What it means
A normal forward contract fixes an exchange rate today for a currency swap on a future date, and at maturity the two currencies change hands. Some currencies, however, have capital controls or are not freely traded offshore, which makes physical delivery difficult or impossible for foreign parties.
An NDF solves this by cancelling the delivery. At maturity, the parties compare the agreed forward rate with an official reference rate, called the fixing rate, and the side that is on the wrong side of the move pays the other the difference in a freely traded currency, usually US dollars.
Businesses use NDFs mainly to hedge exposure in emerging-market currencies. A company that expects to receive payments in a restricted currency, or has a subsidiary there, can lock in a rate through an NDF and know how much it will receive in dollars.
Speculators also use NDFs, since the contract requires little upfront cash. A trader can take a view on whether a currency will strengthen or weaken without holding any of it, although the leverage amplifies both gains and losses.
NDFs are traded over the counter, meaning directly between banks and clients and not on an exchange, so the quality of the counterparty matters. Pricing reflects interest rate differences between the two currencies and also the cost and risk of the restriction, which can make the NDF rate differ from the onshore forward rate.
The fixing source must be agreed in advance and can change in a crisis, so contracts include rules for what happens if the official reference rate is not available. Treasurers should read those fallback clauses before trading, not after a crisis.
In practice
Real-world examples.
Example
A European manufacturer expects to receive 80,000,000 units of a restricted currency from a local customer in three months. It enters an NDF to sell the currency forward and fix the dollar value of the payment.
Example
A global fund wants exposure to a restricted currency without opening local bank accounts. It uses an NDF to take a view and settles any profit or loss in dollars. Because only the difference changes hands, the fund can size the position without moving large sums.
Example
A treasurer at a company with a subsidiary in a country with currency controls uses an NDF to hedge the future dividend from that subsidiary, since the cash cannot be easily moved before the payment date. The NDF locks in the dollar value even though the dividend itself stays in the local bank until later.
Formula
Calculation
Settlement amount (in dollars) = Notional x (Fixing rate - Forward rate) / Fixing rate
Rates are quoted as units of local currency per US dollar. A positive result is paid to the buyer of dollars.
Worked example: a company buys $1,000,000 forward against a restricted currency at a forward rate of 76.00 (illustrative). At maturity the official fixing rate is 80.00.
Difference = 80.00 - 76.00 = 4.00 local units per dollar
Settlement = $1,000,000 x 4.00 / 80.00 = $50,000
Because the dollar strengthened beyond the agreed rate, the company receives $50,000. This offsets the higher local-currency cost of its dollar obligation.
If the fixing had instead been 72.00, the settlement would be $1,000,000 x (72.00 - 76.00) / 72.00 = -$55,555.56, and the company would pay that amount.Case study
Seen in the real world.
Atlas Foods International is an illustrative, fictional exporter that sells to a market with strict currency controls. Its customer pays in local currency, which is difficult to convert and move offshore, and the finance team was concerned that the currency was weakening.
The treasurer arranged NDFs covering the next six months of expected receipts, fixing the rate at a level that kept the company's margin intact. As the currency fell, the NDFs paid out in dollars and offset the lower dollar value of the invoices. Without the hedge, the weaker currency would have removed most of the profit on the contract.
The team learned that the hedge only worked because forecasts were accurate, and an over-hedged position would have created losses when a customer paid late. In this illustrative story, they reviewed their hedge ratios each quarter and agreed to cover only about 70% of the forecast receipts. They also documented the fixing source and the bank's valuation method so that auditors could follow the accounting.
Watch out
Common mistakes.
- Believing an NDF delivers the currency, when only the cash difference is settled.
- Hedging forecast sales that may not happen, which can turn a hedge into a speculative loss.
- Ignoring the fixing source, when the official reference rate determines the payoff.
Questions
People also ask.
Why do non-deliverable forwards exist?
They allow hedging and trading in currencies with restrictions on offshore delivery.
In which currency is an NDF settled?
Usually in US dollars, though other major currencies are possible if both sides agree.
Is an NDF the same as a regular forward?
No, a regular forward ends in physical exchange of both currencies, while an NDF ends with a single net cash payment.
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