What is a Forward Discount?
A forward discount is a term that denotes a condition in which the forward or expected future price for a currency is less than the spot price. It is an indication by the market that the current domestic exchange rate is going to decline against another currency. This forward discount is measured by comparing the current spot price with the spot price plus net interest payments over a given length of time, to the price of a forward exchange contract for that same length of time. If the forward contract price is less than the spot plus expected interest payments, then the condition of a forward discount exists.
- Forward premium is a condition that exists in a comparison between a forward exchange contract and the spot price of a currency.
- To understand this condition you first need to understand what forward contracts are.
- Forward contracts are like futures, but not standardized and executed with two specific parties in an over-the-counter transaction.
- Forward discounts imply that those who enter into the forward contract expect the currency they intend to exchange into to decrease at some point in the future.
How a Forward Discount Works
While it often occurs, a forward discount does not always lead to a decline in the currency exchange rate. It is merely the expectation that it will happen because of the alignment of the spot, forward, and futures pricing. Typically, it reflects possible changes arising from differences in interest rates between the currencies of the two countries involved.
Forward currency exchange rates are often different from the spot exchange rate for the currency. If the forward exchange rate for a currency is more than the spot rate, a premium exists for that currency. A discount happens when the forward exchange rate is less than the spot rate. A negative premium is equivalent to a discount.
Example of Calculating Forward Discount
The basics of calculating a forward rate requires both the current spot price of the currency pair and the interest rates in the two countries (see below). Consider this example of an exchange between the Japanese yen and the U.S. dollar.
- The ninety-day yen to dollar (¥ / $) forward exchange rate is 109.50.
- The spot rate ¥ / $ rate is = 109.38.
Calculation for an annualized forward premium = (109.50-109.38÷109.38) x (360 ÷ 90) x 100% = 0.44%
In this case, the dollar is "strong" relative to the yen since the dollar's forward value exceeds the spot value by a premium of 0.12 yen per dollar. The yen would trade at a discount because its forward value regarding dollars is less than its spot rate.
To calculate the forward discount for the yen, you first need to calculate the forward exchange and spot rates for the yen in the relationship of dollars per yen.
- ¥ / $ forward exchange rate is (1÷109.50 = 0.0091324).
- ¥ / $ spot rate is (1÷109.38 = 0.0091424).
The annualized forward discount for the yen, in terms of dollars = ((0.0091324 - 0.0091424) ÷ 0.0091424) × (360 ÷ 90) × 100% = -0.44%
For the calculation of periods other than a year, you would input the number of days as shown in the following example. For a three-month forward rate: Forward rate = spot rate multiplied by (1 + domestic rate times 90/360 / 1 + foreign rate times 90/360).
To calculate the forward rate, multiply the spot rate by the ratio of interest rates and adjust for the time until expiration.
Forward rate = Spot rate x (1 + foreign interest rate) / (1 + domestic interest rate).
As an example, assume the current U.S. dollar to euro exchange rate is $1.1365. The domestic interest rate or the U.S. rate is 5%, and the foreign interest rate is 4.75%. Plugging the values into the equation results in: F = $1.1365 x (1.05 / 1.0475) = $1.1392. In this case, it reflects a forward premium.
What is a Forward Contract?
A forward contract is an agreement between two parties to purchase or sell a currency at a definite price on a particular future date. It is similar to a futures contract with the primary difference being that it trades in the over-the-counter (OTC) market. Counterparties create the forward contract directly with each other and not through a formalized exchange.
Benefits of the forward contract include customization of terms, the amount, price, expiration date, and delivery basis. Delivery may be in cash or the actual delivery of the underlying asset. Drawbacks over future contracts include the lack of liquidity provided by a secondary market. Another deficiency is that of a centralized clearing house which leads to a higher degree of default risk. As a result, forward contracts are not as readily available to the retail investor as futures contracts.
The contracted forward price may be the same as the spot price, but it is usually higher, resulting in a premium. If the spot price is lower than the forward price, then a forward discount results.
Investors or institutions engage in holding forward contracts to hedge or speculate on currency movements. Banks or other financial institutions engaging in investing in forward contracts with their customers eliminate the resulting currency exposure in the interest rate swaps market.