What is a Non-Deliverable Forward (NDF)
Non-deliverable forwards (NDF) are a cash-settled and usually short-term forward contract. The notional amount is never exchanged, hence the name "non-deliverable." Two parties agree to take opposite sides of a transaction for a set amount of money (in the case of a currency NDF) at a contracted rate. The profit or loss is calculated on the notional amount of the agreement by taking the difference between the agreed upon rate and the spot rate at the time of settlement.
NDFs are commonly quoted for time periods from one month up to one year. They are most frequently quoted and settled in U.S. dollars and have become a popular instrument for corporations seeking to hedge exposure to foreign currencies that are not internationally traded or whose trade is limited or legally restricted in the domestic market. If a country's currency is restricted from moving offshore, it won't be possible to settle the transaction in that currency with someone outside the restricted country. But, the two parties can settle the NDF by converting all profits and losses on the contract to a freely traded currency. They can then pay each other the profits/losses in that freely traded currency.
Non-Deliverable Forward (NDF)
Breaking Down the Non-Deliverable Forward (NDF)
Non-deliverable forwards (NDFs) are usually executed off-shore, meaning outside the home market of the illiquid or untraded currency.
That said, non-deliverable forwards are not limited to illiquid markets or currencies. They can be used by parties looking to hedge or expose themselves to a particular asset, but who are not interested in delivering or receiving the underlying product.
Non-Deliverable Forward Structure
All NDFs have a fixing date and a settlement date. The fixing date is the date at which the difference between the prevailing spot market rate and the agreed-upon rate is calculated. The settlement date is the date by which the payment of the difference is due to the party receiving payment. The settlement of an NDF is closer to that of a forward rate agreement (FRA) than to a traditional forward contract.
If one party agrees to buy Chinese yuan (sell dollars), and the other agrees to buy U.S. dollars (sell yuan), then there is potential for a non-deliverable forward between the two parties. They agree to a rate of 6.41 on $1 million U.S. dollars. The fixing date will be in one month, with settlement due shortly after.
If in one month the rate is 6.3, the yuan has increased in value relative to the U.S. dollar. The party who bought the yuan is owed money. If the rate increased to 6.5, the yuan has decreased in value (U.S. dollar increase) so the party who bought U.S. dollars is owed money.
The largest NDF markets are in the Chinese remnimbi, Indian rupee, South Korean won, new Taiwan dollar, and Brazilian real. The largest segment of NDF trading takes place in London, with active markets also in Singapore and New York. Some countries, including South Korea, have limited but restricted onshore forward markets in addition to an active NDF market.
The largest segment of NDF trading is done via the U.S. dollar. There are also active markets using the euro, the Japanese yen, and, to a smaller extent, the British pound, and the Swiss franc.