Historically, the Bank of Thailand also enforced a ban on NDF quotation by international banks that had business activity in Thailand, similar to Bank Negara Malaysia. For currencies where both DTCC and BIS data is available, BIS data is larger by a factor of 2 to 4. DNDFs tend to price in less depreciation than NDFs when the rupiah faces depreciation pressures.
However, instead of delivering the currency at the end of the contract, the difference between the NDF rate and the fixing rate is settled in cash between the two parties. NDFs hedge against currency risks in markets with non-convertible or restricted currencies, settling rate differences in cash. Thankfully, both parties involved in the non-deliverable contract can settle the contract by converting all losses or profits to a freely traded currency, such as U.S. dollars.
Trending in Derivatives
For the COVID-19 pandemic there is some evidence of NDFs leading onshore markets for a few currencies. Policy approaches to NDFs vary widely across Asia from close integration with onshore markets to severe restrictions on NDF trading. As shown in the top panels of Table 2, offshore NDFs account for 29.5% of total forward trading, higher than the 21.1% share that would hold if the deliverable/non-deliverable split were the same onshore and offshore. Similarly, DFs trade disproportionately onshore.4 The lower six panels of Table 2 show that the strength of the relationship, though uniformly highly significant in statistical terms, varies across the six currency pairs.
The IDR rate in the DNDF market is fixed by BI using the Jakarta Interbank Spot Dollar Rate daily and has typically been below that in the NDF market. The spread was the widest when the IDR came under depreciation pressure in mid-May and early August 2019 amid the escalation in US-China trade tensions. During the COVID-19 market turbulence the DNDF – NDF spread reached record levels with the NDF market pricing more depreciation (Figure 17). Market contacts argue that DNDFs helped reduce depreciation pressure on the IDR spot rate in stress episodes by absorbing some USD demand. Relative to the IDR NDF market, the DNDF remains small and there has not been a significant move of trading volume from the NDF market to DNDFs so far.
Non-Deliverable Forward Contracts
So, they can pay one another the losses or gains in the freely traded currency. One party pays another the difference between the NDF rate and the spot rate; the payment is usually in U.S. dollars. Besides, NDFs get traded over the counter (OTC), encouraging the flexibility of terms to satisfy the needs of both parties involved. Another good thing about forward contracts is that it operates under non-standardized terms.
This could be related to spillovers from dislocations in the MYR NDF or from concerns over the rapid depreciation of the Chinese yuan. In 2018, the combined shock of EM equity, oil and CNY declines led to some pricing deviations between onshore forwards and NDFs, most notably in the IDR. Figures 10 through 15 present the difference in onshore and NDF implied interest rates over time. During the taper tantrum in 2013, large dislocations between onshore and offshore pricing occurred for IDR and INR with the offshore markets pricing large depreciations. Besides IDR and INR, the taper tantrum affected TWD offshore/onshore pricing, but had relatively little effect on the onshore/offshore pricing differentials of other Asian currencies. We innovate by exactly time-matching NDF and onshore price quotes, unlike most of the existing literature which uses end-of-day quotes across time zones.
What are the key features of Non-Deliverable Forwards (NDFs)?
For the COVID-19 pandemic period, we find some evidence for an increased influence of NDFs on onshore markets for a few currencies. A typical example of currency risk in business is when a company makes a Cryptocurrency Pockets Development Companies 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.
So, the parties will settle the difference between the prevailing spot rate and the predetermined NDF to find a loss or profit. DNDFs could also help reduce selling pressure by foreign investors in the bond market. As shown in section IV, NDF implied interest rates tend to spike in stress episodes which makes hedging of currency risk for bond investors expensive, in turn leading them to liquidate bond positions. One-directional influences without controlling for time differences are not surprising.20 New information released during the European and New York trading hours will be priced into NDFs in London or New York when Asian markets are closed.
Can NDFs be utilized for purposes beyond hedging?
This cash settlement feature makes NDFs particularly useful for hedging exposure to currencies that face trading restrictions or are not easily accessible in international markets. In contrast, DFs are more suitable for entities that genuinely need the physical delivery of the currency, such as businesses involved in international trade or investments. Interest rates are the most common primary determinant of the pricing for NDFs. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated.
- The share of NDFs in RUB forward trades in London bottomed out in October 2014, and has since risen slightly in the three subsequent semiannual London surveys (Graph 4, left-hand panel).
- Effectively, the borrower has a synthetic euro loan; the lender has a synthetic dollar loan; and the counterparty has an NDF contract with the lender.
- NDFs are commonly used in scenarios where either one of the currencies involved is non-convertible or when there are currency restrictions in place.
- Unlike a deliverable forward contract which involves the exchange of assets or currency at an agreed rate and future date, a non-deliverable forward (NDF) requires cash flow, not tangible assets.
Like other financial instruments, non-deliverable forward contracts also have setbacks. In fact, to understand the fundamentals of non-deliverable forward vs. forward-deliverable contracts, you must know what forward contracts are. So, this guide will first elaborate on what forward contracts as well as the differences between deliverable and non-deliverable forward contracts.
Appendix 1: Realized volatility of onshore forwards and NDFs
The 2015 episode was mostly confined to large price dislocations in the MYR FX space with NDFs first pricing large depreciation relative to onshore forwards and then appreciation. MYR was exposed during this time to the decline in oil prices since Malaysia is a net energy exporter, unlike the other Asian countries in the sample, and relies to a significant extent on oil and gas revenues for fiscal funding. Implied yield differentials were also volatile following BNM’s reinforcement of a ban on MYR NDFs in November 2016. NDFs were pricing substantial depreciation for the IDR and PHP during short episodes in the fall of 2016.
While this mechanism mirrors a secondary currency loan settled in dollars, it introduces basis risk for the borrower. This risk stems from potential discrepancies between the swap market’s exchange rate and the home market’s rate. While borrowers could theoretically engage directly in NDF contracts and borrow dollars separately, NDF counterparties often opt to transact with specific entities, typically those maintaining a particular credit rating. Domestic non-deliverable forwards (DNDFs) are net-settled in local currency and traded onshore in the jurisdiction of the issuing country.
Advantages of an NDF
The complex nature of these derivatives and their association with specific business needs make them less suitable for individual participation. Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. 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.
Although DNDFs do not count against central banks’ foreign exchange reserves, large short USD DNDF positions can be risky for the central bank. If counterparties choose to not roll over DNDF positions at maturity and instead demand USD in the spot or deliverable forward market, depreciation pressures can be exacerbated. For banks, investors, and corporates, DNDFs may not be perfect substitutes for deliverable instruments or NDFs. For example, corporates may have an actual USD demand in the future and therefore prefer currency delivery.
