NDFs are typically used by businesses engaged in international trade, and they are less common among individual investors. The complex nature of these derivatives and their association with specific business needs make them less suitable for individual participation. The use of NDFs is significantly influenced by regulatory environments, especially in countries where currency controls or restrictions are in place. NDFs provide a viable solution for businesses to navigate these regulatory challenges while still managing currency risk effectively. The legal framework and regulatory stance in a particular jurisdiction can impact the availability and use of NDFs.
For investors or traders seeking access to restricted, thinly traded emerging market currencies, NDFs provide a way to gain synthetic exposure without being subject to onshore capital controls. Since NDFs only involve a cash payment in a convertible currency at maturity, they avoid any restrictions. A non-deliverable forward (NDF) is a two-party currency derivatives contract to exchange cash flows between the NDF and prevailing spot rates.
Key Risks of Trading NDFs
Like other financial instruments, non-deliverable forward contracts also have setbacks. For example, if a country’s currency gets restricted from moving offshore, settling transactions in that currency won’t be easy in another foreign country. In fact, to understand the fundamentals of non-deliverable forward vs. forward-deliverable contracts, you must know what forward contracts are. So, this guide will first elaborate on what forward contracts as well as the differences between deliverable and non-deliverable forward contracts. This might be because of the emerging economies being more integrated with global trade. The United Kingdom is by far the most preferred location for NDF trading and a significant portion of it is done in the form of electronic trading.
Graph 5 shows that, as of April 2016, the Asian centres traded a mix of forwards that was very light in NDFs, compared with April 2013. Still, the rouble NDF has lingered for 10 years and even enjoyed a modest revival recently. One interpretation of the revival is that credit and legal concerns since 2014 have prolonged the life of the rouble NDF. In 2013, the concentration of liquidity in offshore markets (including the NDF) was ascribed to concerns about the enforceability of collateral arrangements in Russia (HSBC (2013)).
Why Trade NDFs? Pros and Cons
Finally, this analysis helps policymakers to assess progress in derivatives reforms. The microstructure of NDF trading is evolving under the global force of legal and regulatory reforms of derivatives markets. NDFs have started the transition from a decentralised, bilateral microstructure to centralised trading, disclosure and clearing. Disclosure of derivatives transactions (including NDFs) has become mandatory in many jurisdictions (CPMI-IOSCO (2015), FSB (2016)). Centralised NDF clearing took off in September 2016 when US, Japanese and Canadian banks began to post higher required margins for uncleared derivatives.
NDFs for longer tenors will have wider differentials between the contract rate and spot rate compared to short-term NDFs. The difference in interest rates between the currencies Operational Crm in an NDF drive its pricing to a large extent. The currency with the higher interest rate will trade at a forward premium to the currency with a lower interest rate.
Legal and Regulatory Risks
The lower barriers to access make them preferred by investors with smaller capital. Investors like hedge funds also use NDFs to speculate on emerging market currency movements. The one-way nature of NDF contracts make them a flexible tool for arbitrage as well. So far, you understand how non-deliverable forward contracts work and how investors can benefit from them. However, how do they differ from their counterpart deliverable forward contracts?
- 9 Interviews with market participants in Hong Kong in late 2013 suggested that they perceived that the CNH had already eclipsed the NDF market in April.
- Lastly, NDFs offer a chance to speculate on where a currency might go in the future.
- NDFs traded offshore may not be subjected to the same regulations as onshore currency trading.
- Our list of non-deliverable currencies in 2024 is essential for providing a comprehensive understanding of current currency restrictions and their implications for international trade and financial transactions.
- They are most frequently quoted and settled in U.S. dollars and have become a popular instrument since the 1990s for corporations seeking to hedge exposure to illiquid currencies.
- In India, the impression that the offshore NDF drove the domestic market in summer 2013 has reportedly prompted consideration of opening up the domestic market to foreign investors (Sikarwar (2013)).
Non-deliverable forward (NDF) is a cash-settled contract, which means that the two parties to the contract do not actually exchange the currencies. Instead, they settle the contract in cash at the predetermined exchange rate on the settlement date. Non-deliverable swap (NDS) is a physically settled contract, which means that the two parties to the contract actually exchange the currencies on the settlement date. Some nations choose to protect their currency by disallowing trading on the international foreign exchange market, typically to prevent exchange rate volatility.
The Basics of Non-Deliverable Forward Contracts
As Graph 3 shows, the widening of the band and the tendency for actual trading to occur near its edges make for substantial basis risk. When the NDF settles at the fixing rate, this can be 1 percentage point higher or lower than the rate at which the renminbi can actually be sold onshore. From the standpoint of a firm trying to fix the dollar value of profits to be remitted from China, a 1% gap between the NDF and the actual rate of exchange can produce unwanted volatility. Since the band’s widening, the CNH has averaged an absolute difference from the Shanghai close of just 0.1%, much narrower than the 0.7% absolute gap between the Shanghai fixing and close. The CNH is becoming more attractive to those seeking to hedge because it tracks the onshore rate better than the NDF. First, some investors, including official investors, have mandates that do not permit NDFs but do permit CNH.
During the global financial crisis, the NDF tended to lead the onshore market. A rise in the influence of the NDF was even more noticeable in May-August 2013 (eight out of nine cases). In India, the impression that the offshore NDF drove the domestic market in summer 2013 has reportedly prompted consideration of opening up the domestic market to foreign investors (Sikarwar (2013)). For instance, in the smaller markets of Chile and Peru,5 where the central bank measures not just turnover but also net positions, the data show a sharp turnaround in positioning in May-June 2013.
The base currency is usually the more liquid and more frequently traded currency (for example, US Dollar or Euros). Vincent is a writer and researcher with an interest in finance, banking, startups, and remittance. He founded Nexin Startups, an online platform offering startup advice to investors and entrepreneurs. 7 See Wooldridge (2016) for further discussion on central clearing of OTC derivatives.
Second, the Triennial Survey shows $17 billion in renminbi options, including those written offshore on the CNH, and these generate activity in deliverable forwards. Implied volatility in the CNH tends to be very low, and market participants report a reach for yield among investors who bet on the stability of the renminbi/dollar rate. The liquidity thereby generated in the CNH market, however cyclical, has attracted asset managers, including some hedge funds, to switch from NDFs. The latest Triennial Survey reported $127 billion in daily NDF turnover (Table 1). This represented 19% of all forward trading globally and 2.4% of all currency turnover.
For Asian currencies, the London or New York close reflects news from Europe and the US morning that arrives after the domestic market has closed. Thus, it is not surprising that the NDF market moves the domestic forward market on the following day, especially when financial markets are more volatile. The Granger causality test for the Brazilian real is much more revealing given more proximate time zones. NDFs are commonly used in scenarios where either one of the currencies involved is non-convertible or when there are currency restrictions in place.
Settlement of NDF contracts is subject to timing mismatches or errors, creating risk around execution of payments. The current spot exchange rate and market forecasts of where the spot rate will be on the maturity date impact NDF levels. In some cases, NDFs may have lower costs compared to forward contracts on restricted currencies since they do not incur the expenses related to physical delivery of the currencies.