Understanding Forward Premiums in Forex Markets

From an economic standpoint, the forward premiums in foreign exchange markets and futures markets are based on overall changes in supply and level of exports. Essentially, the forward premium is a proxy for the supply curve, the spread between futures and spot rates known as carry yield.

If forward prices are greater than spot rates, markets are in contango. This means the cost of storing supply is increasing with time. There is an expected decrease in supply with a decreasing shift in the supply curve. If forward prices are less than the spot rates, markets are backwarded. This means that the cost of storing supply is decreasing with time, and there is an expected increase in supply with an increasing shift in the supply curve.

Assuming that eventually the forward price and the spot price will converge, there could be a trading opportunity afforded by major discrepancies between the two rates. For instance, if the euro has a major premium factored into the forward rate compared to the current spot rate, then there may be a good trading opportunity. In this instance, one can sell the forward contract and buy the spot rate currency to profit from converging prices, all else equal.