Spreads on Forward Currency Quotations
The spread on a forward currency quotation is calculated in the same manner as the spread for a spot currency quotation.

The reasons that spreads vary with forward foreign currency quotations are similar to the reasons for the variability of spreads with spot foreign currency quotations. The unique factor associated with spreads for forward foreign currency quotations is that spreads will widen as the length of time until settlement increases. Currency exchange rates would be expected to have a higher range of fluctuations over longer periods of time, which increases dealer risk. Also, as time increases, fewer dealers are willing to provide quotes, which will also tend to increase the spread.

Calculating a Forward Discount or Premium, Expressed as an Annualized Rate.
Forward currency exchange rates often differ from the spot exchange rate. If the forward exchange rate for a currency is higher than the spot rate, there is a premium on that currency. A discount exists when the forward exchange rate is lower than the spot rate. A negative premium is equivalent to a discount.

Example: Forward Discount Premium
If the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38, then the dollar is considered to be "strong" relative to the yen, as the dollar's forward value exceeds the spot value. The dollar has a premium of 0.12 yen per dollar. The yen would trade at a discount because its forward value in terms of dollars is less than its spot rate.

The annualized rate can be calculated by using the following formula:

Formula 5.3

Annualized Forward Premium = Forward Price - Spot Price         12            x  100%
                                                                Spot Price                    # of months

Answer:

So in the case listed above, the premium would be calculated as:

Annualized forward premium=

((109.50 - 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%

Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward and spot rates for the Japanese yen in terms of dollars per yen. Those numbers would be (1/109.50 = 0.0091324) and (1/109.38 = 0.0091424), respectively.

So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be:
((0.0091324 - 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%
Interest Applications

Related Articles
  1. Trading

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  2. Trading

    Understanding The Spread in Retail Currency Exchange Rates

    Understanding how exchange rates are calculated and shopping around for the best rates may mitigate the effect of wide spreads in the retail forex market.
  3. Trading

    Combining Forex Spot And Futures Transactions

    The spot, futures and option currency markets can be traded together for maximum downside protection and profit.
  4. Investing

    3 Strategies to Mitigate Currency Risk (EUFX)

    Discover the often overlooked risk known as currency risk, and learn three strategies to mitigate or eliminate it in your portfolio.
  5. Investing

    What Does Bid And Asked Mean?

    Bid and asked is a two-way price quotation.
  6. Investing

    What is a Forward Rate?

    Forward rate is used in both bond and currency trading to represent the current expectations of future bond interest rates or currency exchange rates.
  7. Trading

    How Currency Forward Contracts Work

    A currency forward contract locks the exchange rate for a currency’s purchase or sale at a future date.
  8. Trading

    S&P 500 Options On Futures: Profiting From Time-Value Decay

    Writing bull put credit spreads are not only limited in risk, but can profit from a wider range of market directions.
  9. Trading

    Forex: Gauging Forex Market Sentiment With Open Interest

    Examining open interest on currency futures can help you confirm the strength of a trend in forex market sentiment.
  10. Trading

    How to Calculate an Exchange Rate

    Struggling to get a grasp on exchange rates? Here's what you need to know.
Frequently Asked Questions
  1. How Can Trading Volume Exceed Shares Outstanding?

    The number of shares traded can be greater than the number of outstanding shares, but it's rare.
  2. Why Do a Reverse Merger Instead of an IPO?

    Reverse mergers are often the most cost-efficient way for private companies to trade publicly.
  3. Determining a Firm's Percentage of Credit Sales

    Find out where to look for information about determining a company's percentage of credit sales.
  4. What Does the Diluted Share Price Reveal?

    Learn how diluted share price affects earnings and the company's overall financial performance.
Trading Center