DEFINITION of 'Non-Deliverable Swap - NDS'
A currency swap between major and minor currencies that is restricted or not convertible. A non-deliverable swap (NDS) is so-called because there is no delivery of the two currencies involved in the swap, unlike a typical currency swap where there is physical exchange of currency flows. Periodic settlement of an NDS is done on a cash basis, generally in U.S. dollars. The settlement value is based on the difference between the exchange rate specified in the swap contract and the spot rate, with one party paying the other the difference. A non-deliverable swap can be viewed as a series of non-deliverable forwards bundled together.
INVESTOPEDIA EXPLAINS 'Non-Deliverable Swap - NDS'
Multinational corporations use NDSs to mitigate the risk that they may not be allowed to repatriate profits because of currency controls. They also use NDSs to hedge the risk of abrupt devaluation or depreciation in a restricted currency with little liquidity, and to avoid the prohibitive cost of exchanging currencies in the local market. Financial institutions in nations with exchange restrictions use NDSs to hedge their foreign currency loan exposure.
The key variables in an NDS are:
- the notional amounts (that is, the amounts of the transaction)
- the two currencies involved (the non-deliverable currency and the settlement currency)
- the settlement dates
- the contract rates for the swap, and
- the fixing rates and dates – the specific dates on which the spot rates will be sourced from reputable and independent market sources.
For example, consider a financial institution – let’s call it LendEx – based in Argentina, that has taken a five-year US$10 million loan from a U.S. lender at a fixed interest rate of 4% per annum payable semi-annually. LendEx has converted the U.S. dollar into Argentine pesos at the current exchange rate of 5.4, for lending to local businesses. However, it is concerned about the future depreciation of the peso, which will make it more expensive to make the interest payments and principal repayment in U.S. dollars. It therefore enters into a currency swap with an overseas counterparty on the following terms:
- Notional amounts – US$400,000 for interest payments and US$10 million for the principal repayment.
- Currencies involved – Argentine peso and US$.
- Settlement dates – 10 in all, the first one coinciding with the first interest payment and the 10th and final one coinciding with the final interest payment plus principal repayment.
- Contract rates for the swap – For the sake of simplicity, say a contract rate of 6 (pesos per dollar) for the interest payments and 7 for the principal repayment.
- Fixing rates and dates – Two days before the settlement date, sourced at 12 noon EST from Reuters.
Here’s how the NDS works. On the first fixing date – which is two days before the first interest payment / settlement date – assume the spot exchange rate is 5.7 pesos to the U.S. dollar. Since LendEx has contracted to buy dollars at a rate of 6, it would have to pay the difference between this contract rate and the spot rate times the notional interest amount to the counterparty. This net settlement amount would be in U.S. dollars and works out to $20,000 [i.e. (6.0 - 5.7) x 400,000 = 120,000 / 6 = $20,000].
On the second fixing date, assume the spot exchange rate is 6.5 to the U.S. dollar. In this case, because the spot exchange rate is worse than the contracted rate, LendEx will receive a net payment of $33,333 [calculated as (6.5 – 6.0) x 400,000 = 200,000 / 6 = $33,333].
This process continues until the final repayment date. A key point to note here is that because this is a non-deliverable swap, settlements between the counterparties are made in U.S. dollars, and not in Argentine pesos.
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