NON DELIVERABLE FORWARD ( NDF)

Non Deliverable Forward  ( NDF) has been very much in the news   while we have seen  the USD rapidly  rising against  Indian  Rupee  in the Indian forex market for the last two months.  I would like to give a brief on the NDF and how it works, in this article.

NDF is a very useful  instrument  in the hands of corporate treasurers who wish to hedge their exposures to foreign currencies which are not traded internationally and which do not have a forward market outside their countries. Examples of such currencies are Indian Rupee, Philippine Peso, Taiwan dollars, Korean Won, Indonesian Rupiah and Chinese Yuan. NDF s  are distinct from deliverable forwards as the NDF s trade outside the countries of the corresponding currencies.

The offshore NDF markets form an important part of the global and Asian foreign exchange markets, equilibrating market demand and supply in the presence of capital controls. A liquid NDF  market could serve International Portfolio investors by affording them an otherwise unavailable means to hedge foreign exchange risk.  The ability to hedge forex risk  is particularly essential for offshore bond investors. As a result NDF markets could potentially facilitate foreign investment in Asia’s expanding local currency bond markets and thereby add diversity and liquidity to them.

For the six Asain currencies mentioned above, the NDF turnover  represents  10 % to 20 % of the combined  trading volume of onshore outright forwards, foreign exchange swaps and NDF s.

NDF is  a short  term committed  forward “ cash settlement” currency derivative  instrument. It is essentially an outright forward contract in which profit or loss is adjusted  between the two counterparties  based on the difference between  the contracted NDF rate and the prevailing spot FX rate on an agreed notional amount.

The notional amount is the face value of NDF which is agreed between the two counterparties.  There is never any intention to exchange the two currencies principal amounts.  Only the difference between the NDF rate and the spot market rate  is settled  on the due date. The settlement is always done in USD.

To illustrate,  On 10^th January 2008,  ABC Corporation sells  INR  45 mn. NDF  to  HSBC, 3 months forward for value, 11 th April 2008 at the NDF rate of USD/INR  45.00 , in effect buying USD 1 mn. Rate fixing date is 10^th April 2008.

On 10 th April 2008, (the fixing date), at 12 noon  India time, both parties will compare the NDF  rate with the prevailing USD/INR fixing rate as RBI’s USD/INR reference spot rate.

In case, the NDF rate and prevailing rate are equal, no payment needs to be paid by any of the parties.

In case,  the prevailing rate  on 10^th April  08 is Rs.50 per USD,   Rs,45 mn agreed  for in NDF  would fetch  USD 900000.( 45 000 000 /50). Hence  the difference  amount  of USD 100000 will be paid by  HSBC to ABC Corpn on the settlement date, i.e. on 11^th Apr 08.    T here is no movement of INR 45 mn.

In the other scenario, if the prevailing rate is Rs. 40 per USD,  on 10^th April  08, Rs.45 mn agreed in NDF would fetch USD 1 125 000. Hence the difference amount of USD  1 25 000 will be paid by ABC Corpn to HSBC on the settlement date, i.e. 11.04.08. Again there would be no movement of  INR 45 mn.

The NDF therefore offers an alternative hedging tool  for  foreign investors with local currency exposure. It can also be used as a speculative instrument to  take positions offshore in the local currency.  The participants in the NDF market comprise multinational corporations, portfolio investors, hedge funds, and proprietary foreign exchange accounts of commercial and investment banks. Both hedging demand and speculative demand are present in NDF market.

The main trading locations for NDF s are in Hongkong, Singapore, Korea, Taiwan, Newyork, London and Tokyo. Singapore is the largest hub for trading Asian NDF s. The major centres for INR- NDF are Singapore, Hongkong and London. Singapore is the most active INR NDF market.

Generally participants take position in the INR  NDF market based on their view on where the INR spot would be after a certain time period in the on shore market ( Indian forex market). Entities who  have access to both the markets take advantage of the arbitrage opportunities if available  between both the markets. Arbitrage opportunity is generally available between the INR NDF market and the on shore market.  

No authentic data is available on the daily average volumes in NDF market, but the INR – NDF market is estimated to be around USD 150 – 200 mn  per day.  ( Source : CCIL)