What is a Non-Deliverable Forward (NDF)?
A non-deliverable forward (NDF) is a straight futures or forward contract, where, much like a non-deliverable swap (NDS), the parties involved establish a settlement between the leading spot rate and the contracted NDF rate. The settlement is made when both parties agree on a notional amount. NDFs are settled in cash. The most commonly used currency for settlement is the U.S. dollar.
NDFs are also referred to as forward contracts for difference (FCDs). They are heavily used in countries where forward FX trading is banned. Ultimately, an NDF is used to manage volatility with exchange rates.
- A non-deliverable forward (NDF) is an FX exchange contract, where two parties agree to, on a date in the future, exchange currencies for the prevailing spot rate
- The difference between the NDF rate and the spot rate is the amount paid to the party who paid more of its own currency; the cash payment is most often made using U.S. dollars.
- NDFs are traded over-the-counter (OTC), allowing for flexible terms that end up satisfying both parties involved
The Non-Deliverable Forward Market
Because NDFs are traded privately, they are part of the over-the-counter (OTC) market. The contract is drawn up and agreed upon by only the parties involved. It allows for more flexibility with terms, and because all terms must be agreed upon by both parties, the end result of an NDF is generally favorable to all.
There are a number of countries with a currency that must actively utilize NDFs. The list of countries includes:
- Egypt (Egyptian pound)
- Nigeria (Naira)
- South Korea (won)
- Taiwan (Taiwanese dollar)
- India (rupee)
- Venezuela (bolivar)
How a Non-Deliverable Forward Works
Non-deliverable forwards are used as a short-term way to settle currency exchanges between counterparties. A settlement date is agreed upon and put into the NDF contract. The imbalance between loss and profit when the exchange occurs is settled by a notional amount: a face value for the NDF that both parties agree upon.
There are several important features of an NDF, aside from the notional amount mentioned above. They include:
- Fixing date: An agreed upon date when the spot rate and NDF rate are compared, and a notional amount is then determined
- Date of settlement: The day that both parties agree to make the difference between the exchange rates due; one party pays the other party on this day, while the receiving party retrieves the difference of the rates in cash
- NDF rate: The rate that is agreed upon on the date of the transaction; it is the straight forward rate of the currencies involved in the exchange
- Spot rate: The most up-to-date rate for the NDF, as provided by the central bank
NDFs are settled with cash, meaning the notional amount is never physically exchanged. The only cash that actually switches hands is the difference between the prevailing spot rate and the rate agreed upon in the NDF contract.
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