Non-deliverable forwards (NDFs), also known as contracts for differences, are contractual agreements that can be used to eliminate currency risk. While they can be used in commodity trading and currency speculation, they are often used in currency risk management as well. This article discusses their use in relation to currency risk management.
Currency risk is the risk that a business, investor or individual will lose money as a result of a change to exchange rates.
A typical example of currency risk in business is when a company makes a sale in a foreign currency for which payment will be received at a later date. In the intervening period, exchange rates could change unfavourably, causing the amount they ultimately receive to be less. There are many ways by which businesses look to control this risk. One way is through currency forward trades.
Non-deliverable forward trades can be thought of as an alternative to a normal currency forward trade. Whereas with a normal currency forward trade an amount of currency on which the deal is based is actually exchanged, this amount is not actually exchanged in an NDF.
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.
Non-deliverable forwards are most useful and most essential where currency risk is posed by a non-convertible currency or a currency with low liquidity. In these currencies, it is not possible to actually exchange the full amount on which the deal is based through a normal forward trade. NDFs are used as a replacement instead. An NDF essentially provides the same protection as a forward trade without a full exchange of currencies taking place.
Also known as an outright forward contract, a normal forward trade is used to lock the exchange rate for a future date.
If we go back to the example of a business that will receive payment for a sale it has made in a foreign currency at a later date, we can see how a forward trade is used to eliminate currency risk.
The risk that this company faces is that in the time between them agreeing to the sale and actually receiving payment, exchange rates could change adversely causing them to lose money. Forward trades are used to eliminate this risk.
If the company goes to a forward trade provider, that organisation will fix the exchange rate for the date on which the company receives its payment. The exchange rate is calculated according to the forward rate, which can be thought of as the current spot rate adjusted to a future date. Once the company has its forward trade it can then wait until it receives payment which it can convert back into its domestic currency through the forward trade provider under the agreement they have made.
Usually, the forward trade provider will act as a third party in the exchange, handling the transfer of money between the business and the counterparty which is making the payment to them.
A key part of the process is that the actual funds are exchanged. 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.
Non-deliverable forwards can be used where it is not actually possible to carry out a physical exchange of currencies in the same way as normal forward trade.
The restrictions which prevent a business from completing a normal forward trade vary from currency to currency. However, the upshot is the same and that is they will not be able to deliver the amount to a forward trade provider in order to complete a forward trade.
Non-deliverable forwards provide a way around this. What happens is that eventually, the two parties settle the difference between a contracted NDF price and the future spot rate for an exchange that takes place in the future.
In order to avoid the restrictions imposed by the foreign currency in question, NDF is settled in an alternative currency. The most common currency used for NDFs is the US dollar.
An NDF used to hedge against currency risk is completed according to the following process:
A company that is exposed to currency risk will approach the provider of an NDF to set up the agreement. The two parties agree to what is called a notional amount. This is the amount of currency that is at risk. If we go back to our example of a company receiving funds in a foreign currency, this will be the amount that they are expecting to be paid in the foreign currency.
The next step is to calculate the contracted NDF rate. This is the exchange rate on which the settlement calculation will be based. In our example, this could be the forward rate on a date in the future when the company will receive payment. This exchange rate can then be used to calculate the amount that the company will receive on that date at this rate.
Following on from this, a date is set as a ‘fixing date’ and this is the date on which the settlement amount is calculated. In our example, the fixing date will be the date on which the company receives payment.
On this date, the difference in the amount that the company gets for exchanging what they receive at the spot exchange rate (the current market rate at that point in time) compared to what they would have got at the contracted NDF rate is calculated.
The two parties then settle the difference in the currency they have chosen to conduct the non-deliverable forward.
If the exchange rate has moved unfavourably, meaning that the company receives less than expected at the spot rate, the provider of the NDF contract will reimburse them by the appropriate amount.
On the other hand, if the exchange rate has moved favourably, meaning that at the spot rate they receive more than expected, the company will have to pay the excess that they receive to the provider of the NDF.
A crucial point is that the company in question does not lose money as a result of an unfavourable change to the exchange rate.
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. While the company has to sacrifice the possibility of gaining from a favourable change to the exchange rate, they are protected against an unfavourable change to the exchange rate.
In business, it is often far more important to be able to accurately forecast incoming and outgoing payments than it is to be able to have the possibility of benefiting from favourable exchange rate changes. Businesses that are exposed to currency risk commonly protect themselves against it, rather than attempt to carry out any form of speculation.
What non-deliverable forwards provide is the opportunity to protect a business (or an investor or individual if needs be) that is exposed to currency risk in a currency for which a normal forward trade is not possible.
There are various alternatives when it comes to finding protection from currency risk to normal forward trades and non-deliverable forward trades.
One similar alternative is an option trade. With an option trade, a company that is exposed to exchange rate risk can rely on a similar agreement to a forward trade. The difference is that there is no commitment involved.
With a forward trade, once one has been agreed to, both parties are contractually obliged to complete the agreed exchange of currencies. With an option trade, there is no such commitment. While there is a premium to be paid for taking out an option trade, the benefits provided by their optional nature are significant.
If a business has hedged against currency risk that it is exposed to with an option trade it can also benefit if exchange rates change favourably.
Rather than being committed to completing an exchange at the forward rate (as is set in a forward trade) which prevents them from being able to take advantage of the favourable change in the exchange rate, the company can opt not to use the option trade. When the time comes, they simply trade at the spot rate instead and benefit by doing so.
Meanwhile, the company is prevented from being negatively affected by an unfavourable change to the exchange rate because they can rely on the minimum rate set in the option trade.
Bound specialises in currency risk management and provide forward and option trades to businesses that are exposed to currency risk. As well as providing the actual means by which businesses can protect themselves from currency risk, Bound also publish articles like this which are intended to make currency risk management easier to understand.