Discount And Premium
The concept of Discount and Premium arises in foreign exchange transactions with
respect to Forward and Spot rates. Forward exchange rate is the rate of exchange
applicable for delivery of foreign exchange at a future specified date; example:
Forward exchange contract for 3 months or 90 days. Spot rate is the rate of exchange
of the day on which the transaction takes place and of the days the transaction
is executed. Forward exchange rates can be at a premium or at a discount. To find
out if the forward exchange rate is at a premium or at a discount, we have to compare
the Spot rate and Forward rate. A foreign currency is said to be at a premium when
its forward rate is higher than the spot rate. A foreign currency is said to be
at a discount when its spot rate is higher than the forward rate. It can be expressed
as follows:
Forward Rate > Spot Rate, then forward rate of foreign currency is at a Premium
Spot Rate > Forward Rate, then forward rate of foreign currency is at a Discount
Calculation of Forward rate Premium or Discount in annualized percentages:
Forward Rate > Spot Rate, then forward rate of foreign currency is at a Premium
Spot Rate > Forward Rate, then forward rate of foreign currency is at a Discount
Calculation of Forward rate Premium or Discount in annualized percentages:
| Premium | = |
Forward rate – Spot rate
Spot rate |
x |
12 months
N |
|
|
|
|||||
| Discount | = |
Spot rate – Forward rate
Spot rate |
x |
12 months
N |
|
Where: N = number of months for which forward contract has been made.
Example:
From the data given below, let us calculate forward premium or discount, as it is
applicable in the case:
INR per British Pound
INR per British Pound
| Spot Rate | => | INR 78.0001 | – | INR 78.2254 |
| 1 month forward rate | => | INR 78.4256 | – | INR 78.5200 |
| 3 months forward rate | => | INR 77.8952 | – | INR 77.9999 |
| 6 months forward rate | => | INR 78.8925 | – | INR 78.9925 |
Solution:
Premium with respect to Bid Price:
Premium with respect to Ask Price:
Please note: Spot rates are higher than the forward rates in the case of 3 months forward contract. Hence, forward rates are at a discount.
Discount with respect to Bid Price:
Discount with respect to Ask Price:
| 1 month | = |
(78.4256 – 78.0001)
78.0001 |
x |
12 x 100
1 |
= 6.55 % per annum |
|
|
|||||
| 6 months | = |
(78.8925 – 78.0001)
78.0001 |
x |
12 x 100
6 |
= 2.29% per annum |
Premium with respect to Ask Price:
| 1 month | = |
(78.5200 – 78.2254)
78.2254 |
x |
12 x 100
1 |
= 4.52% per annum |
|
|
|||||
| 6 months | = |
(78.9925 – 78.2254)
78.2254 |
x |
12 x 100
6 |
= 1.96% per annum |
Please note: Spot rates are higher than the forward rates in the case of 3 months forward contract. Hence, forward rates are at a discount.
Discount with respect to Bid Price:
| 3 months | = |
(78.0001 – 77.8952)
78.0001 |
x |
12 x 100
3 |
= 0.54% per annum |
Discount with respect to Ask Price:
| 3 months | = |
(78.2254 – 77.9999)
78.2254 |
x |
12 x 100
3 |
= 1.15% per annum |
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