise in the future, investors pay a premium now to lock in a price for acquiring it in the future. Simply put, this is the forward premium. The investment will work if the currency rises more than the premium paid.
Forward premiums and discounts are expressed as an annual percentage and are calculated using the following formula:
Forward Premium = ((Forward Contract Price – Current Spot Price) / Current Spot Price) * 100
Many economists and researchers express forward premiums or discounts in annualized figures. Seasonal forward premiums are calculated by multiplying the above formula by the duration of the contract.
Seasonal Forward Premium = ((Forward Contract Price – Current Spot Price) / Current Spot Price) * (360 / Duration of Forward Contract) * 100
Knowing whether there is a forward premium in forex trading can be a useful indicator for investors to determine market trends and make investment decisions accordingly.
For example, when there is a forward premium, it may indicate that the local currency has a lower interest rate. Conversely, when there is a forward discount, it may indicate that the local currency is facing higher interest rates.
What Does This Mean for Individual Investors?
Investors trading forward contracts in the forex market can use the forward premium/discount formula to help them assess future currency price movements for a specific currency pair.
Simply put, a forward forex contract determines how much you pay today to acquire the currency in the future. Your forward premium or discount helps calculate the direction of movement of the currency that may assist in making a trading decision.
You should keep in mind that the forward price, whether it’s a premium or a discount, does not guarantee that the currency pair price will move in parallel. However, it is an indicator that should be used alongside other technical analysis indicators to assist investors in making investment decisions in the forex market.
Source: https://www.thebalancemoney.com/what-is-a-forward-premium-in-forex-trading-5268053
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