Non-Deliverable Forwards: Hedging Restricted Currencies

Key Takeaways

• An NDF locks in a future exchange rate for a restricted or thinly traded currency but settles the profit or loss in a convertible currency, usually US dollars, with no physical delivery of the restricted currency.
• NDFs exist because capital controls or convertibility limits block a normal deliverable forward from working across borders.
• At maturity the contract rate is compared against a published fixing rate, and only the net difference changes hands.
• NDF forward rates are anchored to onshore interest rate differentials, but supply and demand offshore can push them away from covered interest parity.

What It Is

A standard forward contract obliges two parties to swap two currencies at an agreed rate on a future date, with both amounts actually delivered. That works fine for freely convertible currencies like the euro or yen.

Many emerging market currencies are not freely convertible. Governments impose capital controls, restrict who may hold the currency offshore, or limit cross border transfers. Examples over the years have included the Chinese renminbi, Indian rupee, Brazilian real, and Korean won. A foreign investor cannot simply take delivery of these currencies in a London or New York account.

The non-deliverable forward solves this. The two parties agree a forward rate and a notional amount, but at maturity neither delivers the restricted currency. Instead they settle the gain or loss in a convertible currency, almost always the US dollar.

The Intuition

Think of an NDF as a bet on where an exchange rate will land, settled in dollars. If you need to hedge exposure to a currency you are not allowed to hold offshore, you do not actually need the currency itself. You only need to be made whole for how its value moves. The NDF pays you exactly that difference in a currency you can hold, which reproduces the economics of a hedge without ever touching the restricted money.

How It Works

An NDF has four moving parts:

• Notional amount. The face size of the contract, often quoted in US dollars.
• Contract rate. The forward exchange rate the two parties agree on today.
• Fixing date and fixing rate. A future date on which an official reference rate is published, such as a central bank fix or a benchmark like the WM/Reuters or EMTA rate.
• Settlement. The difference between the contract rate and the fixing rate, converted to dollars and paid by whichever party is on the losing side.

Because the profit or loss is naturally expressed in the restricted currency, it is divided by the fixing rate to convert it into dollars for payment. Only that net dollar amount moves. The restricted currency never crosses a border.

Pricing starts from covered interest parity: the forward rate reflects the interest rate gap between the two currencies. But because NDFs trade offshore, away from the controlled onshore market, demand for hedging can push NDF rates away from that theoretical level, opening a gap between onshore and offshore pricing.

Worked Example

A US fund expects to buy US dollars in three months and worries the Korean won will weaken, making dollars more expensive. It enters a non-deliverable forward to buy USD 10,000,000 against won at a contract rate of 1,200 won per dollar.

At the fixing date, the won has weakened to a fixing rate of 1,250 won per dollar. The fund was on the right side of the move.

• Gain in won per dollar = 1,250 - 1,200 = 50 won.
• Total gain in won = 10,000,000 x 50 = 500,000,000 won.
• Converted at the fixing rate: 500,000,000 / 1,250 = USD 400,000.

The counterparty pays the fund USD 400,000. No won ever changes hands. That USD 400,000 offsets the extra cost the fund now faces buying dollars at the weaker spot rate, which is exactly what a hedge is supposed to do. Had the won instead strengthened to 1,150, the fund would have paid the counterparty, again in dollars.

Common Mistakes

1. Confusing an NDF with a deliverable forward. In an NDF, the restricted currency is never delivered. Only the net cash difference settles, and it settles in dollars.
2. Ignoring the fixing source. The entire settlement hinges on one published reference rate. If the counterparties disagree on which fix applies, or the fix is disrupted, the payout is disputed.
3. Assuming NDF rates match onshore forwards. Offshore NDF pricing can drift from onshore rates and from covered interest parity, especially in stressed markets.
4. Overlooking counterparty and dollar settlement risk. An NDF is an over the counter contract. You still face the credit of the party who owes you the dollar payment.
5. Treating the notional as cash at risk. Only the rate difference is ever exchanged, so the true exposure is far smaller than the headline notional.

Frequently Asked Questions

Q: What is a non-deliverable forward in plain terms? It is a currency forward that settles in cash rather than by delivering the two currencies. You lock a future rate for a restricted currency, and at maturity only the dollar value of the rate difference is paid, so the restricted currency never moves.

Q: Why would anyone use a non-deliverable forward instead of a normal forward? Because the currency in question cannot be freely delivered offshore. Capital controls or convertibility limits block a standard deliverable forward, so the NDF reproduces the hedge using dollar cash settlement instead.

Q: How is an NDF settled at maturity? The agreed contract rate is compared with a published fixing rate on the fixing date. The difference is calculated in the restricted currency, converted to dollars at the fixing rate, and the losing party pays that net amount to the other.

Q: Which currencies typically trade as NDFs? Emerging market currencies with capital controls or limited offshore convertibility, historically including the Chinese renminbi, Indian rupee, Brazilian real, Korean won, and Taiwan dollar. Freely convertible currencies use ordinary deliverable forwards.

Q: Do NDFs eliminate all risk? No. They remove the exchange rate exposure they are written on, but you still carry counterparty credit risk, basis risk between onshore and offshore rates, and reliance on the chosen fixing source behaving normally.

Sources

1. Investopedia. "Non-Deliverable Forward (NDF)." https://www.investopedia.com/terms/n/ndf.asp
2. McCauley, R., Shu, C., Ma, G. "Non-deliverable forwards: 2013 and beyond." BIS Quarterly Review, March 2014. https://www.bis.org/publ/qtrpdf/r_qt1403h.htm
3. Investopedia. "Currency Forward." https://www.investopedia.com/terms/c/currencyforward.asp
4. Investopedia. "Covered Interest Rate Parity." https://www.investopedia.com/terms/c/covered-interest-rate-parity.asp

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.