Let us first understand how Foreign Exchange rates are presented in practical life.
In practical life, there is two foreign exchange quote.
(1) The first quote ( bid) :- Bid is the rate at which the bank buys left-hand currency.
(2) Second quote ( ask );- Ask is the rate at which the bank sells the left-hand currency.
Example
1 Euro = $ 1.1700/$1.1800
Euro is left-hand currency and $ is right-hand currency.
In this example, the bank will buy 1 Euro for $ 1.1700 and the bank will sell 1Euro for $ 1.1800.
Spot and Forward Rates in Foreign Exchange
Spot Rate:- In a spot transaction, the currencies are delivered either immediately ( on the same day ) or within specified days and the rate at which transaction takes place is known as spot rate.
Forward Rate:- In a future transaction, a contract is made between two parties for the purchase and sale of the one currency against other at a stipulated future date at a rate agreed upon at the time of contract. In Future contracts, deliveries of currencies are made on the stipulated future date. The exchange rate of a future delivery transaction is called as Forward Rate.
Forward Margin ( Premium/Discount )
The forward rate for a currency may be higher or lower than its spot rate. The difference between the forward rate and spot rate is known as forward margin or swap points.
Premium:- If the forward rate is higher than the spot rate then it is said to be at Premium.
Example
Spot Rate 1 Euro = $ 1.1700
6-month Forward Rate 1 Euro = $ 1.2500
here, Euro is at a premium by 0.08 points or 6.84%.
Discount:- If the forward rate is lower than spot rate then it is said to be at Discount.
Example
Spot Rate 1 Euro = $ 1.1700
6-month Forward Rate 1 Euro = $ 1.1200
here, Euro is at a discount of 0.05 points or 4.27%.
The formula for calculating Premium/Discount percentage.
Premium/Discount % = (Forward price of that currency - Spor price of that currency) X 100/ Spor price of that currency.
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