Non-deliverable forwards: impact of currency internationalisation and derivatives reform

Taiwan POC also maintains limits on non-resident investment in local currency bonds and has onshore currency transaction reporting requirements. Asia accounts for the most traded NDF currencies worldwide, with the largest volumes in the Korean won (KRW), Indian rupee (INR), and New Taiwan dollar (TWD). For these currencies, NDF volumes exceed turnover in other foreign exchange products including spot transactions. In Asia, sizeable NDF markets also exist for the Chinese yuan (CNY) and the Indonesian rupiah (IDR), and to a lesser extent for the Malaysian ringgit (MYR), Philippine peso (PHP), and Vietnamese dong. The renminbi and rouble stand out from the other four owing not only to the declining share of NDFs in forward turnover, but also to the declining segmentation between onshore and offshore markets. For the renminbi, the relationship between deliverability and location has weakened – a drop in the chi-squared statistic from 5,452 to 3,732 (Table 3) – as offshore deliverable CNY trades doubled and offshore NDF trades shrank.

what are non deliverable forwards

Usually, the foreign currency is sent to the forward trade provider who converts it into the original company’s domestic currency and transfers it to them. Also known as an outright forward contract, a normal forward trade is used to lock the exchange rate for a future date. Instead, two parties ultimately agree to settle any difference that arises in a transaction caused by a change to the exchange rate that happens between a certain time and a time in the future. An example of an NDF is a contract between a U.S. importer and a Chinese exporter to exchange USD for CNY at a fixed rate in 3 months and settle the difference in cash on the settlement date. Because NDFs are traded privately, they are part of the over-the-counter (OTC) market.

what is the difference between an NDF and a FX Forward contract

She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit. There are also active markets using the euro, the Japanese yen and, to a lesser extent, the British pound and the Swiss franc. NDF currencies play a significant role in international finance and trade, particularly in regions where certain currencies are not freely tradable or face restriction. In practice, the settlement currency is almost always either the same as pay or the same as receive currency. E.g., you swap EUR for RUB and settle in EUR, or you swap USD for BRL and settle in USD.

  • Starting in February 2020 when Indonesia experienced large portfolio outflows and IDR depreciation pressures, BI increased sales of DNDFs to close to USD 8 bn (Figure 16).
  • In Korea and Chinese Taipei, some domestic financial firms are allowed to trade NDFs (Tsuyuguchi and Wooldridge 2008), Annex A).
  • Our analysis of the direction of influence between NDF and onshore FX markets provides new insights by differentiating between time-zone induced and concurrent spillovers.
  • In a path exemplified by the Korean won (KRW), NDFs gained in importance in a policy regime with restrictions on offshore deliverability.
  • Convertibility risk is a concern given that DNDFs are settled in domestic currency at maturity.
  • You can either specify both notionals in pay and receive currency; or specify one of the notionals, and the strike rate (also called forward rate), in which case you multiply one notional by the strike to get the other notional.

The contract has no more FX delta or IR risk to pay or receive currencies after the determination date, but has FX delta (and a tiny IR risk) to the settlement currency between determination and maturity dates. Median volatility of Asian NDFs is larger than volatility of onshore deliverable forwards. Asia accounts for three of the top four NDF currencies by volume globally according to the BIS survey. The INR, KRW, and TWD accounted for 55% of total daily global NDF turnover of USD258 bn as of April 2019 (Figure 1). Outside of Asia, the Brazilian real (14%) and the Russian ruble (2%) have sizeable NDF markets.

How Do Non-Deliverable Forwards Work?

The CNH is becoming more attractive to those seeking to hedge because it tracks the onshore rate better than the NDF. A non-deliverable forward (NDF) is usually executed offshore, meaning outside the home market of the illiquid or untraded currency. For example, 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.

what are non deliverable forwards

In other words, a non-deliverable forward contract is a two-party contract to exchange cash flows between an NDF and a prevailing spot rate. The spot rate is the most recent rate for an NDF, as issued by the central bank. Domestic non-deliverable forwards (DNDFs) are net-settled in local currency and traded onshore in the jurisdiction of the issuing country. They are distinct from NDFs which are typically settled in USD and trade offshore. They are also distinct from deliverable onshore forwards for which the entire notional amount is exchanged on the due date and not just the profit or loss (net settlement).

VI. Domestic Non-Deliverable Forwards (DNDFS)

With a forward trade, once one has been agreed to, both parties are contractually obliged to complete the agreed exchange of currencies. While there is a premium to be paid for taking out an option trade, the benefits provided by their optional nature are significant. A crucial point is that the company in question does not lose money as a result of an unfavourable change to the exchange rate. The use of NDFs is significantly influenced by regulatory environments, especially in countries where currency controls or restrictions are in place. NDFs provide a viable solution for businesses to navigate these regulatory challenges while still managing currency risk effectively.

what are non deliverable forwards

In these currencies, it is not possible to actually exchange the full amount on which the deal is based through a normal forward trade. An NDF essentially provides the same protection as a forward trade without a full exchange of currencies taking place. Non-deliverable forwards (NDFs), also known as contracts for differences, are contractual agreements that can be used to eliminate currency risk.

Introduction to Non-Deliverable Forwards (NDFs)

For currencies with the largest NDF markets, McCauley, Shu, & Ma (2014) find two-way spillovers in normal times and one-directional effects from NDFs to onshore markets in crisis periods. Reserve Bank of India (2019) finds two-way influences for INR in normal times, and NDF to onshore during crisis episodes. For KRW, Park (2001) finds onshore to NDF spillovers before 1997 and the reverse after.

what are non deliverable forwards

In India, the fast growth of the INR NDF market raised concerns around the forces determining the currency value and the authorities’ ability to ensure currency stability (Reserve Bank of India, 2019). The Reserve Bank of India commissioned a Task Force to study the offshore INR market. The commission recommended steps to develop the onshore FX market including longer trading hours, new FX products, some liberalization of Foreign Exchange Vs Crypto underlying asset requirements for FX positions, and other market development steps. The Reserve Bank of India allowed onshore banks to participate in the NDF market from June 2020. Relative to other foreign exchange products—spot, outright forwards, swaps, options—NDF trading volumes are large for INR, KRW, and TWD (Figure 2). For these currencies, NDF volumes far exceed all other FX products including spot trading.

II. The Size of NDF Markets in Asian Currencies

For Asian markets, the influence of NDF market action must be understood as reflecting news flows after the Asian market close as well as a more global set of market participants. Its deliverable and non-deliverable markets persist in parallel even as arbitrage joins them and markets deepen. The Chinese renminbi’s recent internationalisation follows neither path and the offshore deliverable renminbi is outcompeting the NDF. This is what currency risk management is all about and the result of a non-deliverable forward trade is effectively the same as with a normal forward trade.

Non-deliverable swap (NDS) is a physically settled contract, which means that the two parties to the contract actually exchange the currencies on the settlement date. NDF markets in major Asian currencies are large, often with higher trading volumes than onshore FX markets. During market stress periods including the COVID-19 pandemic, pricing of NDFs often diverges from onshore FX markets. In most cases NDFs price more depreciation than onshore markets in the initial phases of markets stress.

The motivation behind these restrictions is to safeguard financial stability, curb financial speculation and maintain control over the currency onshore. Non-deliverable forward (NDF) markets in many Asian emerging market currencies are large, rapidly growing, and often exceed onshore markets in transaction volume. NDFs tend to price significant depreciation during market stress episodes including COVID-19. Our analysis shows that influences tend to run both ways after controlling for differences in timezones between markets. For the COVID-19 pandemic there is some evidence of NDFs leading onshore markets for a few currencies.

2 Note, however, that the Triennial Survey allocates trading by the location of the sales desk, while the London survey does so by the location of the trading desk. Because two big banks have moved their sales desks out of London but still trade there, the London share on the sales desk basis is only about a third of net-net turnover. Two different paths for the evolution of NDF markets can be distinguished.