Non Deliverable Forwards NDFs, Meaning & How it work

NDFs allow you to trade currencies that are not available in the spot market, hedge your currency risks and avoid delivery risk. 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 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. For investors in a such a country’s securities, they may want tohedge the FX risk of such investments but such restrictions reducethe efficacy of such hedges. A swap is a financial contract involving two parties who exchange ndf meaning the cash flows or liabilities from two different financial instruments.

Why do Traders Use NDF Contracts?

Anna Yen, CFA is an investment writer with over https://www.xcritical.com/ 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. Her work has been published on sites like Quicken and the crypto exchange Bybit. Effectively, the borrower has a synthetic euro loan; the lender has a synthetic dollar loan; and the counterparty has an NDF contract with the lender. There are also active markets using the euro, the Japanese yen and, to a lesser extent, the British pound and the Swiss franc.

What Is a Non-Deliverable Swap (NDS)?

The contract’s profit or loss is determined based on the difference between the agreed exchange rate in the NDF contract and the prevailing market rate at the time of settlement. The operational mechanism of NDFs in India is similar to that of the global NDF market. Indian entities enter into NDF contracts with offshore counterparties, agreeing to buy or sell a specific amount of INR at a predetermined exchange rate on a future date. These contracts are settled in a convertible currency, usually the US dollar. Non-deliverable forwards (NDFs) are a unique type of foreign currency derivatives used primarily in the forex market.

• NDFs for longer tenors will have wider differentials between the contract rate and spot rate compared to short-term NDFs.
• A non-deliverable forward (NDF) is a straight futures or forward contract, where, much like a non-deliverable swap (NDS), the parties involved establish a settlement between the leading spot rate and the contracted NDF rate.
• 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.
• A non-deliverable forward (NDF) is a forward or futures contract in which the two parties settle the difference between the contracted NDF price and the prevailing spot market price at the end of the agreement.

Synthetic foreign currency loans

Most contracts like this involve cash flows based on a notional principal amount related to a loan or bond. Expectations about future currency movements play a significant role in NDF pricing. Traders and market participants analyse economic indicators, geopolitical events, and central bank policies to determine the likely direction of the currency pair.

Understanding Forex NDF Contracts: A Comprehensive Guide

What non-deliverable forwards provide is the opportunity to protect a business (or an investor or individual if needs be) that is exposed to currency risk in a currency for which a normal forward trade is not possible. Usually, the foreign currency is sent to the forward trade provider who converts it into the original company’s domestic currency and transfers it to them. Instead, two parties ultimately agree to settle any difference that arises in a transaction caused by a change to the exchange rate that happens between a certain time and a time in the future. Currency risk is the risk that a business, investor or individual will lose money as a result of a change to exchange rates.

Non-Deliverable Forward (NDF) Meaning, Structure, and Currencies

If expectations point towards currency depreciation, the NDF price will reflect a discount to account for the potential loss. Conversely, if expectations anticipate currency appreciation, the NDF price will incorporate a premium. Bound specialises in currency risk management and provide forward and option trades to businesses that are exposed to currency risk. As well as providing the actual means by which businesses can protect themselves from currency risk, Bound also publish articles like this which are intended to make currency risk management easier to understand.

The Non-Deliverable Forward Market

E.g., you swap EUR for RUB and settle in EUR, or you swap USD for BRL and settle in USD. It also provides an avenue for speculators to take positions on the future movement of currencies that are not freely convertible. Speculators can leverage their understanding of economic and political factors impacting these currencies to potentially profit from fluctuations in their value. Following on from this, a date is set as a ‘fixing date’ and this is the date on which the settlement amount is calculated.

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How a Normal Forward Trade Works

J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. NDFs can be used to create a foreign currency loan in a currency, which may not be of interest to the lender.

This post will discuss the key components that influence the pricing of derivatives and more. 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. 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.

In our example, the fixing date will be the date on which the company receives payment. Since there is no principal exchanged, the holder of an NDF contract is reliant on the credit quality and financial standing of the counterparty bank or dealer to fulfill their payment obligations. 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.

What happens is that eventually, the two parties settle the difference between a contracted NDF price and the future spot rate for an exchange that takes place in the future. The risk that this company faces is that in the time between them agreeing to the sale and actually receiving payment, exchange rates could change adversely causing them to lose money. A non-deliverable forward (NDF) is a forward or futures contract in which the two parties settle the difference between the contracted NDF price and the prevailing spot market price at the end of the agreement. A non-deliverable forward (NDF) is a forward or futures contract in which the two parties settle the difference between the contracted NDF price and the prevailing spot market price at the end of the agreement. NDFs allow hedging and speculation for currencies with high exchange rate risk or potential returns.

It is mostly useful as a hedging tool in an emerging market where there is no facility for free trading or where conversion of underlying currency can take place only in terms of freely traded currency. 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.

On the other hand, if the exchange rate has moved favourably, meaning that at the spot rate they receive more than expected, the company will have to pay the excess that they receive to the provider of the NDF. If the exchange rate has moved unfavourably, meaning that the company receives less than expected at the spot rate, the provider of the NDF contract will reimburse them by the appropriate amount. The basis of the fixing varies from currency to currency but can be either an official exchange rate set by the country’s central bank or other authority or an average of interbank prices at a specified time. The current spot exchange rate and market forecasts of where the spot rate will be on the maturity date impact NDF levels.

Periodic settlement of an NDS is done on a cash basis, generally in U.S. dollars. The settlement value is based on the difference between the exchange rate specified in the swap contract and the spot rate, with one party paying the other the difference. An NDF is a contract to exchange cash flows between two parties based on the predicted future exchange rates of a particular currency pair. It differs from typical forward contracts as no physical delivery of the underlying currencies occurs at maturity.

The largest NDF markets are in the Chinese yuan, Indian rupee, South Korean won, new Taiwan dollar, and Brazilian real. The largest segment of NDF trading takes place in London, with active markets also in Singapore and New York. Some countries, including South Korea, have limited but restricted onshore forward markets in addition to an active NDF market. Although businesses can use NDF liquidity and other benefits to enter into emerging markets by managing their currency, it does contain an element of risk. 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. 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. Pricing non deliverable forwards contracts involves a comprehensive methodology that considers various factors and NDF pricing formula. One crucial aspect is the interest rate differentials between the two currencies involved in the contract.

By kibriDagan in FinTech on 16.05.2023