Forward rate
‘Forward rate’ is the price paid for hedging by buying dollars in the forward market. Forward transactions take place at a premium or discount to the spot rate. Forward premium is when the forward (or expected future) exchange rate is higher than the spot (or present) exchange rate. It is an indication by the market that the current domestic exchange rate is going to increase against the other (foreign) currency. This circumstance can be confusing because an increasing exchange rate means the currency is depreciating in value. A forward premium is frequently measured as the difference between the current spot rate and the forward rate, so it is reasonable to assume that the future spot rate will be equal to the current futures rate. On the contrary, Forward discount is when the forward exchange rate is lower than the spot exchange rate. Forward premium or Forward discount is normally expressed as annualized percentage of the difference.
When the exchange rate is quoted as D/F, (where ‘D’ i.e., price currency of the domestic currency and ‘F’ i.e. the base currency of the foreign currency) and the forward exchange rate is higher than the spot rate, it means that the foreign currency is trading at a forward premium. It shows that the foreign currency has appreciated because it will take more units of the domestic currency to buy one unit of the foreign currency. An appreciation for foreign currency is the depreciation for domestic currency. Hence, when the foreign currency trades at a forward premium, the domestic currency trades at a forward discount and vice versa.
For
example, assume that we are in India market and the INR/USD spot exchange rate
is 73.45 and 3-month (or 90 days) forward exchange rate is 73.62. This means
that right now it takes 73.45 Indian rupees to buy 1 U.S Dollar and at 3 months
maturity, it will take 73.62 Indian rupees to buy 1 U.S dollar, i.e. 0.17
Indian rupees more per 1 U.S Dollar. It shows that the foreign currency i.e.
the U.S Dollar is trading at a forward premium because it takes more Indian
rupees to buy U.S Dollar in future. The INR is trading at forward discount
because 1 Indian rupee is worth less in future.
Formula:-
We
can use the following formula to know the percentage forward premium or Forward
discount for the foreign currency.
Forward
premium / discount = [(Forward exchange rate – Spot exchange rate) / Spot
exchange rate]
When the result (Forward exchange rate – Spot exchange rate) is positive, it is a forward premium and when the result is negative, it is the forward discount.
Using
the example above, we can find out the forward premium / discount as below :-
Forward
premium / discount = [(73.62 – 73.45) / 73.45]
= + 0.17 / 73.45
= + 0.0023145 or - 0.23%
Therefore, in this case, as it is a positive result, Forward premium for USD is 0.23% for 90 days. If we want to say annual rate of forward premium, then [0.23 x (360/90)] it is 0.92%. Because we get a positive figure, the foreign currency (i.e. USD) trades at a forward premium.
Let’s
convert the above to indirect quote i.e., to USD/INR i.e. foreign currency in
numerator and domestic currency in denominator. Then, the spot exchange rate
works out to 0.013615 (=1/73.45) and 0.013583 (=1/73.62). By just looking at
the figures, we can conclude that U.S Dollar trades at a forward premium
because it takes less USD (0.013583 is less than 0.013615) to buy INR in 3
month (90 days).
When the indirect quote is used i.e. when the price is expressed in foreign currency terms, the formula for forward premium or discount is different as follows :-
Forward
premium / discount = [{(1/Forward exchange rate) – (1/Spot exchange rate)} / (1/Spot
exchange rate)]
When
the result {(1/Forward exchange rate) – (1/Spot exchange rate)} is negative, it
is a forward premium and when the result is positive, it is the forward
discount.
Using
the example above, we can find out the forward premium / discount as below :-
Forward
premium / discount = [(0.013583 – 0.013615) / 0.013615]
= - 0.000032 / 0.013615
= - 0.0023503 or - 0.235%
Therefore,
in this case, as it is a negative result, Forward premium against INR is 0.236%
for 90 days. If we want to say annual rate of forward premium, then [0.235 x
(360/90)] it is 0.94%.
Forward Rate calculation when interest rates involved
The outright forward transactions are over-the-counter transactions undertaken by dealers. In India, it is generally the banks that transact in forward markets. The maturity date agreed upon by the parties generally varies from months to a year or two. But maturities beyond that tend to have wider bid-ask spreads, in other words, tend to be more expensive, so are rare. The forward rate could be in premium or discount, based on the interest rate differential in case of currencies which are fully convertible and in case of partially convertible currencies, they are determined purely on the basis of demand and supply.
For example, in India, the USD/INR forward rate for six months could be in premium or at a discount over the spot rate, based on how liquid the dollar is. Typically, a forward premium reflects possible changes arising from differences in the interest rate between the two currencies of the two countries involved. The basics of calculating a forward rate require both the current spot price of the currency pair and the interest rates in the two countries. To calculate the forward rate in domestic country terms, multiply the spot rate by the ratio of interest rates and adjust for the time until expiration. So, the forward rate is equal to the spot rate x (1 + domestic interest rate) / (1 + foreign interest rate). If the result will come in positive, then, there is forward premium for the domestic country and forward discount for the foreign country. Similarly, the result will come in negative, then there is forward discount for domestic country and forward premium for foreign country.
For
example, assume the current U.S. dollar-to-euro exchange rate (USD / EUR) is
$1.1365. The domestic interest rate, or the U.S. rate is 5%, and the foreign
interest rate is 4.75%. Then,
Forward
rate = [Spot rate x {(1 + domestic interest rate) / (1 + foreign interest
rate)}]
= $1.1365 x (1.05 /
1.0475)
= $1.1365 x
1.0023866348
= $1.1392
Therefore,
in this case, it reflects a forward premium in domestic country terms as the
result in positive.
Currency futures
Exchange-traded
currency forward transactions are known as currency futures. Before April 2007,
only banks were allowed to trade in currency forwards market through over-the-counter
deals. But it was not a structured market, in the sense that it was not traded
on an RBI-recognised exchange platform. But in 2007, RBI and Sebi allowed
trading of currency futures on the National Stock Exchange. The objective of opening
trading in currency futures on the exchanges was to deepen the futures market
by allowing the small retail investors to take a view and hedge their foreign
exchange risks. The regulatory authorities in India are on their way to allow
trading in currency options on exchanges as well, though it is already
available as a product.
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