Understanding Non-Deliverable Forwards in Forex Trading

The loss or profit gets calculated depending on the notional amount deliverable forward of the agreement. However, the notional amount in a non-deliverable forward contract is never exchangeable. A forward contract is a mutual agreement in the foreign exchange market where a seller and buyer agree to sell or buy an underlying asset at a pre-established price at a future date. 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.

The Fundamentals of Deliverable vs. Non-Deliverable Forward Contracts

Additionally, NDFs promote financial innovation and inclusion by offering new products and opportunities for financial intermediaries and end-users. 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. This will determine whether the contract has resulted in a profit https://www.xcritical.com/ or loss, and it serves as a hedge against the spot rate on that future date.

what is the difference between an NDF and a FX Forward contract

Further, there is a ready trading market should either the buyer or the seller decide to close out their position ahead of expiration. Similar to futures, forwards can be settled on either physical delivery or cash settlement. Now that you know the fundamentals of deliverable forward vs. non-deliverable forward contracts, don’t confuse the two options. NDFs involve the cash settlement of the difference between the NDF and the spot rate, while a deliverable forward contract involves the physical exchange of the agreed amount. The good thing about NDFs is that they are available in a vast range of currencies and offer means of hedging foreign exchange risk in markets that don’t support the physical delivery of money. Customers, both corporations and financial institutions such as hedge funds and mutual funds, can execute forwards with a bank counter-party either as a swap or an outright transaction.

What are the benefits of non-deliverable forwards?

A currency trader works for a large company that operates in several different markets and currencies. That company is based in the US; however, it also sells in Canada; hence, they sell products and generate revenue in different currencies. A portion of their sales are in Canadian dollars; ultimately, they need to be exchanged back to US dollars.

Advantages of Non-Deliverable Forward Contracts

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 notional amount. A forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be customized for any asset, for any amount, and for any delivery date. The parties can settle in cash, paying out the net benefit/loss on the contract, or deliver the underlying. When the contract settles in delivery of the underlying asset, that final stage is called forward delivery.

How are forward contracts traded and settled?

The determination date (also called fixing date or valuation date) is (usually) 2 business days before the maturity date, using the holiday calendars of the currencies. You can either specify both notionals in pay and receive currency; or specify one of the notionals, and the strike rate (also called forward rate), in which case you multiply one notional by the strike to get the other notional. In 1 month (maturity date or settlement date), I pay you USD 1 milion and receive from you EUR 1.2 million.

Access to Restricted Currencies

Deutsche Bank will pay BASF this settlement amount in EUR based on the NDF-spot differential. BASF enters a 90-day MXN/EUR NDF contract with Deutsche Bank to sell 300 million MXN at an NDF rate of 21 MXN per EUR. Delayed confirmations, increased cancellations and amendments raise the likelihood of operational issues in OTC NDF markets compared to exchange trading. Forex trading involves significant risk of loss and is not suitable for all investors.

How Deliverable Forward Contracts Operate

The domestically traded and domestic currency-settled NDF market disappeared four years after liberalisation in 1983 (Debelle et al (2006)). Data made available through mandatory disclosure have made it possible to study NDF market dynamics at a high frequency. For example, DTCC data suggest that NDFs experienced peak volumes in August 2015 (Graph 6, centre panel).

For the renminbi, deliverable forwards (DFs) have been displacing NDFs offshore. It also helps businesses to conduct trade with emerging markets in the absence of convertible and transferable currency and manage the exchange rate volatility. The settlement of NDFs mostly takes place in cash as per the agreement made between the two parties. Most non-deliverable forward uses the dollar in the largest NDF markets like the Chinese Yuan, Brazilian Real, South Korean Won, and New Taiwan Dollar. A forward contract is a customizable legal agreement that obliges two parties, the buyer and the seller, to trade an asset for a current price at a fixed date in the future. Forwards derive their value from the underlying assets, for example, commodities like wheat, or foreign currencies, like USD.

Meanwhile, post-trade transparency and regulation of multilateral trading venues were implemented for US residents in October 2013. The corner of the foreign exchange market represented by NDFs also opens a window for assessing the progress of derivatives reforms. Trading of NDFs has begun to shift to centralised platforms, and higher margin requirements for non-cleared derivatives trades implemented in September saw centralised clearing of NDFs jump. Disclosure of trades has become mandatory in a number of jurisdictions, and the resulting increased transparency can inform a better understanding of market dynamics. A large number of jurisdictions now require public trade reporting for NDFs and other derivatives (FSB (2016)).

Currency forward is an essential solution for institutional investors used as a hedging tool and is customizable. One of the benefits is that it doesn’t require an upfront margin payment and can be tailored to any amount necessary, unlike exchange-traded currency futures. One party pays another the difference between the NDF rate and the spot rate; the payment is usually in U.S. dollars. Besides, NDFs get traded over the counter (OTC), encouraging the flexibility of terms to satisfy the needs of both parties involved. 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. All NDF contracts 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 conclude the transaction.

• NDFs are primarily traded in over-the-counter markets between authorized financial institutions and large corporations.
• The costs to Korea of maintaining won NDFs may decline with the changing market structure.
• In normal practice, one can trade NDFs without any physical exchange of currency in a decentralized market.
• 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)).
• TWD NDF trading surged even more on 11 August, to 486% of the previous day’s volume, or an estimated 3.7 times the April volume.

Note that we lag the VIX for the Asian currencies, using the previous day’s New York close. According to the DTCC data (see below), trading of NDFs on electronic platforms has risen considerably in the last few years. The share of NDF trading on swap execution facilities (SEFs) reached 15% for the rouble, about 30% for the rupee, won and New Taiwan dollar, and 45% for the real and renminbi in September 2016 (Graph 6, left-hand panel). This increase in centralised NDF trading occurred without a requirement that FX products be traded on such platforms (FSB (2016)). Reform allows us to assess NDF turnover spillovers from surprises like the adjustment in the renminbi exchange rate regime in August 2015.

By contrast, the substantial decline in CNY NDFs and the rapid growth of KRW and Taiwan dollar (TWD) turnover owed little to movements against the US dollar. Apart from the six surveyed currency pairs, NDF markets are active in a number of other currencies. The DTCC data (see below) show that the Indonesian rupiah, Malaysian ringgit, and Chilean and Colombian pesos also have sizeable NDF trading. 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. Because futures contracts are standardized and traded on exchanges, counterparty risk is mitigated by the exchange’s clearing mechanism.

Since April 2013, NDF trading has been affected by investors’ and borrowers’ hedging in anticipation of a reduction in global monetary easing. Over the last several years, investors poured large sums into emerging market local currency bonds, and in some markets increased their holdings to substantial shares of outstanding bonds. For their part, many emerging market firms that had used their unprecedented access to the global dollar (and euro) bond market to fund domestic assets also had exposures to hedge. NDFs provide liquidity and price discovery for currencies with limited or no spot market activity.

One cannot convert Chinese Yuan to dollars, so it makes it difficult for American businesses to settle the transaction. A long-dated contract structure doesn’t depend on whether it is flexible or closed, and it is to be executed at a longer time in the future as opposed to the short-term forward. Most forwards are signed to expire within three to six months to a year, whereas long-dated forwards can last for a year or even longer. For example, a corporation needing wheat to produce cereal is the buyer, and a farmer growing wheat is the seller. The investor buying the asset, in this case, the cereal company, takes the long forward position, a position of ownership of the underlying asset, whereas the farmer, the seller, takes the short forward position.

On the whole, deviations are largest for the renminbi and the Indian rupee, as well as the Indonesian rupiah and Philippine peso (Table 4). The liberalised Russian rouble serves as a benchmark, with much narrower differentials. The NDF market has maintained its share globally in overall FX trading, despite shrinkage of CNY NDF turnover in recent years. This market’s resilience reflects hedging and position-taking demand for currencies subject to restrictions on non-resident use.

Graph 5 shows that, as of April 2016, the Asian centres traded a mix of forwards that was very light in NDFs, compared with April 2013. The microstructure of NDF trading is evolving under the global force of legal and regulatory reforms of derivatives markets. NDFs have started the transition from a decentralised, bilateral microstructure to centralised trading, disclosure and clearing. Disclosure of derivatives transactions (including NDFs) has become mandatory in many jurisdictions (CPMI-IOSCO (2015), FSB (2016)). Centralised NDF clearing took off in September 2016 when US, Japanese and Canadian banks began to post higher required margins for uncleared derivatives. So, the borrower receives a dollar sum and repayments will still be calculated in dollars, but payment will be made in euros, using the current exchange rate at time of repayment.

NDFs traded offshore may not be subjected to the same regulations as onshore currency trading. 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.

Non-deliverable swaps are financial contracts used by experienced investors to make trades between currencies that are not convertible. Because of the complicated nature of these types of contracts, novice investors usually shouldn’t take on NDSs. Swaps are commonly traded by more experienced investors—notably, institutional investors. They are commonly used to manage different types of risks like currency, interest rate, and price risk. 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.