In the case of Malaysia, the spot market result is more important than the forward market result given that the former is much larger. Non-deliverable forwards (NDFs) are forward contracts that let you trade currencies that are not freely available in the spot market. They are popular for emerging market currencies, such as the Chinese yuan (CNY), Indian rupee (INR) or Brazilian real (BRL).
Korea embraced NDFs by allowing domestic financial institutions to participate. In contrast, Malaysia enforced regulation to limit MYR NDF trading and took measures to deepen onshore FX markets. China is following yet another path with the offshore deliverable CNH market. Different policy approaches reflect country specific circumstances and preferences.
C. Price Linkages During the COVID-19 Pandemic
Instead, the parties settle the contract in cash based on the difference between the contracted exchange rate and the prevailing market rate. This cash settlement feature makes NDFs practical in scenarios where physical delivery is challenging. Thankfully, both parties involved in the non-deliverable contract can settle the contract by converting all losses or profits to a freely traded currency, such as U.S. dollars. So, they can pay one another the losses or gains in the freely traded currency. One party pays another the difference between the NDF rate and the spot rate; the payment is usually in U.S. dollars.
The largest NDF markets are in the Chinese yuan, Indian rupee, South Korean won, New Taiwan dollar, Brazilian real, and Russian ruble. The largest segment of NDF trading takes place in London, with active markets also in New York, Singapore, and Hong Kong. Prior to COVID-19, deliverable onshore forwards, NDFs, and DNDFs were priced close to each other. Deviations in Korean won NDF and onshore forward implied interest rates have been limited. Pricing differentials between onshore and offshore markets can be very large.
Foreign/Currency Exchange Resources
Restrictions on currency positions without underlying asset exposures in onshore markets were an additional concern. An intuitive way to look at the pricing of currency forwards is to back out the home currency implied interest rates using covered interest rate parity (CIP). For example, to obtain the KRW interest rate implied in a KRW/USD NDF one would take the NDF price, the spot price, and the US interest rate as given and solve for the KRW interest rate using the standard CIP equation. The higher the implied interest rate for the home currency, the greater is the forward implied currency depreciation for that currency.
NDFs are settled with cash, meaning the notional amount is never physically exchanged. The only cash that actually switches hands is the difference between the prevailing spot rate and the rate agreed upon in the NDF contract. A deliverable forward (DF) is a forward contract involving the actual delivery of the underlying currency at maturity. A DF is usually used for currencies that are freely convertible and traded in the spot market, such as the euro (EUR), British pound (GBP) or Japanese yen (JPY). Two parties must agree and take sides in a transaction for a specific amount of money, usually at a contracted rate for a currency NDF. So, the parties will settle the difference between the prevailing spot rate and the predetermined NDF to find a loss or profit.
Enabling Hedging and Speculation
As a hedging market, they grew along with the increased trading of swaps and forwards in the broader global FX market (Moore et al (2016)). We estimate that outstanding DNDFs auctioned by BI were in the range Non-deliverable Forward Ndf of USD1 to 4 bn prior to COVID-19. Starting in February 2020 when Indonesia experienced large portfolio outflows and IDR depreciation pressures, BI increased sales of DNDFs to close to USD 8 bn (Figure 16).
But, the two parties can settle the NDF by converting all profits and losses on the contract to a freely traded currency. They can then pay each other the profits/losses in that freely traded currency. A non-deliverable forward (NDF) is a straight futures or forward contract, where, much like a non-deliverable swap (NDS), the parties involved establish a settlement between the leading spot rate and the contracted NDF rate. Non-Deliverable Forward (NDF) is a derivative contract used primarily in the foreign exchange (forex) market.
What are the benefits of non-deliverable forwards?
On this evidence, it appears that, even though the CNY NDF turnover is fading, renminbi developments are boosting Asian NDFs. This information will be reflected in Asian markets the following trading day. As a result, there will be a significant impact from the NDF on onshore FX prices simply because the same information is priced in at different times. This is of interest to market participants and policy makers to understand currency dynamics and when deciding on market structure features such as trading hours. However, it is not necessarily evidence that price discovery takes place to a greater extent in one market than the other.
Data made available through mandatory disclosure have made it possible to study NDF market dynamics at a high frequency. For example, DTCC data suggest that NDFs experienced peak volumes in August 2015 (Graph 6, centre panel). This timing points to the influence of the changes to the renminbi’s exchange rate management on NDF volumes, not only in the renminbi but also in other Asian currencies (see box).
Usage and significance of NDFs
We do not include CNY in the analysis given that the offshore Chinese yuan (CNH) market is increasingly replacing CNY NDF trading as discussed in section III. MYR NDFs were stable during the taper tantrum, but pricing was very volatile in 2015 and after the central bank’s reinforcement of the NDF ban in November 2016. Chinese yuan NDF activity dropped amid the rise of the offshore deliverable forward market (CNH). KRW and INR are the most widely traded NDFs in London, the world’s largest market for NDFs. NDFs are typically used by businesses engaged in international trade, and they are less common among individual investors. The complex nature of these derivatives and their association with specific business needs make them less suitable for individual participation.
- Convertibility risk is a concern given that DNDFs are settled in domestic currency at maturity.
- The corner of the foreign exchange market represented by NDFs also opens a window for assessing the progress of derivatives reforms.
- For currencies with the largest NDF markets, McCauley, Shu, & Ma (2014) find two-way spillovers in normal times and one-directional effects from NDFs to onshore markets in crisis periods.
- One party pays another the difference between the NDF rate and the spot rate; the payment is usually in U.S. dollars.
- By using NDFs, companies can hedge against the uncertainty of exchange rate movements, especially when dealing with currencies subject to restrictions or controls.
Market contacts argue that DNDFs helped reduce depreciation pressure on the IDR spot rate in stress episodes by absorbing some USD demand. Relative to the IDR NDF market, the DNDF remains small and there has not been a significant move of trading volume from the NDF market to DNDFs so far. Although DNDFs do not count against central banks’ foreign exchange reserves, large short USD DNDF positions can be risky for the central bank. If counterparties choose to not roll over DNDF positions at maturity and instead demand USD in the spot or deliverable forward market, depreciation pressures can be exacerbated. For banks, investors, and corporates, DNDFs may not be perfect substitutes for deliverable instruments or NDFs. For example, corporates may have an actual USD demand in the future and therefore prefer currency delivery.
Market contacts pointed out the link between hedging costs and bond holdings. Empirically, hedge costs and flows into local currency bonds are correlated, but many factors including global risk aversion are driving this correlation. For example, the borrower wants dollars but wants to make repayments in euros. So, the borrower receives a dollar sum and repayments will still be calculated in dollars, but payment will be made in euros, using the current exchange rate at time of repayment.
Global NDF trading
Spot trading rose by more than that of NDFs over a five-day period in the case of the real, according to the Central Bank of Brazil. The NDF is a key instrument in EME currencies’ offshore, but not onshore, trading (Graph 3; see Ehlers et al (2016) for an analysis of CNY on- and offshore trading). For a full picture of FX instrument composition, we again add exchange-traded turnover to the over-the-counter turnover collected in the Triennial. Reform allows us to assess NDF turnover spillovers from surprises like the adjustment in the renminbi exchange rate regime in August 2015.
