Non-Deliverable forwards: An introduction

Acompany requiring a certain amount of foreign currency at a predetermined future date faces the risk that the exchange rate may move in an adverse direction by the time the requirement falls due. In order to mitigate this risk, it can enter into an agreement called a Forward Contract (often referred to as a forward).

A Forward Contract is an agreement to buy or sell an asset at a certain future time for a certain price1. In essence, the forward contract allows a company to buy the foreign currency at a specified point in the future, at a price fixed today. The company may, also enter into a Non-Deliverable Forward (NDF) contract.

An NDF, although broadly similar to a forward, is a cash-settled, short-term forward or futures contract where parties agree to a rate/price for a predetermined date in the future, without the obligation to deliver the notional amount on maturity.

The NDF is settled at maturity for the difference in the Spot FX rate and the NDF rate. As settlement was done in cash, one party compensates the other with an amount reflecting the difference between the contracted forward rate and the value of the designated ‘fixing’ rate (the representative spot market rate), as is the case with the “Naira-settled OTC FX Futures” traded on FMDQ OTC Securities Exchange.

These contracts [Naira-settled OTC FX Futures] are NDFs where parties agree to an exchange rate for a predetermined date in the future, without the obligation to deliver the underlying US Dollars (the notional amount) on the maturity/settlement date.

Uses of NDFs

The demand for NDFs arises principally out of regulatory and liquidity issues in the underlying currency, where overseas players are essentially barred from access to the domestic market.

They are typically utilised by banks, multinational corporations, investment managers, and proprietary traders to hedge currency risk. They are used in managing the currency risks associated with exporting or importing products purchased in foreign currency, investing or borrowing overseas, repatriating profits, or settling other FX contractual arrangements. They are also used as a tool to facilitate locking in the enhance yields of currencies .

Components to an NDF

Notional – This is the face value of the NDF to be transacted Fixing Date – This is the date at which the difference between the prevailing Spot market exchange rate and the agreed upon NDF rate is calculated Settlement Date – This is the date on which the payment of the difference between the NDF and spot rate is paid.

Effective Date – This is the date when the NDF contract takes effect, usually the trade date

Maturity Date – This is the date the contract expires.

Key differences between Non-Deliverable Forwards and Forwards

NDF contracts are similar to forward contracts; however, they do differ in some respects to forwards.

Key differences between Non-Deliverable Forwards and Forward Contracts

Non-Deliverable Forwards:

1) Margin required to be posted at contract initiation. The margin will require marking to market, with the winner’s account being credited with the difference while the loser’s account is reduced by same.

2) There is no physical settlement of the asset at maturity

3) The NDF market is regulated (usually by the government) and highly controlled.

Forwards

1) No margin requirement posted. Contracts are settled at maturity and do not require marking to market or parties to the contract settling up until the expiration of the contracts.

2) At maturity, the asset is physically settled.

3) The forward market is typically not regulated.

Key Benefits of NDFs

There are no up-front costs

They provide protection against unfavourable foreign exchange rate movements between the time an NDF contract is executed and the maturity date

They are flexible and the maturity date and contract amount can be tailored to meet specific requirements

They help improve planning and capital budgeting as companies can make forecasts on budgets and investments with a greater degree of certainty

They improve management of foreign exchange risk as companies can hedge against cash flow shortfalls. They increase predictability of financial results as hedging enables companies deliver more predictable earnings by aligning their corporate hedging strategy to future FX cash flows in order to reduce the impact of currency volatility

They serve as hedging tools for foreign investors with local currency exposure, allowing corporates and other investors hedge or take investment positions offshore on local currency movements without actually dealing in the underlying

Risks associated with NDFs

They are not perfect hedges against exposures, as any benefit of a favourable exchange rate movement, between the time the NDF is executed and the maturity date, may be foregone

There is some exposure to counterparty and credit risks. In the event that a party to the contract is unable to perform their obligations under the NDF contract, the other party may be exposed to market exchange rate fluctuations as if the NDF contract was not executed. There are charges for any cancellations or adjustments to the contract. There is potential for limited liquidity in this specialised product.

An NDF is indeed a useful risk management tool used to hedge currency fluctuations and should ideally be used where you have a genuine commercial need to manage currency risk associated with a particular currency pair and not for speculative purposes.