Description:-
Non-deliverable forwards are used to hedge or speculate against currencies when exchange controls make it difficult for foreigners to trade in the spot market directly. The idea is the same as a regular foreign exchange forward – an investor or company wants to lock in an exchange rate for a certain period in the future.
The contracts are called “non-deliverable” though, since no exchange of the underlying currency takes place. Instead the whole deal is settled in a widely traded currency, normally U.S. dollars
Why are they traded?
Investors who buy assets in emerging markets use them to hedge the currency risks posed by their investments.
Multinational companies operating in markets with exchange controls to mitigate the risk of swings in the currency rate hitting their bottom line.
Banks and hedge funds to take speculative positions.
Example:-
XYZ Company imports telecommunication equipment from a Brazilian supplier at a cost of BRL 3 million. XYZ Co. is invoiced and payment is due in 180 days. The supplier wishes to be paid in USD in an amount equivalent to BRL 3 MM. Thus XYZ Co., and not the supplier, is exposed to exchange rate fluctuations.
XYZ Co: Buys BRL / Sells USD
Amount: BRL 3.0 MM
Forward NDF Rate: 0.7690
Scenario 1:
NDF Hedge is In-the-Money
Spot Fixing Rate: 0.8000
At maturity XYZ Co. has the obligation to buy BRL 3.0 MM from Square 1 Bank at the rate of 0.7690 compared to the spot fixing rate of 0.8000. However, since BRL is a non-convertible currency, the net amount will be settled in USD. (BRL 3.0 MM * 0.8000) – (BRL 3.0 MM * 0.7690) = USD 93,000
Scenario 2:
NDF Hedge is Out-of-the-Money
Fixing Rate: 0.7410
At maturity XYZ Co. has the obligation to buy BRL 3.0 MM from Square 1 Bank at the rate of 0.7690 compared to the fixing rate of 0.741. However, since BRL is a non-convertible currency, the net amount will be settled in USD. (BRL 3.0 MM * 0.741) – (BRL 3.0 MM * 0.7690) = – USD 84,000
XYZ Co. will have Square 1 Bank wire USD 2.223 MM to the Brazilian supplier and will pay USD 84,000 to Square 1 Bank. The sum of the payments equals the budgeted amount of USD 2.307 MM. The supplier will then convert the USD to BRL with its own bank.
Life cycle events: –
Profit/loss on the NDF trade results from change in the Fix price of the 2 currencies in the trade. The amount settles on maturity.
OTCWIRE 