What Is a Discount Spread?
A discount spread occurs when the forward points that are subtracted from the spot rate result in a negative forward spread. In a discount spread, the bid price will be higher than the offer price, indicating that there expected price in the future will be lower than it is at present; while in a premium spread, the bid price will be lower than the offer price, indicating the opposite.
A discount spread may occur in a forward currency trade situation in which the bid price is higher than the offer (ask) price. This implies that it is cheaper to buy the spread than to sell it, so that it is trading at a discount.
- A discount spread in financial markets is when a forward spread is negative, indicating that the price of some asset is more valuable today than it is expected to be in the future.
- The forward spread is the forward rate less the spot rate, or in the event of a discount rate, the spot rate minus the forward rate.
- Discount spreads can occur when there is a short-term demand or supply squeeze, or when there are interest rate differences on forex trades that result in a bid higher than the offer.
How a Discount Spread Works
Forward spreads give traders the indication of supply and demand over time. The wider the spread, the more valuable the underlying asset is expected to be in the future. The narrower the spread, the more valuable it is in the present. Narrow spreads, or even negative (discount) spreads, may result from short-term shortages, either real or perceived, in the underlying asset. With currency forwards, discount spreads occur frequently because foreign currencies have different interest rates attached to them which will affect their future value.
There is also an element of carrying cost. Owning the asset now suggests that there are costs associated with keeping it. For commodities, that can be storage, insurance, and financing. For financial instruments, it could be financing and the opportunity costs of locking into a future commitment Carrying costs may change over time. While storage costs in a warehouse may increase, interest rates to finance the underlying may increase or decrease. In other words, traders must monitor these costs over time to be sure their holdings are priced properly.
Forward points are used to arrive at the prices for both an outright forward contract and for a foreign currency swap. Forwards are most commonly done for periods of up to one year. Prices for further out dates are available, but liquidity is generally lower. Forward points are typically quoted numerically, such as +15.5 points, or minus -32.68 points. Each point represents 1/10,000, so +15.5 points means 0.00155 when added to a currency spot price. So, if the Swiss Franc can be bought versus the U.S. Dollar at the rate of 1.2550 for spot, and the forward points are +15.5, the forward rate is 1.25655 (or 1.2550 + 0.00155). Since points here were added, this would constitute a premium spread instead of a discount.
Example of a Discount Spread
As an example of a discount spread, forward points would be deducted from the spot price. For instance, assume a EUR/USD spot rate of EUR 1 = 1.4000 / 1.4002 USD, and that six-month interest rates for the euro are higher than for the USD. If the discount spread for six months is 25 / 24, the six-month euro rate will be EUR 1 = 1.3975 / 1.3978 (1.4000 - 0.0025 and 1.4002 - 0.0024).
As another example, taking the Swiss Franc and U.S Dollar (USD/CHF), if the spot rate is 1.2550 and the forward points are minus -32.68, the forward rate will be quoted at a discount: 1.2550 - 0.003268 = 1.251732.
Finally, as an example of a discount spread where the bid is higher than the offer, a forward currency trade may be quoted as USD/CAD 1.30/1.29. Notice that the bid is greater than the offer in this case, which is unusual and causes it to be classified as a discount spread.