Non-deliverable forward

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In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount It is used in various markets such as foreign e!change and commodities NDFs are prevalent in some countries where forward F" trading has been banned by the government (usually as a means to prevent e!change rate volatility)

[edit] Market
#he NDF market is an over$the$counter market NDFs began to trade actively in the %&&'s NDF markets developed for emerging markets with capital controls, where the currencies could not be delivered offshore (ost NDFs are cash settled in )* dollars
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#he more active banks -uote NDFs from between one month to one year, although some would -uote up to two years upon re-uest #he most commonly traded NDF tenors are I(( dates, but banks also offer odd$dated NDFs NDFs are typically -uoted with the )*D as the reference currency, and the settlement amount is also in )*D

[edit] Structure and features

.n NDF is a short$term, cash$settled currency forward between two counterparties /n the contracted settlement date, the profit or loss is ad0usted between the two counterparties based on the difference between the contracted NDF rate and the prevailing spot F" rates on an agreed notional amount #he features of an NDF include1

the notional amount1 #his is the 2face value2 of the NDF, which is agreed between the two counterparties It should again be noted that there is never any intention to e!change the notional amounts in the two currencies the fixing date1 #his is the day and time whereby the comparison between the NDF rate and the prevailing spot rate is made the settlement (or deliver ! date1 #his is the day when the difference is paid or received Depending on the currencies dealt, the fi!ing date is one or two good business days before the settlement date the contracted NDF rate1 #his is the rate agreed between the two counterparties on the transaction date, and is essentially the outright forward rate of the currencies dealt

the "revailing s"ot rate1 #he fi!ing spot rate on the fi!ing date is usually provided by the central bank, and is commonly calculated by calling a number of dealers in the market for a -uote at a specified time of day, and taking the average #he e!act method of determining the fi!ing rate will be agreed when a trade is initiated, but most NDF markets have their own conventions

3ecause an NDF is a cash$settled instrument, the notional amount is never e!changed #he only e!change of cash flows is the difference between the NDF rate and the prevailing spot market rate that is e!changed on the settlement date 4onse-uently, NDFs are 2non$cash2 products, which are off$the$balance$sheet and as the principal sums do not move, possess much lower counter$party risks NDFs are committed short$term instruments5 both counterparties are committed and are obliged to honor the deal Nevertheless, either counterparty can cancel an e!isting contract by entering into another offsetting deal at the prevailing market rate

[edit] #ricing and valuation

.n investor enters into a forward agreement to purchase a notional amount, N, of the base currency at the contracted forward rate, F, and would pay NF units of the -uoted currency /n the fi!ing date, that investor would theoretically be able to sell the notional amount, N, of the base currency at the prevailing spot rate, S, earning NS units of the -uoted currency #herefore, the profit, 6, on this trade in terms of the base currency, is given by1

[edit] $ses
[edit] S nthetic foreign currenc loans
NDFs can be used to create a foreign currency loan in a currency which may not be of interest to the lender For e!ample, the borrower wants dollars but wants to make repayments in a second currency *o, the borrower receives a dollar sum and repayments will still be calculated in dollars, but payment will be made in another currency using the current e!change rate at time of repayment #he lender wants to lend dollars and receive repayments in dollars *o, at the same time as disbursing the dollar sum to the borrower, the lender enters into a non$ deliverable forward agreement with a counterparty (for e!ample, on the 4hicago market) that matches the cash flows from the foreign currency repayments 7ffectively, the borrower has a (synthetic) second currency loan5 the lender has a (synthetic) dollar loan5 and the counterparty has an NDF contract with the lender

)nder certain circumstances, the rates achievable using synthetic foreign currency lending may be lower than borrowing in the foreign currency directly, implying that there is a possibility for arbitrage .lthough this is theoretically identical to a second currency loan (with settlement in dollars), the borrower may face basis risk1 the possibility that a difference arises between the swap market8s e!change rate and the e!change rate on the home market #he lender also bears counterparty risk #he borrower could, in theory, enter into NDF contracts directly and borrow in dollars separately and achieve the same result NDF counterparties, however, may prefer to work with a limited range of entities (such as those with a minimum credit rating)

[edit] S"eculation
It is estimated that between 9' to :' per cent of NDF trading is speculative +%, #he main difference between the outright forward deals and the non$deliverable forwards is that the settlement is made in dollars since the dealer or counterparty can not settle in the alternative currency of the deal

[edit] %eferences
% ; a b <ipscomb, <aura (Federal =eserve 3ank of New >ork) 2.n /verview of Non$Deliverable Foreign 7!change Forward (arkets2 (?DF) http1@@www bis org@publ@cgfsAAfednyB pdf =etrieved A''C$'&$A&

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