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Updated May 2, 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. Key Takeaways 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. 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. The yen would trade at a discount because its forward value regarding dollars is less than its spot rate. For a three-month forward rate: To calculate the forward rate, multiply the spot rate by the ratio of interest rates and adjust for the time until expiration. As an example, assume the current U. The domestic interest rate or the U. Plugging the values into the equation results in: 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. 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.
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. Compare Investment Accounts.
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