Key Takeaways
- Swaps cash flows on restricted currencies without delivery.
- Settled in convertible currency like USD only.
- Used for hedging in markets with capital controls.
What is Non-Deliverable Swap (NDS)?
A Non-Deliverable Swap (NDS) is a financial derivative contract where counterparties exchange cash flows based on interest or foreign exchange rates involving a restricted or non-convertible currency, with settlement made in a convertible currency such as U.S. dollars. Unlike traditional swaps, an NDS involves no physical delivery of currencies, enabling transactions despite capital controls or currency restrictions.
This instrument is commonly used in emerging markets where direct currency exchange is limited, allowing firms to manage their obligation exposure without transferring principal amounts.
Key Characteristics
Non-Deliverable Swaps have distinct features that differentiate them from conventional swaps:
- Cash Settlement Only: Settlements occur in a convertible currency, typically USD, based on the net difference between contracted and spot rates.
- Notional Amount: The principal is a reference figure used for calculations but is never exchanged between parties.
- Restricted Currency Involvement: One currency is restricted or non-convertible, such as the Indian rupee or Korean won.
- Interest Rate or FX Basis: Can function as interest rate swaps or FX forwards, settled periodically or at maturity.
- No Physical Currency Delivery: Designed to bypass regulatory hurdles in markets with capital controls.
- Regulatory Compliance: Often traded over-the-counter with mark-to-market monitoring, adhering to local financial regulations.
- Risk Management Tool: Useful for hedging currency or interest rate risk in restricted markets, acting as a safe haven against volatility.
How It Works
In an NDS, two parties agree on a notional amount, contract rate, and settlement dates without exchanging the principal. At each settlement, the difference between the agreed rate and the prevailing spot or reference rate is calculated and settled in USD or another convertible currency.
This mechanism allows you to hedge foreign exchange or interest rate exposure without the need for physical currency delivery. For example, an interest rate NDS mimics a fixed-for-floating swap, but payments are netted and settled in USD, making it practical in restricted currency environments.
Examples and Use Cases
Non-Deliverable Swaps are widely used in emerging markets and by companies facing currency restrictions:
- Airlines: Delta and American Airlines may use NDS to hedge exposure to currencies like the Brazilian real or Indian rupee when operating internationally.
- Emerging Market Corporations: Firms with receivables in restricted currencies such as the Indian rupee often use NDS to lock in rates and avoid currency risk.
- Financial Institutions: Banks trading interest rate swaps on restricted currencies utilize NDS structures to comply with capital controls.
- Investors: Those interested in diversified portfolios can explore bank stocks that engage in derivatives trading including NDS for risk management.
Important Considerations
While NDS offer valuable tools for managing currency and interest rate risk, you should be aware of counterparty credit risk and the impact of local regulations on trading and settlement. Because these swaps settle in a convertible currency, fluctuations in that currency can also affect outcomes.
Proper due diligence and understanding of market liquidity are essential before entering into NDS contracts. For investors new to derivatives, exploring best ETFs for beginners can provide a foundational knowledge before engaging in complex swaps.
Final Words
Non-Deliverable Swaps offer a practical way to hedge exposure in restricted currency markets without physical currency exchange. To leverage this tool effectively, evaluate current market offers and consult a specialist to tailor contracts to your risk profile.
Frequently Asked Questions
A Non-Deliverable Swap (NDS) is a financial derivative where two parties exchange cash flows based on interest or exchange rates involving a restricted currency, with settlement made in a convertible currency like U.S. dollars instead of physically exchanging the currencies.
In an NDS, cash settlement involves calculating the difference between the contracted rate and the prevailing spot rate at maturity or reset dates, then making a net payment in a convertible currency such as USD, avoiding any physical currency exchange.
NDS contracts are designed for currencies that have capital controls or convertibility restrictions, allowing market participants to hedge or speculate without the challenges of physical currency delivery in controlled markets.
NDS can be structured with either interest rate swaps, involving fixed versus floating rates, or foreign exchange basis swaps that settle based on differences between agreed contract rates and official spot rates at settlement.
Unlike traditional currency swaps that involve physical exchange of principal and interest, NDS settlements are cash-only, with no currency delivery, making them suitable for markets with currency restrictions.
NDS usually involve one major convertible currency like the U.S. dollar and one restricted or non-convertible currency such as the Korean won, Brazilian real, or Indian rupee.
Yes, NDS are subject to local financial regulations and currency controls due to their use of restricted currencies, and they are often traded over-the-counter with ongoing mark-to-market monitoring.
The notional amount in an NDS is a reference figure used to calculate cash settlements based on rate differences, but it is never physically exchanged between the parties.
