NDF (non-deliverable forward) is a financial instrument when two contracting partners agree on supplying the difference between the spot rate and forward rate.
NDF appeared in the 1990-s and since then becomes more and more popular.
A settled forward contract allows to hedge trades and speculate in currencies the financial transactions of which has been limited by the government to reduce volatility. NDF is primarily applied to the currencies of developing countries, for example:
- Argentine peso
- Brazilian real
- Venezuelan bolivar
- Egyptian pound
- Kazakh tenge
- Chinese yuan
- Indian rupee
- South Korean won
Main NDF features
A settled forward contract is a short-term off-exchange instrument when two contracting partners agree on delivering the difference between spot rate and forward rate. Under such an arrangement, settlement risk is minimized to that of the rate differences. It can arose during the period between the agreement and the delivery dates.
The indicated difference is paid in US dollars. The majority of settled forwards include US dollar as the second (basic) currency. The contracts for periods from one month to one year are used the most often. If necessary, standard periods can be extended up to two years. The delivery date is the standard terms of major futures expiration.
The main NDF parameters are:
- Notional amount, the face value of the forward contract on which the calculations will be based. The notional amount is always calculated in a single currency.
- Fixing date, the date and the time when the forward rate and spot rate are compared. For settled forwards the Central Bank fixing is used as the spot rate.
- The settlement or delivery date is the day when the difference calculated for the fixing date is payed. As a rule it is 2 days after the fixing date.
- NDF rate and spot rate are exchange rates set by counterparties and central banks correspondingly.
The main difference of NDF from delivery forwards is the absence of necessity to deliver all the contract value on the settlement date. The amount which is to be transferred due under the forward is calculated according to the formula:
Transaction volume=(NDF rate - CB fixing rate)*notional amount
Then profits under the contract are calculated according to the formula:
Profit= (CB fixing rate - NDF rate)/transaction amount
Examples of NDF use
For example, a company sells goods in Ukraine and gets revenue in hryvnias.In half a year a company will have to pay back early borrowed 100 000 US dollars. The fragile political situation implies the necessity of hedging against the risks, so a non-deliverable forward contract is concluded with the bank. At the date of the contract conclusion the rate is 8.9 hryvnias for a US dollar and the notional amount equals to 8,9*100000= UAH 890 000. In 6 months spot rate is fixed, three case scenarios are possible:
- The situation in the country deteriorates and hryvnia is depreciated to level 9,5 USD/UAH. In this case the bank transfers to the company: (9,5-8,9)*100 000/9,5 = 6315,79 USD.
- Hryvnia is appreciated to level 8,7 USD/UAH.. The company must pay the bank (8,7-8,9)*100 000/8,7 = 2298,85 USD.
- The exchange rate doesn’t change, no financial transfers occur.
From 60% to 80% of non-deliverable forwards are used for speculating and only the rest of them -for hedging against the risks and exchange arbitrage.
An example of such operation is alike. A trader expects depreciating of Brazilian real to US dollar and buys the currency in the amount of 5 000 000 USD for one month. NDF rate I set at 1.1280. In a month the calculation is based on The bank of Brazil fixing at level 1.1395. The trader’s profit in this case will be: (1,1395-1,1280)*5 000 000/1,1395 = 50460,72 USD.
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