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Discount And Premium

Discount and Premium Assignment / Homework Help

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:

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
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:

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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