The price of non-deliverable forward contracts, or NDFs, is commonly based on an interest rate parity formula used to calculate equivalent returns over the term of the contract based on the spot price exchange rate and interest rates for the two currencies involved, although a number of other factors can also affect the price.
NDFs are a foreign exchange agreement most commonly used when one of the currencies involved is not freely traded in the forex market and is thus considered "non-deliverable." They are most often used by companies seeking to hedge exposure to currency risk when transacting business in countries whose currency is not freely traded. NDFs are usually short-term contracts between two parties in which the difference between the spot price exchange rate on the contract settlement date and the previously agreed upon exchange rate is settled between the two parties for a notional amount of money. NDFs are typically priced and settled in U.S. dollars.
Pricing NDF Contracts
Interest rates are the most common primary determinant of the pricing for NDFs. Most NDFs are priced according to an interest rate parity formula. 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. NDF prices may also bypass consideration of interest rate factors and simply be based on the projected spot exchange rate for the contract settlement date.