Non-Deliverable Forward

A non-deliverable forward (NDF) refers to a forward contract signed between two signatories for exchanging cash flows based on the existing spot rates at a future settlement date. It allows businesses to settle their transactions in a currency other than the underlying freely traded currency being hedged.

It also helps businesses to conduct trade with emerging markets in the absence of convertible and transferable currency and manage the exchange rate volatility. The settlement of NDFs mostly takes place in cash as per the agreement made between the two parties. Most non-deliverable forward uses the dollar in the largest NDF markets like the Chinese Yuan, Brazilian Real, South Korean Won, and New Taiwan Dollar.

• A non-deliverable forward (NDF) is a financial instrument that involves two parties signing a contract to exchange cash flows at a future settlement date based on the current spot rates.
• It enables companies to use a different currency to settle their transactions, which may not be freely traded or convertible. Thus, they can trade with emerging markets where there is no availability of transferable currency.
• It does not involve any exchange of physical cash despite being cash-based. But deliverable forward involves the physical exchange of the underlying currencies in the forward contract.
• NDFs offer various advantages, including hedging against currency risks, cost-effectiveness, customization, and liquidity.

A Non-Deliverable Forward contract is a financial derivative instrument involving two parties who have entered into an agreement to exchange cash flows on the basis of the difference between a pre-fixed reference exchange rate plus an existing spot rate at a settlement date in the future. It is mostly useful as a hedging tool in an emerging market where there is no facility for free trading or where conversion of underlying currency can take place only in terms of freely traded currency.

Moreover, they do not require the underlying currency of the NDF in physical form. Consequently, the transaction based on NDF tends to be affordable and cost-effective compared to other forward contracts. In addition, an NDF has the characteristics of getting custom contract terms as per the needs of parties involved, like settlement date, reference exchange rate, and notional amount. 

The accounting for non-deliverable forward contracts follows these steps:

• The recording of the NDF has to be done on the balance sheet from the perspective of a seller.
• The asset obligation for the spot rate can be credited on the liability side.
• The asset receivable related to the NDF can be debited on the asset side.

One can describe its working as follows:

• The account manager and the firm's owner agree upon the pair of currencies they use for the notional amount.
• Then, they agree on the non-deliverable forward market rate.
• After that, they choose the settlement date and the fixing date.
• At the fixing date, the exchange rate provided by the central bank of the non-convertible currency is compared to the rate specified in the agreement.
• The settlement currency, then, pays the variance on the settlement date, depending on whether there is an increase or decrease in the rate.

Let us use a few examples to understand the topic.

Example #1

Suppose XYZ corporation sells products in Brazil for which it has to protect the dollar-equivalent funds in Brazilian real. As currency restrictions remain there, an NDF can be helpful to lock the exchange rate. Other conditions are as follows:

XYZ corporation would be the customer payment spanning nine months for BRL ten million.

Hence, it enters an NDF agreement to sell one million BRL and buy the dollar at the rate of Dollar/BRL* 5.3500. the company buys 186,915.89 dollars.

At the agreed-upon date, the prearranged rate of GBP/BRL 5.3500 is compared to the fixing rate set by Brazil's central bank.

This will determine whether the contract has resulted in a profit or loss, and it serves as a hedge against the spot rate on that future date.

Example #2

Suppose a US-based company, DEF Corporation, has a business transaction with a Chinese company. One cannot convert Chinese Yuan to dollars, so it makes it difficult for American businesses to settle the transaction.

Hence, to overcome this problem, an American company signs an NDF agreement with a financial institution while agreeing to exchange cash flows on a certain future date based on the prevailing spot rate of the Yuan.

Therefore, American company settles all the transactions in US dollars while managing the risk associated with the yuan currency.

One can derive many advantages from NDF, like:

• They commonly find use in hedging against currency risks.
• Many firms and individuals participate in the economy of an emerging market, having no facility for currency conversion or transferability with ease and mitigating the currency risk as well.
• Since there are no underlying physical currency and currency conversions in NDF, it is more cost-effective than other forward contracts.
• One can customize NDFs as per the requirements of the party by allowing modification of the supposed amount, reference exchange rate, and settlement date. As a result, it also allows one to manage currency risk during multiple scenarios.
• Most of the financial centers across the world trade using NDF, so they provide a great degree of transparency and liquidity to businesses and individuals.

Although businesses can use NDF liquidity and other benefits to enter into emerging markets by managing their currency, it does contain an element of risk. So they must use it cautiously.

As given in the diagram below, a list of reasons as to why the concept is widely used and helps traders in the financial market is given below. In the ways mentioned below, trading platforms can get an opportunity to create a diverse portfolio of products and services that add to their profits, with a significant degree of control on risk and losses. In this manner, they are also able to increase their customer base and provide a competitive advantage over each other. Traders also get various opportunities to enter the financial market, explore different options, and learn about them. Long with quantity, even the quality of the client base expands and improves.

Source

Although both are financial derivatives for managing currency risks, they are different from each other. Let us use the table below to understand the difference between the two:

This article has been a guide to what is Non-Deliverable Forward. We explain its examples, advantages, disadvantages, and comparison with deliverable forward. You may also find some useful articles here -

• Forward Market
• Forward Commitment
• Forward Price