What it means
When the forward rate for a currency sits above its spot rate, that currency is said to trade at a forward premium. When it sits below, the currency trades at a forward discount, and the two are simply opposite signs of the same calculation.
The reason has nothing to do with market sentiment and everything to do with interest rates. If you can earn 5% holding one currency and only 3% holding another, the forward market must price the second currency higher in the future, or traders could borrow cheaply, invest at the higher rate and pocket a risk-free gain.
Expressing the gap as an annualised percentage makes it usable. A three-month premium of 0.5% and a twelve-month premium of 1.9% look similar in raw terms, but annualising the first gives 2.0%, so the shorter hedge is very slightly the more expensive per year of protection.
Treasurers use the annualised premium as a budgeting number. If a business hedges 12,000,000 euros of exposure a year at a 2% forward premium, it can tell the board that currency protection has a running cost of roughly $240,000 before any offsetting interest benefit is counted.
The nuance worth carrying into any board discussion is that a forward premium is not a fee taken by the bank. It is the market equalising two interest rates, and the company that pays it is usually holding the higher-yielding currency in the meantime, which recovers most or all of the apparent cost.
In practice
Real-world examples.
Example
A Canadian components maker reviews quotes for hedging a Japanese yen payment and finds the yen trading at a 3% annualised forward premium. It calculates the cash effect on a 90,000,000 yen invoice before deciding whether to hedge the whole amount or only half.
Example
A private equity firm modelling a cross-border acquisition builds the annualised forward premium into its five-year cash flow projection. Because the target's earnings are in a low interest rate currency, the premium reduces the projected dollar returns and shifts the firm's bid slightly lower.
Example
A finance manager presents to a sales director who wants to know why quoting in euros costs the business money. She shows that the forward premium is 1.8% a year and equal to the interest rate gap, so the honest answer is that euro pricing has a small carrying cost the sales team should build into its list price.
Formula
Calculation
Annualised forward premium = ((forward rate - spot rate) / spot rate) x (12 / number of months) x 100.
A US company will need euros in three months. The spot rate is $1.2000 per euro and the three-month forward rate is $1.2060.
Difference = $1.2060 - $1.2000 = $0.0060.
Proportional difference = $0.0060 / $1.2000 = 0.005, or 0.5% for the three-month period.
Annualised = 0.5% x (12 / 3) = 2.0%.
The euro is therefore trading at a 2% annualised forward premium against the dollar. On a hedge of 5,000,000 euros, the extra cost against spot is 5,000,000 x $0.0060 = $30,000 for the three months.Case study
Seen in the real world.
The following is an illustrative case involving a fictional company. Northgate Ceramics, an invented tile manufacturer, sold heavily into a market whose currency consistently traded at a forward premium against the dollar. Its commercial director argued that the premium was proof the market expected the currency to strengthen, and pressed the company to leave receipts unhedged so it could capture the upside.
The treasurer ran the numbers over the previous three years. The currency had traded at a forward premium in almost every quarter, yet it had strengthened in only about half of them, and the unhedged approach would have produced wider swings in reported profit with no reliable gain.
Northgate kept hedging, but the exercise changed the language used internally. The premium was reported as a financing cost rather than as a market signal, and the fictional business began quoting its overseas price list with that cost built in, which removed the argument from every subsequent budget meeting.
Watch out
Common mistakes.
- Reading a forward premium as the market's expectation that the currency will appreciate, rather than as a reflection of the interest rate gap.
- Comparing a one-month premium with a twelve-month premium without annualising both, which makes the shorter hedge look far cheaper than it is.
- Recording the premium as a pure loss while ignoring the higher interest earned on the currency held in the meantime.
Questions
People also ask.
What is the opposite of a forward premium?
A forward discount, which occurs when the forward rate is below spot because the currency being bought carries the higher interest rate.
Does a forward premium mean hedging is expensive?
Not necessarily, because the offsetting interest earned on the higher-yielding currency usually recovers most of the apparent cost.
How is the premium quoted in practice?
Dealers quote raw forward points, and the annualised percentage is calculated afterwards for reporting and comparison.
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