A forward premium is the amount by which a currency's forward exchange rate exceeds its spot exchange rate, usually expressed as a percentage of spot for a stated term. The currency being priced, quote units and maturity must be explicit. A hedger uses the premium to compare today's spot and forward quotations; the number alone does not measure a trading profit.
First name the currency being priced
Let and be today's spot and forward prices in USD per EUR, with applying to delivery one year ahead. These are fictional single-price quotations, ignoring bid–ask spreads and fees:
| Quote | USD per EUR |
|---|---|
| Spot, | 1.20 |
| One-year forward, | 1.22 |
EUR is the base currency in the market pair EUR/USD. One euro costs more dollars for forward delivery than for spot delivery, so EUR trades at a forward premium to USD. Its term premium is
The absolute difference, 0.02 USD per EUR, is the forward–spot margin, also called forward points when expressed using the market's point scale. It is not itself a percentage. Check the scale before interpreting a dealer's points quotation.
The percentage above is for the one-year term. If reporting a simple annualised premium for a different maturity, state the year fraction and its day-count basis, then use . That scaling convention differs from an effective compounded annual rate. The Bank of England's data notes illustrate why the label matters: forward margins can be reported in currency units or as percentages per annum.
Invert both quotes, then recompute
Price dollars in euros instead. The reciprocal spot and forward quotations are
Now USD is the currency being priced, and its forward price is lower. USD trades at a forward discount to EUR:
The sign reverses, but the magnitude is not exactly the same. The original percentage divides by ; after inversion the algebra gives a difference relative to . In general, . Compute from unrounded quotes rather than the displayed six-decimal reciprocals.
Original fictional comparison of today's spot and one-year forward quotations. Percentages use exact prices; displayed reciprocal prices and percentages are rounded. Reversing the quote changes the currency being priced and the percentage denominator.
For practice reading the currency units before calculating, the FX lesson covers quote direction, reciprocal relationships, bid/ask conversion and the two funding rates behind FX forwards. It has a public preview; the full lesson is available with a signed-in free account.
Why a premium can coexist with a lower interest rate
Under covered interest-rate parity, the forward reflects the relative cost of funding the two currencies. With USD-per-EUR quotations, simple annual rates and , and a common year fraction ,
This model assumes matched settlement and maturity dates, comparable credit exposure, access to borrowing and lending at the stated rates, and no transaction or balance-sheet costs. With positive funding accumulation factors, a higher USD rate puts EUR at a USD-per-EUR forward premium. The premium compensates in the covered funding comparison; it is not an extra free return. Actual funding constraints and the cross-currency basis can make observed prices depart from this frictionless relation, as the BIS explains.
Finally, “premium” here describes the relationship between two exchange-rate quotations. It is distinct from an option premium paid to purchase an option. Nor does it establish that the future spot rate will rise to the forward rate: the funding replication locks a conversion rate, while an unhedged currency position remains exposed to the future spot outcome. A forecast requires assumptions beyond the covered funding argument.
Sources
- Bank of England, Further details about US dollar forward premium/discount rates; sterling against US dollar forward rates data: reporting units, annualised margins and quote-dependent premium/discount labels.
- CME Group, Understanding FX Quote Conventions: base/quote roles and explicit currency-price conventions.
- Borio, McCauley, McGuire and Sushko, BIS Quarterly Review, Covered interest parity lost: understanding the cross-currency basis: covered funding comparisons, forward points, hedging demand and limits to arbitrage.
- Hull, John C. (2018), Options, Futures, and Other Derivatives, 9th ed., Global Edition, Pearson, §5.10, pp. 139–141: quotation units and the interest-rate-parity replication for currency forwards.