Calc fellow — Non-deliverable forward
A non-delivery FX forward transaction is similar in every sense to a deliverable forward, except for how the cash flow between the two transaction parties is settled on the expiry day.
A forward transaction locks an exchange rate for a period of time, in a specified amount. The locked rate is called the forward rate or forward strike, and both parties agree upon this rate when the deal is created.
FX Forward Chance/Risk structure:
For currency pair: EUR/USD, Notional amount: 1 million EUR
What is the difference between deliverable and non-deliverable forward contracts?
Non-deliverable forward vs forward: Derivatives have two delivery types: Deliverable or non-deliverable, and the delivery type is defined on the deal creation.
Deliverable FX Forward example:
conversion transaction will take place between the two transaction parties, according to the agreed-upon forward rate.
If the two parties agreed that the EUR/USD forward rate is 1.20, and the deal amount is 1 million euros, then on the transaction expiration, the following cash flow will accrue:
One party will sell 1 million euros and purchase 1.2 million dollars, and the other party will purchase 1 million euros and sell 1.2 million dollars. This cash flow between the parties will occur regardless of the market exchange rate on the expiry day.
An FX non-deliverable forward example (NDF):
Non-delivery forward means that the losing side will pay the transaction payout to his counterparty on the expiry day. The fixing rate source representing the market rate at expiry, and will be used to calculate the payout, will be specified and documented at the transaction creation. The possible sources that publish fixing rates can be a central bank (Ex. ECB) or Bloomberg ( BFIX), or Reuters. If the fixing rate source isn’t a central bank. It is also essential to specify the exact hour of the fixing rate publication (Ex., London 4:00 PM).
A non-deliverable forward FX (NDF) payout formulas (payoff):
Non-deliverable forward settlement currency is in the second (minor) currency term. In other words, the payout cash flow is denominated in the minor currency.
Non-deliverable forward calculation, where “Rate at expiry” (or fixing rate) is the rate that was published by the agreed-upon fixing source:
Buy forward payout in minor currency terms =
(Rate at expiry — Forward strike) Notional amount in major currency terms
Numerical example:
- Currency pair: EUR/USD
- Forward strike: 1.18
- Notional amount: 1,000,000 EUR
- The rate at expiry (fixing rate): 1.192
Payout, from the forward buyer point of view = (1.192–1.18)X1,000,000 EUR = 12,000USD
Sell forward payout in minor currency terms =
(Forward strike — Rate at expiry) Notional amount in major currency terms
Numerical example: Same data.
Payout, from the forward seller point of view = (1.18–1.192)X1,000,000 EUR = -12,000USD
Non-deliverable and Deliverable — When to use each?
To answer this question, a treasurer or CFO should ask the following question:
In addition to the fact that there is exposure to a currency, is there also a “physical” need for it?
Therefore, if a company that needs the forward notional amount cash flow (to pay the supplier, for example) and still entered into an NDF hedging transaction, it will pay the bid / ask spread twice. The first time she will pay for the NDF transaction, and the second time she will pay when she needs the currency itself (to pay the supplier, for example).
Explanation: Local price linked to foreign currency
There are cases where there is economic exposure to a particular currency, but there is still no need for cash flows in that currency.
For example, in the domestic market, it is customary to pay for a particular product in the domestic market currency (which is not a dollar). Still, its price in the domestic market varies because it’s linked to its global price, denominated in dollars.
In such a case, a Non-Deliverable transaction is appropriate, as, in the end, there is no currency exchange. The Deliverable transaction, on the other hand, will require currency exchange, after which the hedging company will have to “get rid of” the unnecessary currency and then pay Bid / Ask margins again.
CVA consideration (Credit valuation adjustment):
Suppose a hedging transaction counterparty is a financial entity that we are not sure of its financial stability and still want to execute an OTC hedging transaction with it and without third party settlement service. In that case, a non-deliverable trade will be less risky than a deliverable transaction from the hedging company’s point of view If the counterparty requires that when settling the transaction, the hedging company will transfer the forward transaction amount to him first. If this is the case then the counterparty risk of a non-delivery transaction is only on the exchange rate differences, while the risk in a delivery transaction is on the entire transaction notional amount.
Non-Deliverable Forward Market:
There are markets where the NDF is the only instrument available. Those markets are also called the Non-Deliverable Forward Market. In the non-deliverable forward currency list, there are countries like Egypt (Egyptian pound), South Korea (won), Nigeria (Naira), Taiwan (Taiwanese dollar), India (rupee), and Venezuela (Bolivar).
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Originally published at https://www.calcfellow.com.