Non-deliverable forward

This article is about the financial instrument. For other meanings of NDF, see NDF (disambiguation).

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 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).

Market

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 cash settled in US dollars.^[1]

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. NDFs are typically quoted with the USD as the reference currency, and the settlement amount is also in USD.

Structure and features

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.

The features of an NDF include:

• the notional amount: This is the "face value" of the NDF, which is agreed between the two counterparties. It should again be noted that there is never any intention to exchange the notional amounts in the two currencies
• the fixing date: This is the day and time whereby the comparison between the NDF rate and the prevailing spot rate is made.
• the settlement (or delivery) date: This is the day when the difference is paid or received. Depending on the currencies dealt, the fixing date is one or two good business days before the settlement date.
• the contracted NDF rate: This is the rate agreed between the two counterparties on the transaction date, and is essentially the outright forward rate of the currencies dealt.
• the prevailing spot rate: The fixing spot rate on the fixing date is usually provided by the central bank, and is commonly calculated by calling a number of dealers in the market for a quote at a specified time of day, and taking the average. The exact method of determining the fixing rate will be agreed when a trade is initiated, but most NDF markets have their own conventions. I.e Two days before Settlement/Value date.

Because an NDF is a cash-settled instrument, the notional amount is never exchanged. The only exchange of cash flows is 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 ie cash flow = (NDF rate - spot rate) x notional.

Consequently, NDFs are "non-cash" products, which are off-the-balance-sheet and as the principal sums do not move, possess much lower counter-party risks. NDFs are committed short-term instruments; 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.

Pricing and valuation

An investor enters into a forward agreement to purchase a notional amount, N, of the base currency at the contracted forward rate, F, and would pay NF units of the quoted currency. On the fixing date, that investor would theoretically be able to sell the notional amount, N, of the base currency at the prevailing spot rate, S, earning NS units of the quoted currency. Therefore, the profit, π, on this trade in terms of the base currency, is given by:

$\pi = \frac{NS - NF}{S} = N\left(1-\frac{F}{S}\right)$

Uses

Synthetic foreign currency loans

NDFs can be used to create a foreign currency loan in a currency which may not be of interest to the lender.

For example, the borrower wants dollars but wants to make repayments in a second currency. So, the borrower receives a dollar sum and repayments will still be calculated in dollars, but payment will be made in another currency using the current exchange rate at time of repayment.

The lender wants to lend dollars and receive repayments in dollars. So, at the same time as disbursing the dollar sum to the borrower, the lender enters into a non-deliverable forward agreement with a counterparty (for example, on the Chicago market) that matches the cash flows from the foreign currency repayments.

Effectively, the borrower has a (synthetic) second currency loan; the lender has a (synthetic) dollar loan; and the counterparty has an NDF contract with the lender.

Under certain circumstances, the rates achievable using synthetic foreign currency lending may be lower than borrowing in the foreign currency directly, implying that there is a possibility for arbitrage. Although this is theoretically identical to a second currency loan (with settlement in dollars), the borrower may face basis risk: the possibility that a difference arises between the swap market's exchange rate and the exchange rate on the home market. The lender also bears counterparty risk.

The borrower could, in theory, enter into NDF contracts directly and borrow in dollars separately and achieve the same result. NDF counterparties, however, may prefer to work with a limited range of entities (such as those with a minimum credit rating).

Speculation

It is estimated that between 60 to 80 per cent of NDF trading is speculative.^[1] The main difference between the outright forward deals and the non-deliverable forwards is that the settlement is made in dollars since the dealer or counterparty can not settle in the alternative currency of the deal.

References

1. ^ ^{a b} Lipscomb, Laura (Federal Reserve Bank of New York). "An Overview of Non-Deliverable Foreign Exchange Forward Markets" (PDF). http://www.bis.org/publ/cgfs22fedny5.pdf. Retrieved 2007-09-29.