# Forward Premium: Definition and Calculation

![Forward Premium: A situation in which the expected future price for a currency is greater than the spot price.](https://www.investopedia.com/thmb/6zwUHdJ-0zxEDNtC8FqnKzlmFCU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/forwardpremium.asp-final-a8db94194ed840439f2574264829d011.png)

*— Investopedia / NoNo Flores*

> **Definition**
>
> A forward premium occurs when a currency's future price exceeds its spot price, indicating an expected increase in its value relative to another currency.

## What Is a Forward Premium?

A forward premium results when the forward or expected future price for a currency is greater than the spot price (the price for immediate delivery). It is an indication that the market believes the current domestic exchange rate is going to increase relative to the other currency.

This circumstance can be confusing because an increasing exchange rate means the [currency is depreciating](https://www.investopedia.com/terms/c/currency-depreciation.asp) in value.

### Key Takeaways

*   A forward premium exists when the expected future price for a currency is greater than the [spot price](https://www.investopedia.com/terms/s/spotprice.asp).
*   When a forward premium is negative, is it is equivalent to a discount, and in fact is referred to as a forward discount.
*   Various factors can affect whether a forward premium exists, including interest rate differentials, inflation rates, speculative trading, and a country's economic stability.
*   International businesses and currency traders monitor forward premiums and discounts because they can affect their financial decision-making.

## Understanding Forward Premiums

A forward premium is measured as the difference between the current [spot rate](https://www.investopedia.com/terms/s/spot_rate.asp) and the [forward rate](https://www.investopedia.com/terms/f/forwardrate.asp), so it is reasonable to assume that the future spot rate will be equal to the current futures rate.

According to the forward expectation theory of exchange rates, the current spot futures rate will be the future spot rate. This theory is rooted in [empirical studies](https://www.investopedia.com/terms/e/empiricalprobability.asp) and is a reasonable assumption over a long-term time horizon.

Forward currency [exchange rates](https://www.investopedia.com/terms/e/exchangerate.asp) 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. If the forward exchange rate is less than the spot rate, a discount exists.

> **Important**
>
> Typically, a forward premium reflects possible changes arising from differences in the interest rate between the two currencies of the countries involved.

## Forward Premium Calculation

The [calculation of a forward rate](https://www.investopedia.com/ask/answers/052115/how-do-i-calculate-forward-rate-excel.asp) requires both the current spot price of the currency pair and the interest rates in the two countries:

**Forward Premium/Discount (as a Percentage) = (Forward Rate - Spot Rate) ÷ Spot Rate x 100**

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 is = 109.38.
*   **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 expected 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 relative to dollars is less than its spot rate.

To calculate the forward discount for the yen, you first need to calculate the forward and spot exchange 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).
*   **Annualized forward discount for the yen, in terms of dollars** = ((0.0091324 - 0.0091424) ÷ 0.0091424) × (360 ÷ 90) × 100% = -0.44%

### Forward Rates for Periods Other Than One Year

To calculate for periods other than a year, one needs to input the number of days as shown in the following calculation:

**Forward Rate = Spot Rate × (1 + Interest Rate of Currency A) / (1 + Interest Rate of Currency B)**

where Currency A is the base currency, Currency B is the quote currency, and T is the time period.

So, a three-month forward rate is equal to the spot rate multiplied by (1 + the domestic rate x 90/360 / 1 + foreign rate x 90/360).

As an example, assume the current U.S. dollar-to-euro exchange rate is $1.1365. The domestic interest rate, or U.S. interest rate, is 5%, and the foreign interest rate is 4.75%.

**Forward Rate = $1.1365 x (1.05 / 1.0475) = $1.1392**

In this case, the result reflects a forward premium.

## What Does the Forward Premium Mean?

The forward premium reflects an interest in a particular currency that's driven by a variety of factors, including interest rates. A higher interest rate in one country relative to another can make its currency attractive for those who want to benefit from the higher rate.

## Why Does a Forward Premium Matter?

A forward premium can indicate that the market expects a currency to grow in value in the future. For businesses operating internationally, as well as currency speculators, this can be useful information. If there's a forward premium, a business may want to use a forward contract to lock in an attractive exchange rate for future transactions. If there's a forward discount, it may want to avoid any currency purchases until rates look more favorable for its purposes.

## What Are the Factors That Can Affect Forward Premium?

Interest rate differentials between countries, inflation rates, speculative trading activity, and the state of a country's economic stability can influence forward premium. That means that a forward premium can change, depending on the impact of these factors.

## The Bottom Line

Forward premium represents a higher forward exchange rate for a currency relative to the spot, or current, exchange rate. The opposite is called a forward discount.

It's important for businesses engaged in international transactions not only to monitor forward premiums and discounts but also to understand the factors that affect them. That can inform their decision-making about timing transactions to manage currency exposure to their advantage.