I don’t know how many of us, have actually heard about NDFs or know about this financial instruments and hence, we have picked up this topic for today`s detailed discussion. To start with, we will be explaining the meaning and definition of NDF, going on with market & currencies associated with NDFs. And, our closure for today`s post will be with the structure & the various uses of NDFs.
Meaning: In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is a swap in which, the two legs are a major currency and a nonconvertible currency. The parties net the difference between the exchange rate listed in the swap contract and the spot rate, and one party pays the other that difference. They are usually settled in U.S. dollars. Multinational corporations and countries with minor currencies sometimes use non-deliverable swaps to hedge risk associated with comparatively illiquid currencies.
- NDFs are conceptually similar to forward foreign exchange contracts; the difference is that they do not require physical delivery of the non-convertible currency.
- A principal amount, forward exchange rate and forward date are all agreed at the contract’s inception. At maturity, the difference between the contracted forward rate and the prevailing spot rate is settled in the convertible currency.
- NDFs are cash-settled currency forwards which provide an offshore mechanism to hedge currencies.
- NDF is an efficient method of managing FX exposures for non-convertible currencies since there is no actual exchange of principal funds.
- The NDF contracts are devoid of country or local market risk as NDFs are not conditional upon the FX regime being maintained.
- When trading in NDFs, there is no withholding tax and no custody requirements, unlike trading in securities.
- There is no bid/offer spread on maturity as the contracts are normally settled against a fixing rate
Structure of NDF Swap: An NDF is a short-term, cash-settled currency forward between two counterparties. On the contracted settlement date, the profit or loss is adjusted between the two counterparties based on the difference between the contracted NDF rate and the prevailing spot FX rates on an agreed notional amount. NDF consists of:-
- NOTIONAL AMOUNT: This is the “face value/ principal amount” of the NDF, which is agreed between the two counterparties.
- FIXING DATE: The day and time whereby the comparison between the NDF rate and the prevailing spot rate is made.
- SETTLEMENT DATE / DELIVERY DATE: The day when the difference is paid or received. It is usually one or two business days after the fixing date.
- CONTRACTED NDF RATE: The rate agreed on the transaction date, and is essentially the outright forward rate of the currencies dealt.
- PREVAILING SPOT RATE / FIXING SPOT RATE: The rate on the fixing date usually provided by the central bank, and commonly calculated by calling a number of dealers in the market for a quote at a specified time of day, and taking the average.
As, NDF is a cash-settled instrument, the notional amount is never exchanged. There is only an exchange of cash flows which is actually, the difference between the NDF rate and the prevailing spot market rate, that is determined on the fixing date and exchanged on the settlement date, applied to the notional, i.e. cash flow = (NDF rate – spot rate) × notional. 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 also known as short-term instruments; where 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.
Market For NDF Swap: The NDF market is an over-the-counter market. NDFs began to trade actively in the 1990s. NDF markets developed for emerging markets with capital controls, where the currencies could not be delivered offshore. Most NDFs are typically quoted with the USD as the reference currency, and the settlement amount is also in USD. It is used in various markets such as foreign exchange and commodities. NDFs are prevalent in some countries where forward FX trading has been banned by the government (usually as a means to prevent exchange rate volatility).
List Of Currencies Associated With NDF: Below is a non-exhaustive list of currencies where NDFs are traded. Not all non-convertible currencies have a NDF market. A currency may be convertible by some market participants while being non-convertible to others.
- Asia-Pacific Europe, Middle East and Africa Latin America:- CNY Chinese Renminbi; IDR Indonesian Rupiah; INR Indian Rupee; KRW South Korean Won; MYR Malaysian Ringgit; PHP Philippine Peso; TWD Taiwan Dollar; VND Vietnamese dong
- Europe, Middle East and Africa:- EGP Egyptian pound; ILS Israeli Shekel; KZT Kazakh tenge; RUB Russian Ruble
- Latin America:- ARS Argentine Peso; BRL Brazilian Real; CLP Chilean Peso; COP Colombian Peso; GTQ Guatemalan quetzal; PEN Peruvian nuevo sol; UYU Uruguayan peso; VEB Venezuelan bolívar
Various Uses of NDFs:
. NDFs can be used to create a foreign currency loan in a currency, which may not be of interest to the lender.
. NDFs can be used for Arbitraging.
. NDFs can also be used in speculation business. It is estimated that between 60 to 80 per cent of NDF trading is speculative.
Conclusion: Non-deliverable swaps are used when the swap includes a major currency, such as the U.S. dollar, and a restricted currency, such as the Philippine peso or South Korean won.