Key Takeaways
- Cash-settled FX forward; no physical currency exchange.
- Used for hedging in restricted or illiquid currencies.
- Settlement based on difference between forward and spot rates.
What is Non-Deliverable Forward (NDF)?
A non-deliverable forward (NDF) is a cash-settled forward contract used to hedge or speculate on currencies that cannot be physically delivered due to capital controls or liquidity restrictions. Instead of exchanging the underlying currencies, counterparties settle the difference between the agreed forward rate and the spot rate at maturity in a convertible currency, typically USD.
This contract type enables participants to manage foreign exchange risk in restricted markets without actual currency transfer.
Key Characteristics
NDFs have distinctive features that differentiate them from traditional deliverable forwards:
- Cash settlement: No physical delivery of the underlying currency occurs; settlement is made in a convertible currency.
- Customizable terms: NDF contracts are OTC and tailored to the notional amount, forward rate, and settlement date agreed by the parties.
- Restricted currency pairs: Typically involve one illiquid or restricted currency paired with a freely convertible one, such as BRL/USD or CNY/USD.
- Fixing date: The official spot rate, often published by the central bank of the restricted currency, determines the settlement amount.
- Counterparty risk: Although lower than some OTC derivatives, NDFs still expose parties to default risk without central clearing.
How It Works
When entering an NDF contract, you agree on a notional amount and a forward exchange rate for a specific currency pair. At maturity, the difference between this rate and the prevailing spot rate on the fixing date is calculated and settled in cash, usually in USD.
This arrangement allows you to hedge foreign currency exposure without needing access to the restricted currency itself. For example, a company expecting payment in a non-convertible currency can lock in a forward rate and receive compensation for adverse currency moves through the NDF settlement.
Examples and Use Cases
NDFs serve various purposes across industries and markets:
- Airlines: Delta and American Airlines may use NDFs to hedge currency risk on international fuel purchases or ticket sales in restricted currencies.
- Emerging market investors: Foreign bondholders often use NDFs to manage currency exposure when local currency convertibility is limited.
- Multinational corporations: Firms operating in countries with capital controls employ NDFs to protect receivables or payables in currencies like BRL, CNY, or INR.
- Synthetic exposures: Banks may use NDFs to create synthetic loans by combining dollar disbursements with forward currency contracts, avoiding direct currency transfers.
Important Considerations
While NDFs provide a useful mechanism for hedging restricted currencies, you should be aware of potential basis risk due to differences between onshore and offshore rates, especially in markets like China. Additionally, the absence of central clearing means you must carefully assess counterparty credit risk.
Understanding broader macroeconomics factors influencing currency restrictions and market liquidity can improve your use of NDFs. For portfolio diversification involving fixed income, combining NDF strategies with best bond ETFs may enhance risk management.
Final Words
Non-deliverable forwards offer a practical way to hedge currency risk in restricted markets without exchanging principal. Evaluate your exposure and consult with a financial advisor to determine if an NDF contract fits your risk management strategy.
Frequently Asked Questions
A Non-Deliverable Forward (NDF) is a short-term, cash-settled forward contract where two parties exchange the difference between an agreed forward rate and the spot rate at maturity, without any physical delivery of the currencies involved.
At settlement, the difference between the agreed NDF rate and the prevailing spot rate on the fixing date is calculated and multiplied by the notional amount. The resulting cash payment is made in a convertible currency, typically USD, with no actual exchange of the underlying restricted currency.
NDFs are widely used in markets with capital controls or currency restrictions because they allow investors to hedge or speculate on currencies that cannot be freely traded or physically delivered offshore, enabling synthetic foreign exchange risk management.
NDF contracts usually involve one restricted or illiquid currency, such as the Brazilian real (BRL), paired with a convertible currency like the US dollar (USD) or British pound (GBP).
While NDFs reduce counterparty risk compared to deliverable forwards by settling only the net difference, they are still traded over-the-counter (OTC) without central clearing, exposing parties to default risk.
Companies expecting cash flows in restricted currencies enter into NDFs to lock in an exchange rate. At maturity, any loss or gain from currency fluctuations is settled in cash, offsetting the impact on their local currency revenues or expenses.
The fixing date is usually two business days before settlement when the official spot rate for the restricted currency is observed and compared to the agreed NDF rate to calculate the final payment.
