A Non-Deliverable Forward (NDF) is a financial derivative used in the Forex market. It allows parties to speculate on or hedge against potential changes in currency exchange rates, particularly in emerging markets where currencies are not freely convertible.
What Is NDF?
An NDF is a contract to exchange cash flows between two parties based on the predicted future exchange rates of a particular currency pair. It differs from typical forward contracts as no physical delivery of the underlying currencies occurs at maturity.
NDFs are primarily used in markets where the currency is not freely tradable or faces certain restrictions.
For example, if a company operates in a country with strict rules on currency exchange, it might use an NDF to protect itself from losing money due to changes in currency values. Imagine a company agreeing today on a future exchange rate for a currency with another party. When their agreement ends, they simply pay or receive money based on the difference between this agreed rate and the currency’s real rate at that time. This approach makes it easier to handle currency exchange rules.
Non-Deliverable Forward Example
An example of an NDF could be a U.S. company entering into a contract to sell Indian rupees and buy U.S. dollars six months from now at a predetermined rate. The company might do this, expecting the rupee to depreciate against the dollar.
For instance, if the agreed rate was ₹70 to $1 and the rate at the contract’s maturity is ₹75 to $1, the company would receive a payment based on the difference in these rates, settled in dollars. This transaction allows the company to hedge against its rupee exposure without handling the actual currency. Conversely, if the rupee appreciates, the company would have to pay the difference, demonstrating the risk inherent in such contracts.
How Do NDFs Work in India?
In India, Non-Deliverable Forwards (NDFs) are used primarily for currencies that have restrictions or are not fully convertible, like the Indian Rupee (INR).
Here is the step-wise process:
- Contract Agreement: Parties enter into an NDF contract agreeing on an exchange rate for a specific amount of a non-convertible currency (like INR) against a convertible currency (such as USD), to be settled at a future date.
- No Physical Exchange of Currency: Unlike standard forex transactions, there is no actual exchange of the underlying currency on the settlement date.
- Reference Rate Determination: On the settlement date, a reference rate (typically the prevailing market rate of the INR against the USD) is determined by a mutually agreed external source.
- Cash Settlement: The difference between the contracted NDF rate and the reference rate is calculated. If the INR depreciates against the USD, the seller of the NDF (who agreed to sell INR and buy USD) pays the buyer. Conversely, if the INR appreciates, the buyer pays the seller.
- Settlement in Convertible Currency: The payment is made in a fully convertible currency, usually the USD, equivalent to the INR value difference.
- Use for Hedging and Speculation: Businesses use NDFs to hedge against currency risk in their international transactions involving the INR. Traders and investors use them to speculate on the INR’s future value without direct exposure to the currency.
Difference Between NDF And Forward
The primary distinction between Non-Deliverable Forwards (NDFs) and traditional forward contracts is that NDFs settle in a major currency without exchanging the actual currency, whereas traditional forwards involve the actual exchange of the currencies involved.
| Criteria | NDF | Forward Contract |
| Physical Delivery | No physical delivery of currency; settled in cash. | Involves physical delivery of the underlying currency. |
| Currency Type | Used for currencies with restrictions or limited convertibility. | Typically used for major, freely convertible currencies. |
| Settlement | Settled in a major currency like USD, based on the difference between agreed and prevailing rates. | Settled by exchanging the actual amounts in the agreed currencies. |
| Market Accessibility | Often used in emerging markets with capital controls. | Common in developed markets with fully convertible currencies. |
| Risk Management | Used to hedge against currency risk in restricted markets. | Used to hedge or speculate in freely traded currency markets. |
| Liquidity | May have lower liquidity due to the nature of underlying currencies. | Generally higher liquidity due to involvement of major currencies. |
| Regulatory Environment | Often subject to different regulations due to the nature of the currencies. | Typically under standard forex market regulations. |
To understand the topic and get more information, please read the related stock market articles below.
What Is NDF? – Quick Summary
- NDFs are Forex market derivatives used for speculating or hedging against currency exchange rate fluctuations, particularly in markets with non-convertible currencies.
- An NDF is a contractual agreement to exchange cash flows based on anticipated future exchange rates of a currency pair, with no actual currency delivery at maturity, suited for markets with restricted currencies.
- An example of NDF is a U.S. company entering a contract to exchange Indian rupees for U.S. dollars in the future at a predetermined rate, benefiting if the rupee depreciates against the dollar.
- The main distinction between NDFs and forwards is that NDFs are settled in a major currency without actual currency exchange, whereas traditional forwards involve the exchange of the underlying currencies.
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Non-Deliverable Forward – FAQs
What Is a Non-Deliverable Forward Contract?
A Non-Deliverable Forward (NDF) is a financial derivative used in forex markets. It is a contract to pay the difference between an agreed-upon currency exchange rate and the real rate on a future date, using money rather than exchanging physical currencies.
What is the difference between forward and NDF?
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. In contrast, an NDF involves cash settlement of the difference between the agreed and prevailing market rates, without any physical exchange of currencies.
How does the NDF market work?
The NDF market operates by allowing parties to hedge or speculate on the movement of currencies that restrict their convertibility. The contract’s profit or loss is determined based on the difference between the agreed exchange rate in the NDF contract and the prevailing market rate at the time of settlement.
What is the difference between outright forward and non-deliverable forward?
The key difference between an outright forward and a non-deliverable forward is that outright forward contract involves actual delivery of the currency on a future date, while a non-deliverable forward (NDF) settles the difference between the agreed rate and the market rate in cash, without any physical exchange of currencies.
Who uses NDF?
NDFs are used by corporations, financial institutions, and investors. Corporations use them to hedge currency risk in markets with currency restrictions, while investors and traders use NDFs to speculate on currency movements in emerging markets where full currency convertibility is not available.
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