How Are NDFs Non-Deliverable Forwards Priced?

A non-deliverable forward is a foreign exchange derivatives contract whereby two parties agree to exchange cash at a given spot rate on a future date. The contract is settled in a widely traded currency, such as the US dollar, rather than the original https://www.xcritical.com/ currency. NDFs are primarily used for hedging or speculating in currencies with trade restrictions, such as China’s yuan or India’s rupee. Non-deliverable forwards (NDFs) are contracts for the difference between an exchange rate agreed months before and the actual spot rate at maturity.

What Is a Non-Deliverable Swap (NDS)?

Volumes of NDFs reported to the DTCC involving US counterparties amounted to 40% of the total trading of our six currencies in April 2016. In particular, about a third of NDF trades in the renminbi, rupee, won and New Taiwan dollar were reported for April 2016, and 60% of trades in the real and rouble. NDFs allow hedging and speculation for currencies with high exchange rate risk or potential returns. They allow market participants deliverable forward 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 an NDF and a FX Forward contract

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. 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. 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.

Advantages of Non-Deliverable Forward Contracts

For instance, a company expecting to receive payments in foreign currency can use a forward contract to fix the exchange rate, thus protecting against currency volatility. Similarly, a commodity producer might use forwards to secure stable selling prices. Forwards are preferred by corporations or other financial institutions to lock in current commodity prices or currency exchange rates, used as protection against rising costs. The fact that forwards are traded OTC makes them more flexible and customizable compared to their counterparts, futures contracts.

How to hedge with a forward contract?

• And the third is a controlled opening up of the FX market within a regime that retains effective capital controls.
• This means that currency A is purchased vs. currency B for delivery on the spot date at the spot rate in the market at the time the transaction is executed.
• Investors thereby circumvent limits on home market (“onshore”) trading and on delivery of the home currency offshore.
• The volume response was bigger in the currencies of China’s neighbouring economies.
• Assume a simple situation in which Company A needs to buy 15,236 ounces of gold one year from now.

Similar increases in NDF trading occurred during a bout of CNY turbulence in January 2016. On this evidence, it appears that, even though the CNY NDF turnover is fading, renminbi developments are boosting Asian NDFs. 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)).

Access to Restricted Currencies

This analysis should interest policymakers concerned about spillovers from an offshore NDF market to the onshore market. In addition, for observers of capital account liberalisation, the diversity in policy choices and NDF market developments offer a natural experiment on paths of currency internationalisation. Finally, this analysis helps policymakers to assess progress in derivatives reforms. The more active banks quote NDFs from between one month to one year, although some would quote up to two years upon request. The most commonly traded NDF tenors are IMM dates, but banks also offer odd-dated NDFs.

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

Table 6 shows that both deliverable forwards and NDFs generally respond to global factors. Following Cairns et al (2007), we supplement the (Haldane and Hall / Frankel and Wei) regression of a given currency on the major currencies with an indicator of global risk – the VIX. That is, we regress both the deliverable forward and NDF of a given currency on percentage changes in the euro/dollar forward rate, the yen/dollar rate and the VIX. If the forward rate is affected by global risk conditions, a rise in the VIX would lead to a depreciation, ie an increase in the forward rate defined as above.

Non-deliverable forwards: 2013 and beyond

It can also apply to markets for securities and interest rates as well as commodities. NDFs settle by reference to the official central parity rate against the US dollar (the “fixing rate”) set every day at 9.30 am in the Shanghai, China Foreign Exchange Trade System. However, actual trading occurs within +/-1% bands around this fixing rate, which were widened from +/-0.5% in April 2012.

Commodity forwards vs currency forward contracts

The only cases where global factors seem to figure much more in the NDF rate are the renminbi, Indian rupee and Indonesian rupiah. The rouble has followed the first path.5 It was made fully convertible in mid-2006 amid current account surpluses, large foreign exchange reserves and official ambitions for its international use. Among our six currencies, the rouble NDF has the smallest share among the different instruments used for RUB trading (Graph 1).

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. In this manner, they are also able to increase their customer base and provide a competitive advantage over each other. Traders also get various opportunities to enter the financial market, explore different options, and learn about them. Futures contracts are more liquid as well as transferrable, which is why they are preferred and more suitable for trading by speculative or individual investors. The more flexible and customizable nature of forwards makes them more preferred and attractive to hedgers or institutional investors, adjusted to each party’s individual needs.

This means there is no physical delivery of the two currencies involved, unlike a typical currency swap where there is an exchange of currency flows. 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.

Debelle et al (2006) tell the surprising story of the slow passing of the Australian dollar NDF. Deliverable forwards opened up in 1983, but the NDF continued to trade, lingering until 1987. 7 See Wooldridge (2016) for further discussion on central clearing of OTC derivatives. 2 Some NDFs traded in Brazil settle in reais (Garcia and Volpon (2014); Kohlscheen and Andrade (2014)). NDFs can be used to create a foreign currency loan in a currency, which may not be of interest to the lender. That said, typically these types of deals are not meant to speculate, but rather lock in a rate on an asset that is required in the future.

Nonetheless, different policies towards such restrictions have led to different paths in NDF market development. The Korean won NDF bulks large in trading in that currency owing to official constraints, and its turnover may be spurred by renminbi developments while its liquidity gains from ongoing market centralisation. The rouble NDF is lingering with a low market share despite full convertibility of the currency, possibly due to credit constraints and political developments. At the same time, renminbi DFs are displacing the NDF, thanks to currency internationalisation.