What is a Non-Deliverable Forward (NDF)?

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 (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. This article delves into the intricacies of NDFs, their benefits and risks and how they affect global currency markets.

How Do Non-Deliverable Forwards Work?

An NDF is a two-party contract to exchange cash flows between the NDF and spot rates. The cash flow is calculated as:

Cash flow=(NDF rate−Spot rate)×Notional amount

The features of an NDF include:

• Currency pair: The NDF involves two currencies, usually the U.S. dollar (USD) as the reference currency and a non-convertible or restricted currency.
• Notional amount: The amount of the reference currency agreed to be exchanged at maturity, although it's never actually exchanged.
• Fixing date: When the difference between the contracted NDF rate and the spot rate is calculated. It is usually one or two business days before the settlement date.
• Settlement date: When the cash flow is exchanged between the two parties. It is usually one or two business days after the fixing date.
• NDF rate: The NDF rate is the forward exchange rate agreed by the two parties at the contract's inception. Based on the interest rate differential between the two currencies, it reflects the market expectations of the future spot rate.
• Spot rate: The spot rate is the current market exchange rate between the two currencies on the fixing date. It is usually determined by a reputable source, such as Reuters or Bloomberg, based on a survey of market participants.

NDF Example

InTech Inc., a multinational powerhouse spanning the U.S. and India, regularly imports electronic components from India to fuel innovation. InTech faces a challenge – the Indian rupee (INR) tends to fluctuate against the U.S. dollar (USD), risking profit margins. At the moment, the exchange rate is 1 USD = 76 INR.

InTech uses an NDF contract to curb this risk. Anticipating the need to convert 10 million INR into USD in six months, it trades an NDF with a financial institution and agrees on a future exchange rate of 1 USD = 76 INR.

Two scenarios emerge:

1. Rupee appreciates: If, in six months, the exchange rate is 1 USD = 74 INR, the rupee has appreciated against the dollar. InTech has locked in a worse exchange rate of 1 USD = 76 INR and pays the financial institution the difference between the agreed-upon rate and the actual rate. The loss offsets the improvement in the rupee exchange rate. 

1. Rupee depreciates: Let’s say the rupee weakens against the dollar to 1 USD = 78 INR. In this case, InTech benefits from the NDF contract. The financial institution pays the difference between the agreed-upon rate and the actual rate, effectively hedging the depreciation of the rupee. 

Advantages of Trading NDFs

There are several advantages of trading NDFs, such as:

• Access to non-convertible or restricted currencies: NDFs offer exposure to currencies not freely traded or available in the spot market, such as the CNY, TWD, INR or BRL. This channel can help market participants diversify portfolios, hedge currency risks or speculate on the exchange rate movements of these currencies.
• No delivery risk: Since NDFs are cash-settled, no delivery risk is involved in trading them. This attribute eliminates the need to arrange or pay for the underlying currency's delivery at maturity.
• Leverage and flexibility: NDFs offer leverage and flexibility to market participants, as they can trade large amounts of currency with a small margin or collateral requirement. They can also customize their NDF contracts to suit their particular needs and preferences.

Risks Associated with NDF Trading

Trading NDFs also involves some risks, such as:

• Market risk: The risk of losing money because of unfavorable changes in the exchange rates between the two currencies. Factors such as interest rate differentials, inflation expectations, political events, economic data and market sentiment can affect market risk.
• Counterparty risk: NDFs are over-the-counter (OTC) contracts, meaning they are not traded on a centralized exchange or cleared by a clearinghouse. As a result, they are exposed to counterparty risk, the risk that one party may default on its obligations or fail to honor the contract terms. You can mitigate counterparty risk using reputable and creditworthy counterparties, collateral agreements or third-party guarantees.
• Regulatory risk: The risk of facing legal or regulatory actions or penalties because of non-compliance with the rules and regulations of the jurisdictions where the NDFs are traded or settled. Regulatory risk can be reduced by following the applicable laws and regulations as required.

How NDFs Contribute to Global Currency Markets

NDFs play a vital role in the global foreign exchange markets, especially for emerging market currencies that are not fully convertible or accessible. Some of the contributions of NDFs are:

Providing Liquidity and Price Discovery

NDFs provide liquidity and price discovery for currencies with limited or no spot market activity. By allowing market participants to trade these currencies in a forward market, NDFs facilitate the flow of capital and information across borders and regions. NDFs also reflect these currencies' market expectations and sentiments, which can influence their spot rates and volatility.

Enabling Hedging and Speculation

NDFs allow hedging and speculation for currencies with high exchange rate risk or potential returns. They allow market participants to lock in a forward rate or bet on a future rate movement, managing their currency exposure or profiting from their currency views. NDFs are customizable, offering leverage and flexibility to suit different needs and preferences.

Supporting Economic Development and Integration

NDFs enable economic development and integration in countries with non-convertible or restricted currencies. They encourage trade and investment flows by allowing market participants to access these currencies in a forward market. Additionally, NDFs promote financial innovation and inclusion by offering new products and opportunities for financial intermediaries and end-users.

Deliverable Forward vs. Non-Deliverable Forward

A deliverable forward (DF) is a forward contract involving the actual delivery of the underlying currency at maturity. A DF is usually used for currencies that are freely convertible and traded in the spot market, such as the euro (EUR), British pound (GBP) or Japanese yen (JPY).

The main differences between a DF and an NDF are:

• Delivery: A DF requires the physical delivery of the underlying currency at maturity, while an NDF does not. Instead, an NDF is settled in cash based on the difference between the contracted NDF rate and the prevailing spot rate.
• Currency pair: A DF involves two convertible currencies, while an NDF involves one convertible currency (usually USD) and one non-convertible or restricted currency.
• Market participants: The DF market attracts more diverse participants, such as banks, corporations, hedge funds, central banks, governments and individuals. Banks, hedge funds and corporations with exposure or interest in non-convertible or restricted currencies dominate the NDF market.

Understand NDFs to Navigate Forex

An NDF is a powerful tool for trading currencies that is not freely available in the spot market. By understanding how they work, their benefits and risks and how they differ from DFs, you can use them to diversify your portfolio, hedge your currency risks or speculate on the exchange rate movements of these currencies.

Frequently Asked Questions