The forward margin, or forward spread, reflects the difference between the spot rate and the forward rate for a certain commodity or currency. The difference between the two rates can either be a premium or a discount, depending on if the forward rate is above or below the spot rate, respectively.
The forward margin is the difference between the forward rate less the spot rate, or, in the event of a discount rate, the spot rate minus the forward rate. The forward margin can be large, small, negative, or positive, and represent the costs associated with locking in the price for a future date.
The forward margin will be different based on how far out the delivery date of the forward is as a one year forward will be priced differently than a 30-day forward. The forward margin is often measured in basis points, known as forward points, and if you add or subtract the forward margin to the spot rate, you would get the forward rate.
The forward margin is an important concept in understanding the functioning of forwards markets, which are over-the-counter (OTC) marketplaces that set the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, including the foreign exchange market, securities and interest rates markets, and commodities.
The forward margin gives traders some indication of supply and demand over time of the underlying asset that the forward is based on. The wider the spread, the more valuable the underlying asset is perceived to be in the future. Meanwhile, the smaller margins indicate that the underlying asset is likely to be more valuable now than in the future. The forward margin is often measured in basis points, known as forward points, and if you add or subtract the forward margin to the spot rate, you would get the forward rate.
Factors Determining Forward Margin
Demand and Supply of Foreign Currency
This is similar to the principle of demand and supply of a commodity. If a particular foreign currency is in great demand than its supply, then, naturally, it will be costlier and it will be sold at a premium. If the supply exceeds the demand, the forward rate will be at a discount.
Rate of Interest
The prevailing rate of interest at home and also in the foreign country from which we want to get foreign exchange decide the forward margin. To put it shortly, it depends upon the differences in the rate of interest prevailing at the home centre and the concerned foreign centre. If the rate of interest at the foreign centre is higher that the rate of interest prevailing at home centre, naturally, the interest gained by investing in the foreign centre will be more than the interest gained at home centre. If the rate of interest at the foreign centre is higher than the home centre, the forward margin would be at discount. Conversely if the rate of interest is lower in the foreign centre and higher in the home centre, the forward margin would be at premium.
Another factor influencing forward margin will be due to the hectic activities of investments, taking advantage of differences in the rate of interest between one centre and another. The investor may borrow from low interest centre and invest the amount in the high interest centre. For example, the investor may borrow at London at the rate of 5% p.a. and invest the amount in Chennai at 12% p.a. In order to secure his position, he may cover up his transaction in the forward marker. Then, he will sell spot pound-sterling and buy forward pound-sterling. When many investors do like this, the supply of spot Pound-Sterling increases abundantly putting down the price. The demand for forward pound-sterling increases, pushing up the price.
Exchange control regulations may also put restrictions or conditions on the forward dealing, leading to change in forward margin. Such restrictions may be with respect to keeping of balances abroad, borrowing overseas etc. If the Central Bank of the country intervenes in the forward market, this will influence forward margin.
Speculative Activities Regarding Spot Rates
The forward rates are based on spot rates. Any speculation in the movement of spot rates would also influence forward rates. If exchange dealers anticipate spot rate to appreciate, they will quote forward rate at a premium. If they expect the spot rate to depreciate, the forward rate would be quoted at a discount.