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Every investor who understands the volatility of the financial market knows diversification is the key to mitigating risks. They diversify their funds as much as possible to benefit from one source when another is underperforming.
One of the ways to diversify is to explore the derivatives market. A unique opportunity in the derivative market is Non-Deliverable Forwards. In today’s article, let us understand the meaning and functioning of NDFs, along with their benefits and risks.
What is the NDF market?
NDF stands for Non-Deliverable Forwards.
Non-deliverable forwards are forward contracts in the currency market, where one currency is exchanged for another. However, the physical exchange of currencies does not happen, which is why they are called non-deliverable forwards.
Traders enter into forward contracts with a pre-determined rate. The difference between the contract and the spot rate is settled in cash when the contract expires.
Understanding the functioning of NDF contracts
NDFs are forward contracts. Hence, like all other forward contracts, they are traded on the OTC (Over-the-counter) markets. It is where two parties agree to exchange currencies at a pre-determined rate. Upon expiry, however, they do not exchange currencies. Instead, they compare the spot rate of the currency pair with the pre-determined rate. Based on the change, one trader pays the other in cash to settle the NDF.
NDFs are usually settled in USD (US Dollars) when traders use them to trade illiquid currencies.
Here are some features of an NDF contract:
- It must have a currency pair whose exchange rate is the basis for NDF contracts.
- NDFs have two rates – The contract rate, as agreed by the traders, and the spot rate, which is the exchange rate on the contract expiry date.
- The contract must have a settlement date on which the traders exchange cash for the rate differences.
NDFs are primarily used in currency markets. However, hedging under NDF market can apply to all other financial securities, too.
Example
Two FX traders enter an agreement to exchange rates for USD and INR.
Trader A wants to buy INR and sell USD, while Trader B wants to buy USD and sell INR.
So, they enter into an NFD on 29 April 2024 at the rate of ₹83.46 (1 USD = ₹ 83.46), which will expire in one month.
On 29 May 2024, the exchange rate between USD and INR has reached ₹78.5. This indicates that the value of INR has increased while that of USD has decreased. So, trader A, who wants to buy INR, receives the excess money of ₹4.96 (83.46 – 7.5) from Trader B, who wants to sell INR.
The NDF market in India
Like all other markets, NDFs in India facilitated offshore trades. However, the Reserve Bank of India (RBI) imposed a ban on NDFs in India when the value of INR fell low in 2022. This decline had led to an increase in onshore rates vs NDF rates, which increased arbitraging opportunities, adding more pressure on Indian Rupees.
The ban is now lifted, and INR in the NDF market is a popular currency today. However, regulatory authorities like the SEBI and RBI can impose such restrictions at any time, and hence, traders must be cautious about the rules of NDFs in India.
Benefits and risks
Benefits of NDF contracts include:
- NDFs allow traders to hedge themselves against currency risks by using forward contracts, without physical delivery.
- NDFs give traders access to foreign currencies, which are otherwise illiquid and difficult to trade.
- NDFs allow traders to profit from speculating the currency movement without owning or having to physically deliver the currencies.
- They are a great way to diversify the trader’s investment portfolio and gain exposure to foreign markets.
Risks of NDF contracts include:
- There is a risk that the counterparty may default in fulfilling the obligation, which can lead to a financial loss.
- Currencies are heavily influenced by market events and are subject to high fluctuations. Like high profits, high losses are probable, too.
- NDFs are impacted by regulatory changes in the home country of the currencies involved. The impact can either be positive or negative.
- There is a risk of liquidity in the NDF market. Traders may not find counterparts at desired terms, making it difficult to enter and exit the market.
Bottomline
The NDF market deals with forward contracts around currencies, where traders do not have to physically exchange currencies, but settle the rate differences in cash.
The NDF market offers opportunities for hedging and speculation and is a suitable option for diversifying one’s portfolio. However, traders must be aware of the risks and keenly check the regulations of currencies. This is essential to formulate suitable risk-mitigating strategies and navigate through the NDF market effectively.
FAQs
Deliverable forwards are forward contracts where traders exchange physical assets with each other on the date of contract expiry. A non-deliverable forward, on the other hand, involves the exchange of cash between traders to settle their NDF contracts. This does not involve any physical delivery of assets.
Non-deliverable forwards and non-deliverable swaps are both contracts involving the exchange of cashflows resulting from currency exchange rate differences. The main difference between the two contracts is that an NDS involves one major and one minor currency in its pair, while an NDF does not have a particular pattern like that.
Yes, non-deliverable forwards are derivatives. These are contracts where currency is the underlying asset. The value of the derivative depends on the currency pair’s exchange rate.
Onshore and offshore are two kinds of currency markets. The onshore market is where an investor trades in the local country’s currency and foreign exchange market. An offshore market is where an investor trades on the currency market of a foreign country. For example, an Indian investor trading on London’s Forex market is an example of an offshore market.
The Asia market is well-known for high-volume NDF trading. Some of the top currencies in Asia in NDF trading include Indian Rupee (INR), South Korean Won (KRW), Taiwan Dollar (TWD), etc.