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.

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.

Enabling Hedging and Speculation

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.

non deliverable forward currency

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. Reserve Bank of India (2019) finds two-way influences for INR in normal times, and NDF to onshore during crisis episodes. For KRW, Park (2001) finds onshore to NDF spillovers before 1997 and the reverse after. In 2018, Bank Indonesia introduced a domestic NDF (DNDF) settled on a net basis in IDR (instead of USD for the offshore NDF) to deepen the onshore market. As of May 2020, the DNDF is primarily a monetary policy tool for Bank Indonesia with limited secondary market activity and non-resident participation.

V. Price Linkages Between Onshore and Offshore Currency Markets

Unlike regular forward contracts, NDFs do not require the delivery of the underlying currency at maturity. Instead, they are settled in cash based on the difference between the agreed NDF and spot rates. This article delves into the intricacies of NDFs, their benefits and risks and how they affect global currency markets.

non deliverable forward currency

However, due to regulations and restrictions, you’re unable to easily convert Chinese Yuan into U.S. dollars at the current market exchange rate. To protect yourself from potential losses caused by fluctuations in the Chinese Yuan’s value, you decide to enter into an NDF contract with a financial institution. Another good thing about forward contracts is that it operates under non-standardized terms. That means the involved parties can tailor them to a specific amount and for any delivery period or maturity. A forward contract is a mutual agreement in the foreign exchange market where a seller and buyer agree to sell or buy an underlying asset at a pre-established price at a future date.

Introduction to Non-Deliverable Forwards (NDFs)

TWD NDF trading surged even more on 11 August, to 486% of the previous day’s volume, or an estimated 3.7 times the April volume. While KRW NDF turnover only doubled, its increase of $10 billion was the largest response of the five currencies. In terms of volume, the responses of the INR and BRL NDFs were the smallest. Similar increases in NDF trading occurred during a bout of CNY turbulence in January 2016.

non deliverable forward currency

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 How Much Does It Value To Start A Cryptocurrency Exchange 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.

Example of an NDF

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).

  • As the name implies, it is virtually impossible to convert a non-convertible currency into another legal tender, except in limited amounts on the black market.
  • NDFs tend to price significant depreciation during market stress episodes including COVID-19.
  • Instead, the net of the cash flows is settled in a convertible currency—usually the U.S. dollar—which gets around the non-convertibility of the domestic currency.
  • Instead, they are settled in cash based on the difference between the agreed NDF and spot rates.
  • Some market participants indicated a preference for NDFs at the time due to convenience.

In early 2014, a series of financial sanctions on certain Russian individuals, defence firms, energy firms and banks were reported to have led non-financial firms to use NDFs rather than DFs (Becker (2014)). The share of NDFs in RUB forward trades in London bottomed out in October 2014, and has since risen slightly in the three subsequent semiannual London surveys (Graph 4, left-hand panel). DNDFs could also help reduce selling pressure by foreign investors in the bond market. As shown in section IV, NDF implied interest rates tend to spike in stress episodes which makes hedging of currency risk for bond investors expensive, in turn leading them to liquidate bond positions.

The profit or loss is calculated on the notional amount of the agreement by taking the difference between the agreed-upon rate and the spot rate at the time of settlement. Divergent trends in NDF trading among the six emerging market economy (EME) currencies identified in the Triennial highlight three distinct paths of FX market development. In a path exemplified by the Korean won (KRW), NDFs gained in importance in a policy regime with restrictions on offshore deliverability.

non deliverable forward currency

Relative to other foreign exchange products—spot, outright forwards, swaps, options—NDF trading volumes are large for INR, KRW, and TWD (Figure 2). For these currencies, NDF volumes far exceed all other FX products including spot trading. This underscores the importance of NDF markets for price discovery and relevance from policymakers’ perspective. NDFs provide liquidity and price discovery for currencies with limited or no spot market activity. By allowing market participants to trade these currencies in a forward market, NDFs facilitate the flow of capital and information across borders and regions.

The Fundamentals of Deliverable vs. Non-Deliverable Forward Contracts

This compares to net portfolio outflows of USD 2.4 bn in February and USD 7.9 bn in March. DNDF transactions have largely moved in tandem with the rupiah exchange rate, rising when the rupiah is under depreciation pressure. For the New Taiwan dollar there have been more deviations, often with NDF markets pricing more appreciation than onshore markets.

Asian NDFs have been more volatile on average than corresponding onshore forwards over the period from 2013 to April 2020 (Figure 8). However, the maximum realized volatility was lower in NDFs for the IDR, INR, KRW, and TWD than in the onshore forwards. In crisis episodes, including the COVID-19 pandemic, volatility of NDFs tended to increase slightly more than onshore forward volatility (Appendix 1). Bank of England NDF volume data for London, the world’s largest NDF trading hub, is broadly in line with BIS data (Figure 3). In Tokyo, an important NDF trading hub in Asia, the KRW, INR, TWD, and IDR are the most widely traded NDF currencies (Figure 4). This example elucidates the strategic decision-making process behind an NDF agreement, shedding light on how it becomes a pivotal tool for companies anticipating cash flows in foreign currencies, such as the Brazilian Real (BRL).