Non-deliverable forwards: impact of currency internationalisation and derivatives reform

That is, we regress both the deliverable forward and NDF of a given currency on percentage changes in the euro/dollar forward rate, the yen/dollar rate and the VIX. If the forward rate is affected by global risk https://www.xcritical.com/ conditions, a rise in the VIX would lead to a depreciation, ie an increase in the forward rate defined as above. Note that we lag the VIX for the Asian currencies, using the previous day’s New York close.

Understanding Non-Deliverable Forwards in Forex Trading

Differences between deliverable forward and NDF rates reflect the effectiveness of capital controls. On the whole, deviations are largest for the renminbi and the Indian rupee, as well as the Indonesian rupiah and Philippine peso (Table 4). The liberalised Russian rouble serves as a benchmark, with much narrower differentials. The bulk of NDF trading is settled in dollars, although it is also possible to trade NDF currencies against other convertible currencies such as euros, sterling, and yen. 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. non deliverable forwards Overall, non-deliverable forwards open up possibilities for clients and investors seeking opportunities in inaccessible currencies abroad.

Non-Deliverable Forward – NDF Meaning

Analysis of the two subsample periods shows that the NDF’s influence seems to increase during market stress. During the global financial crisis, the NDF tended to lead the onshore market. A rise in the influence of the NDF was even more noticeable in May-August 2013 (eight out of nine cases). In India, the impression that the offshore NDF drove the domestic market in summer 2013 has reportedly prompted consideration of opening up the domestic market to foreign investors (Sikarwar (2013)).

Supporting Economic Development and Integration

Investors thereby circumvent limits on home market (“onshore”) trading and on delivery of the home currency offshore. 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. Interest rates are the most common primary determinant of the pricing for NDFs. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated. Other factors that can be significant in determining the pricing of NDFs include liquidity, counterparty risk, and trading flows between the two countries involved. In addition, speculative positions in one currency or the other, onshore interest rate markets, and any differential between onshore and offshore currency forward rates can also affect pricing.

Non-Deliverable Currencies in 2024: A Comprehensive List

The remaining sections of Table 2 make clear that the strength of the relationship varies across the six currency pairs (though it is highly statistically significant in all cases). Segmentation is strongest in the Indian rupee, followed by the renminbi,3 the Brazilian real, the Korean won, the New Taiwan dollar and finally the Russian rouble. NDFs enable economic development and integration in countries with non-convertible or restricted currencies.

Understand NDFs to Navigate Forex

See also the results of Eichengreen and Gupta (2013), who find that larger, more liquid markets felt more pressure during the tapering episode. As Graph 3 shows, the widening of the band and the tendency for actual trading to occur near its edges make for substantial basis risk. When the NDF settles at the fixing rate, this can be 1 percentage point higher or lower than the rate at which the renminbi can actually be sold onshore. From the standpoint of a firm trying to fix the dollar value of profits to be remitted from China, a 1% gap between the NDF and the actual rate of exchange can produce unwanted volatility. Since the band’s widening, the CNH has averaged an absolute difference from the Shanghai close of just 0.1%, much narrower than the 0.7% absolute gap between the Shanghai fixing and close.

Risks Associated with NDF Trading

Implied volatility in the CNH tends to be very low, and market participants report a reach for yield among investors who bet on the stability of the renminbi/dollar rate. The liquidity thereby generated in the CNH market, however cyclical, has attracted asset managers, including some hedge funds, to switch from NDFs. The costs to Korea of maintaining won NDFs may decline with the changing market structure. The continuing existence of the NDF market alongside deliverable forwards no doubt exacts a cost in terms of lower liquidity from the division of the forward markets. However, it is possible that the change in the NDF market to more transparent trading and centralised clearing will make NDF markets deeper and more liquid.

What Is a Non-Deliverable Swap (NDS)?

NDFs settle by reference to the official central parity rate against the US dollar (the “fixing rate”) set every day at 9.30 am in the Shanghai, China Foreign Exchange Trade System. However, actual trading occurs within +/-1% bands around this fixing rate, which were widened from +/-0.5% in April 2012. First, some investors, including official investors, have mandates that do not permit NDFs but do permit CNH. Second, the Triennial Survey shows $17 billion in renminbi options, including those written offshore on the CNH, and these generate activity in deliverable forwards.

• An NDF settles with a single cash flow based on the difference between the contracted NDF rate and the spot rate, while an FX swap settles with two cash flows based on exchanging two currencies at a spot rate and a forward rate.
• Non-deliverable currencies (NDFs) are a type of derivative contract that allows investors to trade in currencies that are not freely traded.
• The main difference between forward and NDF is that in a standard forward contract, there is actual delivery of the underlying currencies on the settlement date.
• Thus, it is not surprising that the NDF market moves the domestic forward market on the following day, especially when financial markets are more volatile.

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Consequently, since NDF is a “non-cash”, off-balance-sheet item and since the principal sums do not move, NDF bears much lower counter-party risk. NDFs are committed short-term instruments; both counterparties are committed and are obliged to honor the deal. Nevertheless, either counterparty can cancel an existing contract by entering into another offsetting deal at the prevailing market rate. 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. However, the opaque OTC structure also poses risks around counterparty credit, liquidity constraints, and operational issues. Understanding contract specifications and nuances across NDF providers is vital.

For instance, in the smaller markets of Chile and Peru,5 where the central bank measures not just turnover but also net positions, the data show a sharp turnaround in positioning in May-June 2013. The left-hand panel of Graph 1 shows stocks of long positions in the Chilean peso and Peruvian new sol. The larger stock of positions in Chile declined by $9 billion between end-April and end-June 2013. The smaller position in Peru declined by $2 billion between end-May and end-August. NDFs were used to reduce net exposures, while the Peruvian data show a decline in turnover consistent with the London data for October 2013 discussed below.

Thus we use Tokyo closing rates for the major currencies to analyse East Asian domestic forward rates, London rates for the rupee and the rouble, and New York closing rates for the real. An NDF is a powerful tool for trading currencies that is not freely available in the spot market. By understanding how they work, their benefits and risks and how they differ from DFs, you can use them to diversify your portfolio, hedge your currency risks or speculate on the exchange rate movements of these currencies.

Non-deliverable forwards (NDFs) are contracts for the difference between an exchange rate agreed months before and the actual spot rate at maturity. The spot rate at maturity is taken as the officially announced domestic rate or a market-determined rate. Thus NDFs yield payoffs related to a currency’s performance without providing and requiring funding in the underlying currencies as do deliverable forwards. 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.

This article delves into the intricacies of NDFs, their benefits and risks and how they affect global currency markets. NDFs are contracts for the difference between an agreed exchange rate and the actual spot rate at maturity, settled with a single payment for one counterparty’s profit. They allow hedging and speculation in a currency without providing or requiring funding in it.

However, due to regulations and restrictions, you’re unable to easily convert Chinese Yuan into U.S. dollars at the current market exchange rate. To protect yourself from potential losses caused by fluctuations in the Chinese Yuan’s value, you decide to enter into an NDF contract with a financial institution. 4 Chang (2013, pp 14-15) shows that rising bond yields tracked falling currencies, allowing the liquid foreign exchange market to proxy hedge rates as well.

One interpretation of the revival is that credit and legal concerns since 2014 have prolonged the life of the rouble NDF. In 2013, the concentration of liquidity in offshore markets (including the NDF) was ascribed to concerns about the enforceability of collateral arrangements in Russia (HSBC (2013)). In early 2014, a series of financial sanctions on certain Russian individuals, defence firms, energy firms and banks were reported to have led non-financial firms to use NDFs rather than DFs (Becker (2014)).