Forward Premium

A Forward Premium exists when the price to buy a currency for future delivery is higher than its current price on the open market. In simpler terms, the market is betting that this currency will be worth more in the future compared to another currency. The future price is locked in using a forward contract, which is just an agreement to buy or sell an asset at a predetermined price on a specific future date. The current price is known as the spot exchange rate. For example, if the one-year forward exchange rate for the Euro against the US Dollar is $1.15, while the spot rate is only $1.10, the Euro is said to be trading at a forward premium. This situation doesn't automatically mean the Euro is a “good buy.” Instead, it's typically a reflection of differences in interest rates between the two currency zones, a concept captured by the theory of interest rate parity.

Think of a forward premium not as a prophecy, but as the market balancing the books. The primary reason a currency trades at a forward premium is that its home country usually has lower interest rates than the country of the currency it's being compared against. Imagine you're an investor with US Dollars. You see that interest rates in the Eurozone are 2%, while in the US they are 4%. You might think, “I'll just convert my dollars to euros, earn 2% interest, and then convert back to pocket the difference!” Not so fast. The foreign exchange market anticipates this. To prevent this “free lunch,” the forward exchange rate for the Euro will be higher (a premium) to offset the lower interest rate you'd earn. When you go to lock in the rate to convert your euros back to dollars in the future, the premium you pay effectively cancels out the extra interest you thought you could gain. Therefore, a forward premium is primarily a mechanical adjustment by the market to prevent risk-free profits from interest rate differentials. It's a sign of equilibrium, not a one-way bet on a currency's appreciation.

For a value investor, whose main game is buying great companies at fair prices, a forward premium is a piece of macroeconomic data—useful for context, but dangerous to use for speculation.

A forward premium is a market-implied forecast, heavily influenced by interest rate spreads. It is not a reliable predictor of future spot rates. Currencies can and do move for countless other reasons, including economic growth, political stability, and inflation. A value investor should be deeply skeptical of making an investment decision based solely on the expectation that a currency will rise just because it has a forward premium. The focus must remain on the intrinsic value of the underlying business.

Where the forward premium becomes practical is in hedging. Let's say you're a US-based investor who just bought shares in a fantastic German company. Your investment is in Euros. You worry that a fall in the Euro's value could wipe out your stock gains. You can hedge this risk by selling Euros forward.

• With a Forward Premium: If the Euro has a forward premium against the Dollar, selling it forward means you lock in a rate that's higher than the current spot rate. In this case, hedging not only protects you from currency risk but also generates a small, guaranteed return (the premium itself).
• With a Forward Discount: Conversely, if the currency you're holding has a forward discount (the forward rate is lower than the spot rate), hedging will come at a cost.

Understanding this helps you make an informed decision about whether the cost of protecting your investment from currency swings is worth it.

Calculating the forward premium is straightforward. It's the percentage difference between the forward and spot rates, usually annualized to make comparisons easier. Formula: Forward Premium (%) = ((Forward Rate - Spot Rate) / Spot Rate) x (12 / Number of Months in Forward Period) x 100

Let's use our Euro (EUR) and US Dollar (USD) example again.

• Spot Rate (EUR/USD): 1.1000
• 6-Month Forward Rate (EUR/USD): 1.1088

Now, let's plug these into the formula:

1. Step 1: Calculate the difference: 1.1088 - 1.1000 = 0.0088
2. Step 2: Divide by the spot rate: 0.0088 / 1.1000 = 0.008
3. Step 3: Annualize the result. Since it's a 6-month contract, we multiply by (12 / 6), which is 2. So, 0.008 x 2 = 0.016
4. Step 4: Convert to a percentage: 0.016 x 100 = 1.6%

The Euro is trading at an annualized forward premium of 1.6%. This figure is roughly what you would expect the interest rate difference to be between the US and the Eurozone for that six-month period.