What Is a Non-Deliverable Forward (NDF)?

A non-deliverable forward (NDF) is a cash-settled, and usually short-term, 澳洲幸运5官方开奖结果体彩网:forward contract. The 澳洲幸运5官方开奖结果体彩网:notional amount 🃏is never exchanged, hence the name "non-deliverable."

Understanding Non-Deliverable Forwards (NDF)

A non-d😼eliverable forward (NDF) is a two-party currency derivatives contract to ಌexchange cash flows between the NDF and prevailing spot rates. One party will pay the other the difference resulting from this exchange.

Cash flow = (NDF rate - Spot rate) * Notional amount

NDFs are traded 澳洲幸运5官方开奖结果体彩网: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.

A non-deliverable forward (NDF) is usually executed offshore, meaning outside the home market of the illiquid or untraded currency. For example, if a country's currency is restricted from moving offshore, it won't be possible to settle the transaction in that currency with someone outside the restricted country. However, the two parties can settle the NDF by converting all profits and losses on the contrac🎐t to a freely traded currency. They can then pay each other the profits/losses in that freely traded currency.

That said, non-deliverable forwards are not limited to illiquid markets or currencies. They can be used by parties looking to hedge or expose themselves to a particular asset, but who are not interested in delivering or receiving𓂃 the underlying ✱product.

NDF Structure

All NDF contrac🗹ts set out the currency pair, notional amount, fixing date, settlement date, and NDF rate, and stipulate that the prevailing spot rate on the fixing date be used to c✨onclude the transaction.

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 澳洲幸运5官方开奖结果体彩网:forward rate agreement (FRA) than to a traditional forward contract.

If one party agrees to buy Chinese yuan (sell dollars), and the other agrees to buy U.S. dollars (sell yuan), then there is potential for a non-deliverable forward between the two parties. They agree to a rℱate of 6.41 on $1 million U.S. dollars. The fixing date will be in one month, with settlement due shortly after.

If in one month the rate is 6.3, the yuan has increased in value relative to the U.S.🌺 dollar. The party who bought the yuan is owed money. If the rate increased to 6.5, the yuan has decreased in value (U.S. dollar increase), so the party who bought U.S. dollars is owed money. 

NDF Currencies

The largest NDF markets are in the Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, Brazilian real, and Russian ruble. The largest segment of NDF trading takes place in London, with active markets also in New York, Singapore, and Hong Kong.

The largest segment of NDF trading is done via the U.S. dollar. There are also active markets using the euro, the Japanese yen and, to a lesser extent, the British pound and the Swiss franc.

Main Participants in NDF Market

The main participants in the NDF market include but aren't necessarily limited to:

• Multinational Corporations: MNCs often have operations in multiple countries and regularly engage in cross-border transactions. For these corporations, NDFs provide a way to hedge against currency risk in countries with restricted currencies. By locking in exchange rates through NDFs, they can stabilize their cash flows and avoid unfavorable currency fluctuations.
• Financial Institutions: Banks and other financial institutions also play a major role in both facilitating and trading NDFs. They act as counterparties to NDF contracts and provide liquidity to the market. These institutions also use NDFs to manage their currency exposure or on behalf of clients looking to hedge currency risk.
• Hedge Funds and Investment Firms:
  Hedge funds and other investment firms are often active in the NDF market for speculative purposes. These funds aim to profit from currency volatility by taking positions on anticipated movements in the exchange rates of emerging market currencies.
• Central Banks and Governments:
  In some cases, central banks or government entities may participate in the NDF market. This is often part of broader efforts to manage their currency reserves or stabilize their currency in response to market pressures.

Risks of NDFs

Trading non-deliverable forward contracts comes with several risks. The first risk is market risk. Market risk refers to t💛he potential for losses due to unfavorable movements in the exchange rate of the underlying currency. Since NDFs are often used to hedge or speculate on currencies in emerging markets, these currencies can be highly volatile.

Another risk is counterparty risk which is the risk that the other party in the NDF contract will not fulfill their financial obligations. Since NDFs are traded over the counter, they do not go through a centralized clea💙ringhouse that guarantees the transaction. This makes participants vulꦚnerable to the possibility that their counterparty may default.

Liquidity risk can be a factor in NDF trading. Liquidity risk occurs when there is a lack of buyers or sellers in the market, making it difficult to enter or exit positions at favorable prices. The NDF market, particularly for certain emerging market currencies, can sometimes be less liquid than more establisꩵhed markets like the spot forex market. This can result in wider bid-ask spreads, slippage, or even the inability to execute a trade.

NDFs vs. Currency Swaps

The primary difference between non-deliverable forwards and currency swaps lies in the structure and purpose of the contracts. An NDF is a single agreement where one party agrees toꦗ exchange a predetermined amount of one currency for another at a specific future date, based on a forward rate. A currency swap is a more complex financial instrument that involves the exchange of both the principal amount and interest payments in two different currencies.

In a currency swap, the principal amounts are exchanged at the start of the contract and re-exchanged at maturity, while the interest payments are made periodically throughout th♓e life of the swap. This makes currency swaps useful for long-term hedging or for managing exposure to interest rate differe𓄧nces between two currencies.

The use cases of these two instruments vary. NDFs are primarily used for short-term hedging or speculation, often for currencies that have limited convertibility due to capital controls or liquidity restrictions. They are a way for businesses or investors to manage exposure to currencies they cannot physically hold or trade. Currency swaps are better used for long-term financing or for managing interest rate risk. Currency swaps help businesses with cross-border operations secure better borrowing rates while hedging against exchange rate fluctuatioౠns over a longer period.

ꦰThe settlement process is also different between the two. NDFs are settled in a single, cash-settled payment at the contract’s maturity, based on the difference between the contract rate and the spot rate. This makes NDFs simpler compared to currency swaps. Currency swaps involve multiple cash flows during the life of the contract, including periodic interest payments and the final re-exchange of principal.

The Bottom Line

Non-deliverable🐼 forwards are financial contracts used to hedge or speculate on currencies that are not freely traded due to capital controls or market restrictions. Instead of physically exchanging currencies, NDFs are cash-settled based on the difference between the agreed forward rate and the actual market rate at maturity.