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Before discussing the forward premium, we need to understand what currency forward is.

Currency forward is an agreement between two parties that allows you to buy or sell currency at a fixed exchange rate in the future. Furthermore, currency forwards do not require you to pay an upfront payment before entering the agreement. It also allows the parties to tailor the terms to suit their needs. It is usually used to hedge currency risks.

The currency forward premium is often defined as the difference between the spot and forward rate. The forward premium can also be seen as a situation when the forward rate is higher than the spot rate. On the other hand, when the forward rate is lower than the current spot rate, the situation is described as the forward discount.

Now, we can discuss the calculation of currency forward price. Let's take the currency forward of the GBP/EUR as an example. GBP stands for the British pound sterling, and the EUR stands for Euro.

• Currency forward: GBP/EUR;
• Number of days in the forward contract: 90 days;
• Spot rate: 1.1859; and
• Forward rate: 1.1885.

The calculation of the annualized currency forward premium requires four steps:

1. Determine the spot rate.

The spot rate is the current currency exchange rate of the currency pair. You can find this information by simply Googling it. To understand more about currency exchange rates, please check out our cross exchange rate calculator.

The spot rate of GBP/EUR is 1.1859.

2. Determine the forward rate.

The forward rate is the currency exchange rate on the forward contract. The forward rate of the GBP/EUR is 1.1885.

The forward premium can be calculated using the forward premium formula below:

forward premium = (forward rate − spot rate) / spot rate

The forward premium for GBP/EUR is (1.1885 − 1.1859) / 1.1859 = 0.22%.

4. Calculate the annualized forward premium.

The annualized forward premium is the annual equivalent of the forward premium. We can calculate the metric using the formula below:

annualized forward premium = forward premium × (360 / days)

The annualized forward premium is 0.88%. Please use our day counter to speed up the calculation of the number of days in the forward contract.

How to interpret the currency forward premium

Interpreting the currency forward premium is easy. There are two situations that we need to look at：

• When the forward rate is higher than the current spot rate, the situation is described as the forward premium. This means that the market expects the future spot rate to be higher than the current spot rate.

• When the forward rate is lower than the current spot rate, the situation is described as the forward discount. This means that the market expects the future spot rate to be lower than the current spot rate.

FAQs

What is hedging?

Hedging is a form of risk management where the party eliminates the risks of huge losses at the expense of reducing some potential profits. Hedging is typically carried out by commodity producers such as crude oil companies.

What is foreign currency exposure?

Foreign currency exposure happens when a company has operations in other countries. For example, if a US-based company acquires a UK-based company and continues operating in the UK, the combined entity will have foreign currency exposure.

What is speculating?

Speculating is a form of earning profit by buying a financial instrument and hoping to sell it at a higher price in the future. Speculating also includes shorting financial instruments if one thinks the price will drop in the future. All in all, speculating is a dangerous way to trade by timing the market.

What is arbitrage?

Arbitrage is a way of earning risk-free profit by exploiting the mispricing of securities in different markets. This involves buying the instrument in one market and immediately selling it at a higher price in another market.

How can I calculate the forward premium?

You can calculate the forward premium in three steps:

1. Determine the spot rate.

2. Calculate the forward rate.

3. Apply the forward premium formula:

forward premium = (forward rate − spot rate) / spot rate

What is the annualized forward premium for a 5% 180-day forward?

The annualized forward premium will be 10%. You can calculate it by using this formula:

annualized forward premium = forward premium × (360 / days) = 5% × (360/180) = 10%