In the foreign exchange market, forward exchange market functions side by side with the spot exchange market. The transactions of spot exchange market are known as spot exchange and those of the forward exchange market are known as forward exchange.
The rates at which the foreign exchange is bought and sold in the spot market are called spot rates and the rates at which the foreign exchange is bought and sold in the forward market are called forward rates.
The spot exchange refers to the foreign exchange transactions which require immediate delivery or exchange of currencies on the spot. Normally, the settlement takes place within two days.
A forward exchange involves a purchase or sale of foreign currency to be delivered at some future date. The rate at which the transaction is to take place is determined at the time of sale, but the payment is not made until the exchange is not delivered by the seller.
The spot rate refers to the rate prevailing at a particular time for spot delivery of a specified type of foreign exchange.
The forward exchange rate is the rate at which the future contract for foreign currency is made. With reference to its relationship with the spot rate, the forward rate may be at par, at a premium or at a discount.
(i) When the exchange rate is quoted exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at par.
(ii) The forward rate is said to be at a premium over the spot rate when it is quoted higher than the spot rate. Premium implies that the foreign currency is expensive. One dollar buys more units of other currency in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis.
(iii) The forward rate is said to be at a discount with respect to the spot rate when it is quoted lower than the spot rate. Discount implies that the foreign currency is cheaper. One dollar buys less units of other currency in the forward than in the spot market. The discount is also expressed as a percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is mostly determined by the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium.
When the supply of forward exchange exceeds the demand for it, the forward rate will be quoted at a discount. When the supply and demand for forward exchange are equal, the forward rate will tend to be at par.