Key Points
- A two-party currency derivatives contract known as a non-deliverable forward (NDF) is used to swap cash flows between the NDF and current market prices.
- The Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, and Brazilian real have the biggest NDF markets.
- The majority of NDF trading is conducted in London using the US dollar, while there are other significant markets in Singapore and New York.
Non-Deliverable Forward (NDF)
A cash-settled, often short-term forward contract is known as a non-deliverable forward (NDF). Non-deliverable transactions are those in which the notional amount is never transferred. For a predetermined sum of money—or, in the case of a currency NDF, at a predetermined rate—two parties agree to take opposing sides in a transaction. This implies that the difference between the contractual NDF price and the current spot price is settled between counterparties. The difference between the agreed-upon rate and the spot rate at the time of settlement is used to determine the profit or loss on the notional amount of the agreement.
Learning about Non-Deliverable Forwards (NDF)
A two-party currency derivatives contract known as a non-deliverable forward (NDF) is used to swap cash flows between the NDF and current market prices. The discrepancy arising from this trade will be split equally between the two parties.
Cash flow = (NDF rate – Spot rate) * Notional amount
NDFs are often quoted for time periods ranging from one month to one year and are traded over-the-counter (OTC). They have gained popularity among firms looking to hedging exposure to illiquid currencies during the 1990s and are most usually quoted and settled in U.S. dollars.
A non-deliverable forward (NDF) is often carried out offshore, i.e., away from the illiquid or untraded currency’s domestic market. For instance, it won’t be feasible to settle the transaction in a currency with a party outside the restricted nation if that money is prohibited from moving offshore. The NDF may, however, be resolved between the two parties by changing each party’s earnings and losses from the contract into a freely tradable currency. The earnings or losses may then be divided among them in that freely traded currency.
Having said that, illiquid markets or currencies are not the only ones that use non-deliverable forwards. They may be utilized by parties who are not interested in providing or receiving the underlying product but are trying to hedge or expose themselves to a certain asset.
Non-Deliverable Forward Structure
All NDF contracts specify the currency pair, notional amount, fixing date, settlement date, and NDF rate. They also specify that the transaction will be settled at the spot rate in effect on the fixing date.
The calculation of the difference between the current spot market rate and the agreed-upon rate takes place on the fixing date. The settlement date is the deadline by which the party receiving payment must pay the difference. An NDF settles more like a forward rate agreement (FRA) than like a conventional forward contract.
There might be a non-deliverable forward between the two parties if one agrees to purchase U.S. dollars (sell yuan) and the other agrees to buy Chinese yuan (sell dollars). They settle on a 6.41 percent interest rate on a million dollars. In one month, the fixing date will be established, and settlement will follow soon after.
The value of the yuan in relation to the dollar has grown if the rate is 6.3 after one month. Money is owing to the entity that purchased the yuan. The party that purchased U.S. dollars is due money if the rate rose to 6.5 since the value of the yuan has declined (the value of the dollar has climbed).
NDF Currencies
The Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, Brazilian real, and Russian ruble are the major markets for NDF.
1 NDF trading is mostly conducted in London, while there are other significant markets in New York, Singapore, and Hong Kong.
The U.S. dollar serves as the primary medium of exchange for NDF trading. The euro, the Japanese yen, and, to a lesser degree, the British pound and the Swiss franc, are also used in active markets.
