A non-deliverable forward (NDF) is a forward or futures contract that is settled in cash, and often short-term in nature. In an NDF contract, two parties agree to take opposite sides of a transaction for a predetermined amount of money, at a prevailing spot rate. The term “non-deliverable” is derived from the fact that the notional amount is never exchanged. It is also commonly known as non-deliverable forward contracts that work like regular contracts but do not physically deliver the underlying currency pairs.
So how does NDF trading work? Read on to learn more about NDFs, how it is used for trading and take a look at some examples to help you understand better.
How does an NDF work?
Before understanding how the NDF contract works, there are a few key terms of NDF you must know. These include:
- Fixing date: This is the date when the NDF rate and the prevailing spot market rate is compared to determine the notional contract.
- Settlement date: This is the date when both parties agree to exchange the difference in exchange rates. The paying party will pay the receiving party this difference in cash.
- NDF rate: This is the rate that is agreed upon, on the date of the transaction. It represents the exchange rate for the currencies involved in the NDF.
- Spot rate: This is the most current exchange rate for the NDF, as provided by the central bank.
Now that you have understood the key terms, it’s time to get into how NDFs works. Here’s a formula to help you understand how the NDF value is calculated: NDF value = (Fixing rate – NDF rate)*Notional amount
NDFs are often settled with cash, meaning the notional amount is never physically exchanged. The cash flows that change hands would be the difference between the prevailing spot rate and the rate agreed upon in the contracted NDF rate. Counterparties will settle the difference between the contracted NDF price and the prevailing spot price.
Profit and loss would then be determined by applying the difference between the agreed-upon rate and the spot rate at the time of settlement to the agreement’s notional value.
Examples of NDF usage
For example, if a party agrees to buy South Korean Won (sell dollar) and the other agrees to buy US Dollars (sell South Korean Won), a NDF foreign exchange contract between the two parties can be established. Both parties agree to a rate of 1230 on $10,000 US dollar and the future date will be in one month with settlement due shortly after.
If in one month, the fixing rate is 1230.5 South Korean Won to 1 US dollar, the South Korean Won has decreased in its value relative to the US dollar. The NDF value would then be: (1230.5-1230) * $10,000 = $5,000. As the fixing rate is more than the NDF rate, the party who has bought the US dollar is owed the agreed upon $5,000 on the settlement date.
When are NDFs used?
NDFs can be used in situations by foreign exchange (FX) traders, where the currency being traded is not freely tradable or has restrictions when it comes to convertibility. This can include emerging market currencies, which may be subject to capital controls or other regulations that make it difficult to trade the currency directly. It is also often used in countries where forward FX trading is not available [4].
For example, the Chinese yuan and the Indian rupee are not fully convertible currencies, so companies and traders that operate in those countries may use NDFs to manage currency risk in international trade and investment [5].
Why use NDF for trading?
With such a wide range of trading products available, why should one use NDFs? Here are three reasons.
- Access to non-convertible currencies: NDFs allow traders to gain exposure to currency pair that are not freely traded or that have restrictions on convertibility, such as emerging markets. This can provide opportunities for diversification and potential returns that may not be available through other investment options.
- Liquidity: NDFs are often more liquid than other financial instrument such as options, futures, or swaps. It is used in many countries around the world, especially in emerging markets where their local currency is not fully convertible. This allows for a global market to exist for NDFs, creating more opportunities for trading and thus more liquidity in the market.
- Cost-effective: NDFs are often considered as a cost-effective way to gain exposure to a currency, as they do not require the trader to hold the underlying currency. They are settled in cash, which eliminates the need for FX conversion. This can save costs associated with FX conversion, such as conversion fees and currency risk. Traders are also provided with a means of negating foreign exchange risk in markets where physical delivery is not possible.
Conclusion
Non-deliverable forward contracts are a tool that can be used as a flexible solution for traders looking to diversify into the currency markets that are not freely tradable or have restrictions on convertibility. Traders can also start trading NDF CFDs by opening a live account with Vantage to access global NDF currency markets, including the likes of USDIDR, USDKRW and USDTWD.
However, it is important to note that NDF trading can be complex and may not be suitable for all traders. It is crucial to understand the risks and mechanics involved before engaging in NDF CFDs trading. Traders can opt for a demo account instead, to practice trading NDF CFDs with virtual money.
