Non-deliverable forwards: impact of currency internationalisation and derivatives reform

Segmentation is strongest in the rupee, for which NDFs do not trade onshore at all and DFs trade predominantly onshore, followed by the New Taiwan dollar, won, renminbi, real and rouble. In India, the sense that onshore markets had lost market share led the Ministry of Finance to commission a group of experts (Standing Council on International Competitiveness of the Indian Financial System (2015)). A Non-Deliverable Forward (NDF) is a financial derivative used in forex markets. It is a contract to pay https://www.xcritical.com/ the difference between an agreed-upon currency exchange rate and the real rate on a future date, using money rather than exchanging physical currencies. For instance, if the agreed rate was ₹70 to $1 and the rate at the contract’s maturity is ₹75 to $1, the company would receive a payment based on the difference in these rates, settled in dollars. This transaction allows the company to hedge against its rupee exposure without handling the actual currency.

Non-Deliverable Forward – NDF Meaning

Moreover, they do not require the underlying currency of the NDF in physical form. Consequently, the transaction based on NDF tends to be affordable and cost-effective compared to other forward contracts. In addition, an NDF has the characteristics of getting custom contract terms as per the needs of parties involved, like settlement date, reference exchange rate, and non deliverable currencies notional amount. Non-deliverable swaps are used by multi-national corporations to mitigate the risk that they may not be allowed to repatriate profits because of currency controls. They also use NDSs to hedge the risk of abrupt devaluation or depreciation in a restricted currency with little liquidity, and to avoid the prohibitive cost of exchanging currencies in the local market.

Understanding Non-Deliverable Swaps (NDSs)

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). 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.

What is the difference between NDF and FX swap?

Likewise, the increase in NDF trading in Moscow reduced the segmentation between onshore and offshore rouble markets. Still, the rouble NDF has lingered for 10 years and even enjoyed a modest revival recently. One interpretation of the revival is that credit and legal concerns since 2014 have prolonged the life of the rouble NDF. In 2013, the concentration of liquidity in offshore markets (including the NDF) was ascribed to concerns about the enforceability of collateral arrangements in Russia (HSBC (2013)). In early 2014, a series of financial sanctions on certain Russian individuals, defence firms, energy firms and banks were reported to have led non-financial firms to use NDFs rather than DFs (Becker (2014)). The share of NDFs in RUB forward trades in London bottomed out in October 2014, and has since risen slightly in the three subsequent semiannual London surveys (Graph 4, left-hand panel).

Understanding Non-Deliverable Forwards in Forex Trading

NDFs for longer tenors will have wider differentials between the contract rate and spot rate compared to short-term NDFs. The difference in interest rates between the currencies in an NDF drive its pricing to a large extent. The currency with the higher interest rate will trade at a forward premium to the currency with a lower interest rate. Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate.

Offshore Currency Markets: Non-Deliverable Forwards (NDFs) in Asia

NDFs are contracts for the difference between an agreed exchange rate and the actual spot rate at maturity, settled with a single payment for one counterparty’s profit. They allow hedging and speculation in a currency without providing or requiring funding in it. Investors thereby circumvent limits on home market (“onshore”) trading and on delivery of the home currency offshore. Interest rates are the most common primary determinant of the pricing for NDFs. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated. Other factors that can be significant in determining the pricing of NDFs include liquidity, counterparty risk, and trading flows between the two countries involved.

• Most contracts like this involve cash flows based on a notional principal amount related to a loan or bond.
• Banks also structure NDFs flexibly to meet client business requirements in terms of size, dates, and benchmarks.
• The DTCC data show that KRW and TWD NDF trading involving US counterparties saw larger rises in volumes, even though the INR and BRL rates depreciated more (Graph A, right-hand panel).
• Trading Derivatives carries a high level of risk to your capital and you should only trade with money you can afford to lose.
• For instance, if the agreed rate was ₹70 to $1 and the rate at the contract’s maturity is ₹75 to $1, the company would receive a payment based on the difference in these rates, settled in dollars.

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This is usually the result of government restrictions, which prevent it from being exchanged for foreign currencies. Consequently, since NDF is a “non-cash”, off-balance-sheet item and since the principal sums do not move, NDF bears much lower counter-party risk. NDFs are committed short-term instruments; both counterparties are committed and are obliged to honor the deal. Nevertheless, either counterparty can cancel an existing contract by entering into another offsetting deal at the prevailing market rate.

Reform allows us to assess NDF turnover spillovers from surprises like the adjustment in the renminbi exchange rate regime in August 2015. With this combination of sources, we find that, ironically, liberalisation of the renminbi is boosting other Asian NDFs even as it strangles the CNY NDF. 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.

Is THB a non deliverable currency?

As the name suggests, NDFs are forward contracts where the payments are settled in a convertible currency, usually USD, rather than in the currencies specified in the contract. 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. 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.

Corporations can fine tune their hedging needs via tailored NDF contracts, unlike standardized futures contracts. Banks also structure NDFs flexibly to meet client business requirements in terms of size, dates, and benchmarks. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. NDFs can be used to create a foreign currency loan in a currency, which may not be of interest to the lender.

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. First, they enable investors to trade currencies that might be hard or even impossible to trade otherwise. Lastly, NDFs offer a chance to speculate on where a currency might go in the future.

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. 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.

Her work has been published on sites like Quicken and the crypto exchange Bybit. 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 receiving the underlying product. The Thai government has strict capital controls in place that make it difficult for foreigners to buy and sell THB.

He’d just landed a big contract to export his artisanal coffee to a rapidly growing market in Asia. The local currency was subject to strict controls, making it nearly impossible for him to get paid in a straightforward manner. “How am I supposed to do business if I can’t even get my hands on their money? NDFs are primarily used in markets where the currency is not freely tradable or faces certain restrictions. As given in the diagram below, a list of reasons as to why the concept is widely used and helps traders in the financial market is given below. In the ways mentioned below, trading platforms can get an opportunity to create a diverse portfolio of products and services that add to their profits, with a significant degree of control on risk and losses.

For offshore investors seeking to engage in trade with nations that have non-convertible currencies, they must do so through the use of a financial instrument known as a non-deliverable forward (NDF). Instead, the net of the cash flows is settled in a convertible currency—usually the U.S. dollar—which gets around the non-convertibility of the domestic currency. NDFs are cash-settled and usually structured as short-term forward currency contracts.

Among our six currencies, the rouble NDF has the smallest share among the different instruments used for RUB trading (Graph 1). Bloomberg stopped publishing a separate exchange rate series for the rouble NDF in 2014, citing its price convergence with the deliverable forwards. Hence, to overcome this problem, an American company signs an NDF agreement with a financial institution while agreeing to exchange cash flows on a certain future date based on the prevailing spot rate of the Yuan. Non-deliverable forwards (NDFs) are a unique type of foreign currency derivatives used primarily in the forex market.

Financial institutions in nations with exchange restrictions use NDSs to hedge their foreign currency loan exposure. 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. Imagine you are a U.S. company that has secured a contract to supply machinery to a Chinese company. The total cost of the machinery is 10 million Chinese Yuan (CNY), and the payment is due in six months.