Understanding Non-Deliverable Forwards (NDF)

Non-deliverable Forwards or NDFs are one of the ways for quick and high return on your investment is Currency trading. Let’s understand more about it in this article.

What is the NDF market?

Everyone wants to maximise the return on investment on their respective investments. For finding the most lucrative investment method one tries investing in traditional methods like gold, land, etc, and modern methods like the stock market, commodities market, investing in Equity, derivatives, and currency market. Most Indians believe that the Indian Currency market is limited and highly regulated as it requires a lot of documentation, KYC details, etc.

Investors who don’t want to deal with these rules make sure they trade in currencies on an open market that is not governed by the Reserve Bank of India. Such investors deal in currencies outside of India using NDFs, or Non-deliverable Forwards, on the non-deliverable forward market.

Before we read on NDFs, let us first clearly understand what currency trading is all about.

What is Currency trading?

Currency trading is the practice of buying and selling currencies with the aim of making a profit from fluctuations in their value. The foreign exchange (Forex or FX) market is the largest financial market in the world, and it is where currency trading takes place.

In currency trading, traders will buy one currency and simultaneously sell another currency, with the goal of profiting from the exchange rate difference between the two currencies. For example, a trader might buy US dollars with Euros, anticipating that the value of the US dollar will increase relative to the Euro. If the exchange rate rises as expected, the trader can sell US dollars and buy back Euros, profiting from the difference in exchange rates.

Retail investors, financial institutions, corporations, and governments all use currency trading to buy and sell currencies for a variety of reasons, including international trade, investment, and speculation. Currency traders must have a solid understanding of the market, including the factors that influence exchange rates, the risks involved, and the tools and strategies available to manage those risks.

Few examples of currency pairs-

  1. Indian Rupee vs United States Dollar (USD-INR)
  2. Indian Rupee vs Euro (EUR-INR)
  3. Indian Rupee vs Great Britain Pound (GBP-INR)
  4. Indian Rupee vs Japan’s Yen (JPY-INR)

Two types of the Currency market

Onshore and offshore currency markets refer to the location of currency trading activities and are commonly used to differentiate between markets that have different regulations and exchange rates.

Onshore currency markets are typically located within the country where the currency is issued and are governed by the central bank and government of that country. Banks, financial institutions, and individual investors typically conduct onshore currency trading using local currency accounts. Onshore currency trading exchange rates are generally determined by the supply and demand for the currency within the country. The onshore market is the local currency market of the country in which the dealer has legal residency. For example, the Indian forex market will be the onshore market for Indian residents.

Offshore currency markets, on the other hand, are located outside of the country that issued the currency and are subject to different regulatory environments and exchange rates. Offshore currency trading takes place in financial centres such as London, New York, and Hong Kong, and is frequently used by multinational corporations and institutional investors to hedge currency risk or engage in speculative trading. Offshore currency trading exchange rates are typically determined by supply and demand for the currency in the offshore market, which can sometimes differ from the onshore market due to factors such as capital flows and investor sentiment.

What are NDFs?

NDFs (Non-Deliverable Forwards) are financial contracts that enable investors to hedge or speculate on the future value of emerging market currencies. NDFs are commonly traded in offshore currency markets and are frequently used by investors who do not have direct access to the relevant currency’s onshore market. They are derivatives that are settled in a specific hard currency, most commonly the US dollar (USD), with no physical delivery of the underlying currency at maturity. Instead, the difference between the agreed forward rate and the prevailing spot rate at maturity is settled in the specified currency.

NDFs are commonly used by investors to mitigate currency risk in emerging market economies, where the currency may be subject to volatility and uncertainty. By entering into an NDF contract, an investor can lock in a future exchange rate, thereby mitigating the risk of adverse movements in the currency. For example, an investor might enter into an NDF contract to sell Brazilian reals and buy US dollars at a predetermined exchange rate in six months’ time. If the exchange rate between the Brazilian real and US dollar declines over the six-month period, the investor will receive a payment from the counterparty to the contract to compensate for the loss.

How do NDFs work in India?

The non-deliverable forwards market operates by allowing two parties to trade cash flows based on the NDF price and the current spot price. The agreement is for one party to give the other party the difference resulting from the exchange in order to fulfil the terms of the contract.

These OTC (over-the-counter) transactions are typically settled in the foreign exchange market. For instance, it would be difficult to settle a trade with someone who is outside the country if a currency could not be traded outside the country. In this situation, the parties use non-deliverable forward contracts (NDFs) to convert all profits and losses to a currency that is openly traded in both countries.

Final words

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