What is a Non-Deliverable Forward NDF?

Due to currency restrictions, a Non-Deliverable Forward is used to lock-in an exchange rate. As forwards are traded privately over-the-counter and aren’t therefore regulated, forwards come with a counterparty default risk – there is a chance that one side isn’t able to stick to the agreement. Or for example, an exporter company based in Canada is worried the Canadian dollar will strengthen from the current rate of C$1.05 a year on, which would mean they receive less in Canadian dollars per US dollar. The exporter can enter into a forward contract to agree to sell $1 one year from now at a forward price of US$1 to C$1.06. Currency forward is https://www.xcritical.com/ an essential solution for institutional investors used as a hedging tool and is customizable. One of the benefits is that it doesn’t require an upfront margin payment and can be tailored to any amount necessary, unlike exchange-traded currency futures.

How to hedge with a forward contract?

Non-deliverable forwards (NDFs) are forward contracts that let you trade currencies that are not freely available in the spot market. They are popular for emerging market currencies, such as the Chinese yuan (CNY), Indian rupee (INR) or Brazilian real non deliverable forward contract (BRL). Unlike regular forward contracts, NDFs do not require the delivery of the underlying currency at maturity. Instead, they are settled in cash based on the difference between the agreed NDF and spot rates.

Access to Restricted Currencies

An example of an NDF is a contract between a U.S. importer and a Chinese exporter to exchange USD for CNY at a fixed rate in 3 months and settle the difference in cash on the settlement date. The more active banks quote NDFs from between one month to one year, although some would quote up to two years upon request. The most commonly traded NDF tenors are IMM dates, but banks also offer odd-dated NDFs. NDFs are typically quoted with the USD as the reference currency, and the settlement amount is also in USD. So far, you understand how non-deliverable forward contracts work and how investors can benefit from them. However, how do they differ from their counterpart deliverable forward contracts?

How Deliverable Forward Contracts Operate

An NDF essentially provides the same protection as a forward trade without a full exchange of currencies taking place. The main difference between forward and NDF is that in a standard forward contract, there is actual delivery of the underlying currencies on the settlement date. In contrast, an NDF involves cash settlement of the difference between the agreed and prevailing market rates, without any physical exchange of currencies. For example, if a company operates in a country with strict rules on currency exchange, it might use an NDF to protect itself from losing money due to changes in currency values.

Difference Between NDF And Forward

Similarly, a commodity producer might use forwards to secure stable selling prices. NDFs are also known as forward contracts for differences (FCD).[1] NDFs are prevalent in some countries where forward FX trading has been banned by the government (usually as a means to prevent exchange rate volatility). A non-deliverable forward (NDF) is a cash-settled, and usually short-term, forward contract. The notional amount is never exchanged, hence the name “non-deliverable.” Two parties agree to take opposite sides of a transaction for a set amount of money—at a contracted rate, in the case of a currency NDF. This means that counterparties settle the difference between contracted NDF price and the prevailing spot price.

What are the benefits of non-deliverable forwards?

From 2010, the relationship for the renminbi weakened when an offshore deliverable forward market started trading in parallel with the onshore deliverable forward and offshore NDF markets (McCauley (2011, Graph 1)). In Korea and Chinese Taipei, some domestic financial firms are allowed to trade NDFs (Tsuyuguchi and Wooldridge 2008), Annex A). Non-deliverable forwards are most useful and most essential where currency risk is posed by a non-convertible currency or a currency with low liquidity. In these currencies, it is not possible to actually exchange the full amount on which the deal is based through a normal forward trade.

Non-Deliverable Forward Contracts

Overall, non-deliverable forwards open up possibilities for clients and investors seeking opportunities in inaccessible currencies abroad. When used prudently, NDFs can be an effective tool for risk management as well as for speculative trading strategies. NDFs are primarily used to hedge against currency risk in the near term for corporations that have exposure to developing market currencies which are often subject to high volatility. For example, an American firm with subsidiary in India that earns revenues in rupees but reports in USD can hedge the EUR/INR risk by using NDFs.

• An NDF settles with a single cash flow based on the difference between the contracted NDF rate and the spot rate, while an FX swap settles with two cash flows based on exchanging two currencies at a spot rate and a forward rate.
• For the separately identified NDFs, however, dollar NDFs represent three quarters of all dollar forwards in the six currencies detailed by the survey.
• The exchange rate is calculated according to the forward rate, which can be thought of as the current spot rate adjusted to a future date.
• The one-way nature of NDF contracts make them a flexible tool for arbitrage as well.
• A company that is exposed to currency risk will approach the provider of an NDF to set up the agreement.
• In a case of a cash settlement, the buyer would make a cash payment of $1 per bushel to the farmer, paying for the difference that is owed to the farmer, and who gets the same value overall as stated in the forward contract.

Cybersecurity Tips for Traders in 2024: Staying Safe in the Digital Marketplace

Since April 2013, NDF trading has been affected by investors’ and borrowers’ hedging in anticipation of a reduction in global monetary easing. Over the last several years, investors poured large sums into emerging market local currency bonds, and in some markets increased their holdings to substantial shares of outstanding bonds. For their part, many emerging market firms that had used their unprecedented access to the global dollar (and euro) bond market to fund domestic assets also had exposures to hedge. The strength of this relationship testifies to the robustness of the controls separating the onshore and offshore markets. In India, the sense that NDF activity strongly affected the domestic market in August 2013 has led to discussion of how to bring NDF trading into the domestic market (see below).

With respect to pricing, the theoretical price is still determined bythe forward points which are derived by the relative interest rates to term of the contract. The motivation is that for many currencies (e.g. Russian rouble, RUB), regulations make it difficult to execute a physical delivery FX forward, so instead people trade USD/RUB or EUR/RUB NDFs. 2 Note, however, that the Triennial Survey allocates trading by the location of the sales desk, while the London survey does so by the location of the trading desk. Because two big banks have moved their sales desks out of London but still trade there, the London share on the sales desk basis is only about a third of net-net turnover. For instance, in the smaller markets of Chile and Peru,5 where the central bank measures not just turnover but also net positions, the data show a sharp turnaround in positioning in May-June 2013. The left-hand panel of Graph 1 shows stocks of long positions in the Chilean peso and Peruvian new sol.

In some cases, NDFs may have lower costs compared to forward contracts on restricted currencies since they do not incur the expenses related to physical delivery of the currencies. The lower barriers to access make them preferred by investors with smaller capital. Investors like hedge funds also use NDFs to speculate on emerging market currency movements. The one-way nature of NDF contracts make them a flexible tool for arbitrage as well.

NDFs are traded over-the-counter (OTC) and commonly quoted for time periods from one month up to one year. They are most frequently quoted and settled in U.S. dollars and have become a popular instrument since the 1990s for corporations seeking to hedge exposure to illiquid currencies. The contract has no more FX delta or IR risk to pay or receive currencies after the determination date, but has FX delta (and a tiny IR risk) to the settlement currency between determination and maturity dates. No money or underlying assets exchange hands when the contract is written, and the settlement only occurs at the end once the contract expires. Moreover, forward contracts must be adhered to as they are legally binding, and they oblige both parties to carry out the trade. Futures contracts, on the other hand, trade on exchanges, which means they are regulated and less risky as there is no counterparty risk involved, and are transferable and standardized.

A crucial point is that the company in question does not lose money as a result of an unfavourable change to the exchange rate. The two parties then settle the difference in the currency they have chosen to conduct the non-deliverable forward. Non-deliverable forward trades can be thought of as an alternative to a normal currency forward trade.

The pricing is almost the same as physical-delivery FX forward, just be careful to use the determination date, rather the maturity date. For a few currency/domicile combinations, you may want to use separate discount curves for the currency onshore in a particular domicile. In practice, the settlement currency is almost always either the same as pay or the same as receive currency. E.g., you swap EUR for RUB and settle in EUR, or you swap USD for BRL and settle in USD.

Whereas with a normal currency forward trade an amount of currency on which the deal is based is actually exchanged, this amount is not actually exchanged in an NDF. Deutsche Bank will pay BASF this settlement amount in EUR based on the NDF-spot differential. It expects to receive 300 million Mexican pesos in 90 days from customer sales in Mexico. The difference in interest rates between the currencies in an NDF drive its pricing to a large extent.

It is a contract to pay the difference between an agreed-upon currency exchange rate and the real rate on a future date, using money rather than exchanging physical currencies. Thankfully, both parties involved in the non-deliverable contract can settle the contract by converting all losses or profits to a freely traded currency, such as U.S. dollars. The fixing date is the date at which the difference between the prevailing spot market rate and the agreed-upon rate is calculated. The settlement date is the date by which the payment of the difference is due to the party receiving payment. The settlement of an NDF is closer to that of a forward rate agreement (FRA) than to a traditional forward contract. A non-deliverable forward (NDF) is usually executed offshore, meaning outside the home market of the illiquid or untraded currency.