What is an NDF?

Article reviewed by Fred Allatt - Managing Director - FX Sales, Americas- StoneX Pro

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A non-deliverable forward (NDF) is a forward contract often used to trade non-convertible or restricted currencies. Instead of exchanging the physical currencies, NDFs are cash-settled based on the difference between the agreed-upon exchange rate and the spot rate at maturity.

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Understanding non-deliverable forward (NDF) contracts in global finance

A non-deliverable forward (NDF) is a type of derivatives contract used to trade currencies that are not freely convertible due to restrictions or capital controls. It allows two parties to agree on a forward exchange rate for a specific currency pair and settle the difference between this rate and the prevailing spot rate at maturity.

NDFs are cash-settled, which means there is no physical exchange of the restricted currency itself. Instead, the settlement involves paying the difference between the agreed forward rate (NDF rate) and the prevailing spot rate in a freely tradable currency, such as the U.S. dollar. They are commonly used in markets with restricted or regulated currencies, like the Chinese yuan (CNY), Indian rupee (INR), or Brazilian real (BRL).

Settling an NDF involves comparing the NDF rate to the spot rate at the time of maturity. The difference is then paid by one party to the other, depending on whether the spot rate is higher or lower than the agreed forward rate. NDFs are often used to manage   in markets where physical delivery of the currency is not possible due to restrictions.

While NDFs are mostly used in illiquid or restricted currency markets, they can also be used to speculate on or hedge against a currency’s volatility without the need for physical delivery of the underlying currency.

How an NDF works

NDFs are traded privately in over-the-counter (OTC) markets. The contract terms, including notional amount, duration, and settlement dates are agreed upon by both parties involved. This allows for flexibility and often makes NDFs mutually favorable.

Every NDF contract specifies the following:

• Currency pair: The two currencies involved in the exchange, usually including one restricted or illiquid currency.
• Notional amount: The reference value used to calculate the cash settlement. This amount is not physically exchanged.
• NDF rate: The agreed-upon exchange rate for the underlying currency pair at the time the contract is initiated.
• Fixing date: The date when the spot rate is compared to the NDF rate to calculate the settlement amount.
• Settlement date: The date when the contract is settled and payment is made based on the difference between the agreed-upon NDF rate and spot rate.

Here’s how the NDF process typically works:

• Step 1 - Negotiation: The two parties agree on the currency pair and notional amount of the NDF contract. They choose an NDF rate and set a fixing date and settlement date.
• Step 2 - Rate comparison: On the fixing date, the agreed-upon NDF rate is compared to the spot rate, usually provided by the central bank.
• Step 3 - Settlement: The difference between the NDF rate and spot rate is calculated and the resulting amount is paid in the freely tradable currency on the settlement date.

Unlike traditional forward contracts, NDFs are always cash-settled. This means no physical delivery of the notional currency takes place. Instead, the transaction is completed with a single cash payment based on the difference between the agreed-upon NDF rate and the prevailing spot rate at maturity.

Example of an NDF

Consider an example where two parties enter an NDF to hedge exposure to the Indian rupee (INR). The contract specifies the following terms:

• Currency pair: USD/INR
• Notional amount: $1 million USD
• NDF rate: 5
• Fixing date: Three months from start of contract
• Settlement currency: S. dollars

On the fixing date:

• If the prevailing spot rate is 84.1, it means the INR has increased in value relative to the USD. The party that agreed to sell the USD and buy INR is owed the difference in U.S. dollars.
• If the prevailing spot rate is 85.0, it means the INR has decreased in value relative to the USD. The party that agreed to buy USD and sell INR is owed the difference in U.S. dollars.

How do NDFs facilitate foreign currency trading in restricted markets?

NDFs provide a way for investors and businesses to gain exposure to currencies in markets where capital controls or exchange restrictions limit direct access. In many emerging markets, governments impose capital controls to regulate currency flows. This can make it challenging for international participants to engage in FX trading or invest in the local currency. NDFs address this limitation by allowing market participants to speculate on or hedge against the value of a restricted currency without physically buying or selling it.

For example, a U.S. company wanting to gain exposure to the Chinese yuan (CNY) might use an NDF to gain exposure to the yuan’s movements without having to purchase the currency itself. If the yuan appreciates against the U.S. dollar, the company would receive a cash settlement reflecting the currency’s movements.

What is the role of freely traded currencies in NDF agreements?

Freely traded currencies are used for cash settlement in NDF agreements. Since NDFs typically involve restricted or illiquid currencies that cannot be freely exchanged, the difference between the agreed-upon forward rate and the prevailing spot rate at maturity is settled in a freely traded currency – usually the U.S. dollar. This allows both parties to fulfil the contract without needing to physically exchange the restricted currency.

Key difference between NDFs and standard currency exchange contracts

The primary difference between NDFs and standard forward currency exchange contracts is the settlement method.

In standard forward contracts, the currencies involved are physically exchanged at maturity. NDFs, however, are always cash-settled with no delivery of the underlying currency. Settlement is based only on the difference between the agreed-upon forward rate and the prevailing spot market rate and is paid in a freely traded currency like the U.S. dollar.

How businesses use NDFs to hedge foreign currency exposure

Businesses use NDFs to hedge foreign currency exposure by locking in exchange rates for currencies that cannot be freely traded or converted on the open market. This can help multinational corporations stabilize cash flow and manage risks associated with currency fluctuations, particularly in emerging markets.

Companies operating internationally often have payables or receivables in foreign currencies. When these currencies are non-convertible or restricted, the businesses cannot simply buy or sell them on the open market to hedge their exposure. NDFs provide a solution for this by allowing companies to set an exchange rate for a future date, mitigating the risk of unfavorable currency movements before a payment is due.

For example, consider a US-based company that exports goods to Brazil and expects to receive a payment in six months. If the company is concerned about the Brazilian real (BRL) depreciating against the U.S. dollar during that period, it can use an NDF to sell BRL at a predetermined rate in six months. If the BRL does depreciate, the company will receive a cash settlement to offset the potential loss, reducing the impact of unfavorable exchange rate fluctuations.

What risks are associated with non-deliverable forward (NDF) contracts?

While NDF contracts can be an effective tool for hedging currency risk, they also come with certain risks. These include:

Market risk

As with other deliverable forwards of emerging market currencies or major currencies, NDFs can be exposed to market risk resulting from unfavorable movements in the exchange rate of the underlying currency. Market risk can be slightly higher with NDFs, however, since they often involve emerging market currencies – often known to have higher volatility. If the exchange rate is to shift unfavorably, it can result in unexpected financial losses for the party holding the unfavorable position.

Counterparty risk

NDFs also carry a degree of counterparty risk. They’re traded OTC, which means they don’t go through a centralized clearinghouse which guarantees the exchange. This leaves participants reliant on the other party meeting their financial obligations. If one party defaults on their payment, it could lead to potentially substantial losses for the other party.

Liquidity risk

Most NDFs involve emerging market currencies, which are often less liquid than more widely traded currencies. Low FX liquidity could lead to not enough buyers or sellers on the market, making it difficult to enter or exit positions at a favorable exchange rate. The result could be wider bid-ask spread, slippage, or the NDF trade being unable to be executed altogether.

How do NDFs impact cross-border financial transactions?

NDFs can help simplify cross-border financial transactions by providing a way for businesses and investors to hedge against currency fluctuations in restricted or emerging markets. By providing exposure to currency movements without having to physically buy or sell the restricted currency, NDFs can make international trade and investment more accessible in countries with capital controls.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.