Flipping The Script on Currency Swaps: The Non-Deliverable Swap Explained
A non-deliverable swap (NDS) is an innovative approach to currency swaps involving major and minor currencies, particularly where currency is non-convertible or subject to restrictions. Unlike traditional currency swaps, NDS does not involve the physical exchange of currencies; instead, settlements are conducted on a cash basis, predominantly in U.S. dollars.
The settlement calculation of an NDS is derived from the difference between the contract-specified exchange rate and the prevailing spot rate. One party compensates the other according to this variance. Analysts often describe a non-deliverable swap as an aggregation of multiple non-deliverable forwards.
Highlights You Shouldn’t Miss
- A non-deliverable swap (NDS) is processed and settled in U.S. dollar terms rather than with the physical exchange of currencies involved in the contract.
- This makes NDS a non-convertible and restricted swap, antenatal vertex owing to the absence of the actual delivery of the partnered currencies.
- NDS usage is prominent when the underlying currencies are inherently difficult to procure, thinly traded, or subject to volatile market conditions — examples include developing nations or isolated currencies like those from Cuba or North Korea.
Rally Your Understanding of Non-Deliverable Swaps (NDS)
Global corporations tap into non-deliverable swaps to buffer against the potential barriers imposed by currency controls that impede profit repatriation. NDS also serve as a protective hedge against swift devaluation or depreciation when dealing with restricted currencies wielding little liquidity. Additionally, it counters the steep costs associated with currency exchanges in constrained markets. Financial institutions in countries with stringent exchange controls employ NDS to mitigate exposure to foreign currency loans.
Critical variables in an NDS transaction include:
- Notional amounts — the quantity of the transaction.
- The currency pairing involved — the non-deliverable and the settlement currency.
- Specific settlement date(s) — multiple dates often apply.
- Contract rates outlined for the swap agreement.
- Fixing rates and dates — the defined date(s) for extracting spot rates from credible market sources.
A Practical NDS Perspective
Consider LendEx, a financial institution in Argentina, which secures a five-year US$10 million loan from a U.S. lender at a stable 4% annual interest rate, payable semi-annually. After converting this sum into Argentine pesos at the current rate of 5.4, they loan it to local businesses. Due to concerns over potential depreciation of the peso that might inflate their U.S. dollar interest and principal payments, LendEx enters into a currency swap with an overseas partner. Here’s how they configure the terms:
- Notional amounts (N) — US$400,000 for interest installments and US$10 million for the principal payout.
- Currency pairing — Argentine peso vis-à-vis the U.S. dollar.
- Settlement timetable — Every six months, in total 10 instances—the inaugural settlement overlapping the first interest installment, and the final aligning with the end-of-term settlement and principal payout.
- Contract Rates (F) — Assuming hypothetical rates of 6 pesos/USD for interest settlements and 7 for the principal.
- Fixing dates and rates (S) — Pinpointed two days prior to settlement, procured at noon EST from Reuters.
The profit computation follows: Profit = (NS - NF) / S = N (1 - F/S)
The Breakdown: Let’s envisage that the spot rate, two days prior to the first settlement date, clocks at 5.7 pesos/USD. The contracted purchase rate being 6, compels LendEx to recompense the variance, multiplying by the interest count to the counterparty. This displays as -$20,000 [(5.7 - 6.0) imes 400,000 / 6 = -$20,000].
As we move to the second settlement scenario, visualizing a spot rate of 6.5 pesos/USD; here, the heightened spot rate surpasses the contract value which results in LendEx netting a gain of $33,333 [(6.5 - 6.0) imes 400,000 / 6 = $33,333].
Such processes cycle chronologically through each sequence leading up to the final principle settlement. A distinguishing factor to underscore is that owing to its nature as a non-deliverable swap, settlements are executed entirely in U.S. dollars, precluding physicalities involving Argentine pesos or otherwise.
Related Terms: currency swaps, Non-Deliverable Forwards, hedging, exchange rate, financial risk.
