A spot foreign exchange rate is the rate of a foreign exchange contract for immediate delivery.Spot market transaction settlement takes place on value date which is usually two business days after trade date. Price at which deal takes place is known as benchmark price or spot price.
Forward contract is an agreement to exchange currencies at an agreed rate on specified future date. The agreed rate is called forward rate and difference between spot and forward rate is called as forward margin. Forward contracts are privately negotiated. It has counter party risk and liquidity risks. . Forward contract is not transferable or exchange tradable, its terms are not standardized and no margin is exchanged. The buyer of the forward contract is said to be long on the contract and the seller is said to be short on the contract.
What is a forward premium in the foreign exchange market?
It’s the price paid for hedging by buying currencies in the forward market. Forward transactions take place at a premium or discount to the spot rate. The outright forward transactions are over-the-counter transactions undertaken by dealers. In India, generally the banks transact in forward markets.
The maturity date agreed upon by the parties generally varies from one month to a year or two. But maturities beyond that tend to have wider bid-ask spreads, in other words, tend to be more expensive, so are not very liquid. The forward rate could be in premium or discount, based on the interest rate differential in case of currencies which are fully convertible and in case of partially-convertible currencies, they are determined purely on the basis of demand and supply.
In India forward premia is quoted as percent per annum.
What determines forward premium?
Countries that have fully-convertible currencies, the forward premium is deduced from their interest rate differentials, respectively. The premium/discount is measured in points, which represent the interest rate differential of the countries to which the currencies belong, for the period of maturity.
These points are the quantum of foreign exchange that would neutralise the interest rate differential. Points are subtracted from the spot rate, when the interest rate of the base currency is higher, since the base currency should trade at a forward discount and points are added to the spot rate, when the interest rate of the base currency is lower, since the base currency is expected to trade at a forward premium.
Example of USD/INR forward premium based on interest rate differentials
Spot USD/INR = Rs 61
US 3 months T-Bill yield = 0.02%
India 3 months T-Bill yield = 8.82%
Difference between US 3 months and India 3 months T-Bill yields is 8.80%
3 months forward premia = 8.8%
Calculation of forward rate:
Time period = 3 months (91 days)
Spot = Rs 61
Premium = 8.80%
3 months forward rate = Rs 61+ 8.8 %*( 91/365)*Rs 61 = Rs 62.34
Types of Currency Transactions
‘Cash delivery ‘ means delivery of foreign exchange on the day of transaction.
‘Tom (Tomorrow) delivery’ means delivery of foreign exchange on a working day next to the day of transaction;
‘Spot delivery’ means delivery of foreign exchange on the second working day after the day of transaction
‘Forward contract’ means a transaction involving delivery, other than Cash or Tom or Spot delivery, of foreign exchange;
An outright is an agreement between two counterparts to exchange currencies on a future date at a fixed rate.
A 1-month outright, traded on Thursday, the 15th of August, the value date of it would be the 15th September. If the 15th September is a holiday, the value date will be the 16th September.