Barbican Consulting Limited
Non Deliverable Forwards
Non deliverable forward (NDF)
What is a non deliverable forward? It is a forward foreign exchange contract but instead of there being physical delivery at maturity of the currency pair the counterparties settle the transaction by a single net payment in the convertible currency. This payment represents the profit or loss on the trade.
NDFs are used when a currency is not freely convertible. That is where the authorities only permit the exchange of the domestic currency through the central bank at an official spot rate. The proceeds of which may then be taken out of the country.
If an exporter invoices in a non-convertible currency the invoice amount will eventually need to be sold (normally for USD) through official channels.
As a result of the fluctuation of the spot rate the exporter may receive more or less USD than expected and is therefore subject to currency risk. This risk can be hedged with a NDF.
Let's look at an example:
Suppose a company exports goods to Taiwan and expects to receive a sum in TWD 10,000,000 in three months time. The company now hedges with a NDF.
The company wishes to sell a notional amount in 90 days time of TWD 10,000,000
At the start of the NDF a fixing rate (forward rate) is agreed between the company and its bank. In this case this rate relates to a fixing date 90 days forward.
Suppose that rate was 30.00 (USD1 = TWD30).
Time now passes until the fixing date is reached. Reference is then made to an official source or market quote for the prevailing spot rate at that time. The outcome could be as follows.
1. The fixing rate is 31.00 (higher than the NDF Rate of 30.00).
The company sells TWD10,000,000 at 31.00 to the central bank. In return it receives USD 322,580.64 In comparison with the NDF rate this is a shortfall of:
(10,000,000/30.00) - (10,000,000/31.00) = USD10,752.68
The NDF bank therefore pays USD10,752.68 to the customer.
In total the customer has been hedged at a rate of 30.00 and receives USD333,333.33
2. The fixing rate is 29.00 (lower than the NDF Rate of 30.00).
The company sells TWD10,000,000 at 29.00 to the central bank. In return it receives USD 344,827.58 In comparison with the NDF rate this is a windfall of:
(10,000,000/29.00) - (10,000,000/30.00) = USD11,494.25
The customer therefore pays USD11,494.25 to the NDF bank
In total the customer has been hedged at 30.00 and receives USD333,333.33
3. The fixing rate is 30.00 (the same at the NDF Rate of 30.00), the NDF expires worthless. In total the customer has been hedged at 30.00 and receives USD333,333.33
From this example you can see that the NDF transaction with the NDF bank is settled in USD and it only represents the profit or loss on the notional amount rather than a full exchange of TWD and USD between the customer and bank. Hence non-deliverable forward.
Is there anything else? In order to enter a NDF a customer will need to complete the appropriate documentation. This may be terms and conditions drawn up by a bank or an ISDA Master Dealing Agreement. The bank and customer will also wish to establish that they regard each other as creditworthy and capable of fulfilling their respective obligations under the transaction.
NDFs normally have a maturity dates between 1 month and 1 year. The forward NDF rate is determined by the currency pair, the spot rate and the margins taken by the dealer. Banks may be prepared to close out or extend contracts should this be necessary although this will occur at market rates and will incur further transaction costs.
Whilst NDFs are explained by reference to hedging it is estimated that over 60% of this market is speculative.
Caveat Emptor applies. Anyone considering NDFs should undertake their own due diligence. Money can be lost.
First Published by Barbican Consulting Limited 2011