What is non deliverable forward in derivatives trading?

Non deliverable forwards (NDF) are a unique instrument that helps manage currency risk. Simply put, NDF makes it possible to hedge currency exchange rate movements between two currencies without exchanging either of them physically. It plays a significant role worldwide, especially in emerging markets and developing economies, as currency fluctuations represent major uncertainties and threats.

This article discusses what is non deliverable forward NDF, why it is critical in the context of world finance, and how it works to help avoid currency risks. But, before that, let us first understand what currency trading is all about.

What is currency trading?

Currency trading means swapping one currency for another, aiming to make money from the difference in their values. It’s a really big market, even bigger than stocks. In the past, only big banks and companies could do currency trading. But now, thanks to new technology, regular people can easily get into it too. Even individuals think it’s a good way to invest their money.

In the market, currencies are always traded in pairs. For instance:

• Indian Rupee versus United States Dollar (USD-INR)
• Indian Rupee versus Euro (EUR-INR)
• Indian Rupee versus Great Britain Pound (GBP-INR)
• Indian Rupee versus Japan’s Yen (JPY-INR)

There are two types of currency markets: Onshore Market, and Offshore Market.

Onshore

The “onshore market” is the local currency market of the country where a trader legally belongs. So, if you’re from India, the forex market in India is your onshore market. In these markets, there are strict rules and taxes you have to follow when trading currencies. 

Because of this, many traders prefer to stick to trading in their own country’s market. They feel more comfortable there because they know the factors that can change currency prices, and it’s simpler for them to make trades.

Offshore

When we talk about an offshore market, it means trading in a place outside of where the trader lives. For instance, if someone in India buys currencies from London, that’s considered trading in the offshore market. 

In these markets, the rules and laws might be more relaxed, which can help traders lower the taxes they owe.

What is non deliverable forward contract?

NDF stands for non deliverable forward, which is a financial derivative primarily used to hedge or speculate on currencies created in markets where the currency is grossly restricted or controlled. 

Two parties exchange the difference between the agreed forward rate and the actual prevailing spot exchange rate at the end of an NDF contract. 

Unlike traditional forward contracts, NDFs don’t necessitate physical delivery of the underlying currencies. Instead, a cash settlement is given in a free tradable currency – usually U.S dollars. 

NDFs are often prevalent in emerging markets with currency controls or currency convertibility restrictions.

Example of Non deliverable forwards 

A non deliverable forwards example may involve the currency of India, the rupee and another world freely traded currency, for example, the United States dollar.

If a big company in India with a broad range of export revenue denominated in dollars has no other option to hedge the longtime depreciation of national money and carry out a sell-forward contract, such enterprises may establish an NDF contract with a banking institution and agree to the exchange of difference between the rate fixed by agreement and the current spot rate for dollars.

In this case, for example, if the forward exchange rate agreed on is 1 USD = 75 INR and the spot exchange rate at maturity is 1 USD = 80 INR, then the corporation would receive a cash settlement from the financial institution of the difference in INR value. 

NDFs enable Indian companies to effectively mitigate currency risk, primarily in areas where the INR is subject to changing volatility or restraints imposed by the regulatory framework on currency convertibility.

How do NDFs work in India?

In India, domestic non deliverable forward plays a crucial role for Indian businesses and financial institutions in handling currency risks associated with the Indian Rupee (INR), which isn’t fully convertible.

Similar to the global non deliverable forward market, the operational process of NDFs in India involves local entities engaging in contracts with foreign counterparts. These contracts stipulate the buying or selling of a specific amount of INR at a predetermined rate on a future date. Settlements for these contracts occur in a convertible currency, typically the US dollar.

For Indian companies, NDFs offer a means to hedge against currency fluctuations when engaging in international trade. This strategy allows them to secure exchange rates, safeguarding their profits from adverse currency shifts. 

Financial institutions, meanwhile, may use NDFs for arbitrage opportunities or to manage their trading portfolios effectively.

Pricing NDF contracts

Determining the price of non deliverable forward contracts is a detailed process that takes into account many factors and a special formula for NDF pricing. One important factor is the difference in interest rates between the two currencies in the contract. This difference shows how much the interest rates vary between the countries and affects how NDFs are priced.

When interest rates differ more between currencies, NDF prices usually go up. This is because investors want more compensation for the risks of currency changes.

Another important thing to consider when pricing NDFs is market liquidity. Liquidity means how easy it is to buy or sell NDF contracts in the market. When there’s good liquidity, it means there’s not much difference between the buying and selling prices, which makes it cheaper for investors to trade NDF contracts. This makes NDF contracts more appealing to investors who want to buy or sell them.

Predicting how currencies will change in the future is very important for pricing Non deliverable forwards (NDFs). Traders and others in the market look at things like how economies are doing, big world events, and what central banks are planning to figure out if a currency might go up or down.

If they think a currency might go down, the NDF price will be lower to cover the risk of losing money. But if they think the currency might go up, the NDF price will be higher.

So, pricing NDF contracts means thinking about lots of things, like how interest rates compare, how easy it is to trade, and what people think will happen to currencies in the future.

Conclusion

Non deliverable forwards (NDFs) are essential for handling currency risk, particularly in emerging markets. They’re flexible tools for hedging against exchange rate changes, crucial in global finance. Understanding NDFs is key to making informed financial decisions. For more learning, check out StockGro. 

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