Non-Deliverable Forward Contracts
Much like a Forward Contract, a Non-Deliverable Forward lets you lock in an exchange rate for a period of time. However, instead of delivering the currency at the end of the contract, the difference between the NDF rate and the fixing rate is settled in cash between the two parties.
This is useful when dealing with non-convertible currencies or currencies with trading restrictions.
How does an NDF work?
- You agree on the currency pair and the notional amount with your Account Manager.
- The NDF rate is agreed upon. The fixing date and the settlement date are chosen.
- On the fixing date, the rate from the non-convertible currency’s central bank is checked against the rate in the contract.
- Depending on whether the rate has gone up or down, the difference is paid in a settlement currency on the settlement date– this could mean that you receive money from Smart, or that you pay Smart the difference.
Example of an NDF
A UK company selling into Brazil needs to protect the sterling-equivalent of revenues in local currency, the Brazilian Real. Due to currency restrictions, a Non-Deliverable Forward is used to lock-in an exchange rate.
- The company will receive customer payments in 9-months’ time for BRL 10million.
- You enter an NDF, agreeing to sell BRL 1million, buying GBP at a rate of GBP/BRL 5.3500. You buy GBP 186,915.89.
- On the fixing date, the fixing rate from Brazil’s central bank is checked against the agreed rate of GBP/BRL 5.3500.
- The contract will be in Profit or Loss on the fixing date – this is to hedge against the prevailing Spot Rate on that future date.
- For example, if GBPBRL moves lower, the NDF will be in loss but the company would sell BRL locally at a better rate, the idea being to generate a net-zero (or close-to) outcome.
- Depending on whether the contract is in Profit or Loss, you could receive money from Smart, or you pay Smart the difference on the settlement date.
The table below shows two possible outcomes:
Advantages of an NDF
- NDFs are available in a wide range of currencies and provide means of negating foreign exchange risk in markets where physical delivery is not possible.
- An NDF works like a regular forward contract, but with no physical delivery of the underlying currency pair.
- An NDF provides protection against adverse movements in the exchange rate of the currency pair during the term of the contract.
- The NDF is tailored to your needs – the fixing date and notional amount are chosen by you.
Disadvantages of an NDF
- An NDF provides no protection against adverse movements in the currency markets at the time of paying the net difference.
- When an NDF involves emerging market currencies, the markets are inherently less liquid and more exposed to fluctuations than the markets for major currencies.
- You are unable to participate in favourable movements in the spot rate.
- Cancellations or adjustments may result in a cost to you.