A Non-Deliverable Forward (NDF) is a cash-settled, short-term forward contract uniquely designed to offer investors a powerful tool in the realm of currency derivatives. Known for not exchanging the notional amount—instead settling the profit or loss based on the difference between the contracted rate and the prevailing spot rate—NDFs are game-changers in the financial universe.
Key Takeaways
- Non-Deliverable Forwards (NDFs) are innovative two-party contracts in currency derivatives, meant to exchange cash flows between the NDF rate and prevailing spot rates.
- Globally, the largest markets for NDFs encompass Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, and Brazilian real.
- The U.S. dollar dominates NDF trading, specifically in London, with vibrant market activities also in Singapore and New York.
Understanding Non-Deliverable Forwards (NDF)
NDFs operate as currency derivative contracts where two parties exchange cash flows between the contracted NDF rate and the prevailing spot rate at the time of settlement. The settlement is made using this formula:
Cash flow = (NDF rate - Spot rate) * Notional amount
Usually traded over the counter (OTC), NDFs are typically quoted from one month up to a year and can cater to corporations seeking effective hedging for illiquid currencies. These transactions mainly happen offshore, allowing for settlements in freely traded currencies even when dealing with restricted or illiquid markets.
Despite being significantly utilized in illiquid currency markets, NDFs are versatile, offering exposure or hedge capabilities without the necessity of delivering or receiving the underlying asset.
Succeed with Non-Deliverable Forward Structure
Each NDF contract outlines specific details: the currency pair, notional amount, fixing date, settlement date, and NDF rate, with the provision that the prevailing spot rate at the fixing date concludes the transaction.
To illustrate, if two parties have an agreement where one buys Chinese yuan while the other buys U.S. dollars at an agreed rate of 6.41 on $1 million, the fixing date occurs in one month. Their obligations would be settled based on the exchange rate at that time. Should the rate fall to 6.3, indicating that the yuan appreciates, the contracting party who bought yuan gains. Alternatively, an increase to 6.5 benefits the party who purchased U.S. dollars.
Explore Leading NDF Currencies
The most prominent NDF markets feature the Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, Brazilian real, and Russian ruble. London’s marketplace serves as the hub for these activities, with ancillary markets active in New York, Singapore, and Hong Kong.
In terms of transaction volumes, trades using the U.S. dollar dominate, complemented by robust market participation involving the euro, Japanese yen, and, to a lesser extent, the British pound and Swiss franc.
Related Terms: Forward Contract, Spot Rate, Hedging, Over-the-Counter, Offshore.
References
- Bank for International Settlements. “Offshore Markets Drive Trading of Emerging Market Currencies”, Page 59.
- Bank for International Settlements. “Offshore Markets Drive Trading of Emerging Market Currencies”, Page 61.
