Forward Contract: How to Use It, Risks, and Example

The settlement amount is the difference between the agreed forward exchange rate and the prevailing spot exchange rate at maturity, paid in a convertible currency. It is mostly useful as a hedging tool in an emerging market where there is no facility for free trading or where conversion of underlying currency can take place only in terms of freely traded currency. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated. Other factors that can be significant in determining the pricing of NDFs include liquidity, counterparty risk, and trading flows between the two countries involved. In addition, speculative positions in https://www.xcritical.com/ one currency or the other, onshore interest rate markets, and any differential between onshore and offshore currency forward rates can also affect pricing.

Pros and cons of forward contracts

If foreign investors use NDFs to hedge exposures in local assets in times of stress, sales of these assets in the balance of payment statistics capture their behaviour only very partially. Analysts need not only to follow the money, ie measure capital flows, but also to follow the risk, and newly available data on NDFs can help (Caruana (2013)). As Graph 3 shows, the widening of the band and the tendency for actual trading to occur near its edges make for substantial basis risk. When the NDF non deliverable forward contract settles at the fixing rate, this can be 1 percentage point higher or lower than the rate at which the renminbi can actually be sold onshore. From the standpoint of a firm trying to fix the dollar value of profits to be remitted from China, a 1% gap between the NDF and the actual rate of exchange can produce unwanted volatility.

• The NDF market will continue to grow faster than the foreign exchange market as long as authorities try to insulate their domestic financial systems from global market developments, albeit at the cost of lower liquidity.
• If you need to calculate cross-border risks (such as transferability and convertibility) in addition to FX and IR delta, then you need to keep track of the domicile and jurisdiction of the FX contract (or at least onshore and offshore).
• The continuing existence of the NDF market alongside deliverable forwards no doubt exacts a cost in terms of lower liquidity from the division of the forward markets.
• Deliverable forwards opened up in 1983, but the NDF continued to trade, lingering until 1987.
• Thus, it is not surprising that the NDF market moves the domestic forward market on the following day, especially when financial markets are more volatile.
• In the ways mentioned below, trading platforms can get an opportunity to create a diverse portfolio of products and services that add to their profits, with a significant degree of control on risk and losses.

Stop overpaying with your bank on foreign exchange

NDF prices may also bypass consideration of interest rate factors and simply be based on the projected spot exchange rate for the contract settlement date. Unlike traditional currency forward contracts, where the physical delivery of the currencies takes place upon maturity, NDF contracts are settled in cash. Instead, the parties settle the difference between the agreed-upon exchange rate and the prevailing spot rate at the time of settlement. Non-deliverable forwards (NDFs) are contracts for the difference between an exchange rate agreed months before and the actual spot rate at maturity. The spot rate at maturity is taken as the officially announced domestic rate or a market-determined rate. Thus NDFs yield payoffs related to a currency’s performance without providing and requiring funding in the underlying currencies as do deliverable forwards.

Providing Liquidity and Price Discovery

Besides, NDFs get traded over the counter (OTC), encouraging the flexibility of terms to satisfy the needs of both parties involved. 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. 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.

What Alternatives to Forward Trades are There?

NDFs allow you to trade currencies that are not available in the spot market, hedge your currency risks and avoid delivery risk. The loss or profit gets calculated depending on the notional amount of the agreement. However, the notional amount in a non-deliverable forward contract is never exchangeable. If one party agrees to buy Chinese yuan (sell dollars), and the other agrees to buy U.S. dollars (sell yuan), then there is potential for a non-deliverable forward between the two parties. That said, non-deliverable forwards are not limited to illiquid markets or currencies. They can be used by parties looking to hedge or expose themselves to a particular asset, but who are not interested in delivering or receiving the underlying product.

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Effective capital controls can drive a wedge between on- and offshore exchange rates, especially at times of market strain. In this section, after documenting the deviations, we test which market, onshore or offshore, provides leading prices. If the company goes to a forward trade provider, that organisation will fix the exchange rate for the date on which the company receives its payment. The exchange rate is calculated according to the forward rate, which can be thought of as the current spot rate adjusted to a future date.

Non-Deliverable Forwards Case Study

The continuing existence of the NDF market alongside deliverable forwards no doubt exacts a cost in terms of lower liquidity from the division of the forward markets. However, it is possible that the change in the NDF market to more transparent trading and centralised clearing will make NDF markets deeper and more liquid. If so, the won’s path may prove to be conducive to more market development than seen to date.

How are forward contracts traded and settled?

While the rouble deliverable forward is slowly displacing the NDF, the Korean won NDF continues to dominate trading and may gain liquidity from ongoing market centralisation. At the same time, the renminbi offshore deliverable forward is closing in on the NDF, notwithstanding capital controls. Its deliverable and non-deliverable markets persist in parallel even as arbitrage joins them and markets deepen. The Chinese renminbi’s recent internationalisation follows neither path and the offshore deliverable renminbi is outcompeting the NDF. With a forward trade, once one has been agreed to, both parties are contractually obliged to complete the agreed exchange of currencies.

If we go back to our example of a company receiving funds in a foreign currency, this will be the amount that they are expecting to be paid in the foreign currency. Non-deliverable forwards can be used where it is not actually possible to carry out a physical exchange of currencies in the same way as normal forward trade. If we go back to the example of a business that will receive payment for a sale it has made in a foreign currency at a later date, we can see how a forward trade is used to eliminate currency risk. NDFs are primarily traded in over-the-counter markets between authorized financial institutions and large corporations.

Non-deliverable forward (NDF) contracts are a type of financial derivative used in foreign exchange markets. Unlike standard forward contracts that involve the actual exchange of currencies, NDFs settle in cash and do not require the physical delivery of the underlying asset. They are typically used in markets with capital controls or where the currencies are not freely convertible.

Futures are marked-to-market daily, while forwards are settled only at the end of the contract term. The estimation results suggest that, by and large, domestic markets, not just NDFs, incorporate global factors. In particular, contemporaneously measured major exchange rates figure similarly in both deliverable forwards and NDFs. The only cases where global factors seem to figure much more in the NDF rate are the renminbi, Indian rupee and Indonesian rupiah.

Even though forwards aren’t commonly used by individual investors, it is a great idea to get an understanding of what they are either way. Once the connection between forward contracts and other derivatives has been established, you can start using these financial tools. Forwards can offer several benefits to both parties, such as privacy, and the fact that they can be customized to each party’s specific requirements and needs. As these contracts are private, it is hard to assess the size of the forward market and the true extent of its risks. A closed forward contract is where the rate is fixed, and it is a standard; it is where both parties agree to finalize an agreement transaction on the set specific date in the future. The costs to Korea of maintaining won NDFs may decline with the changing market structure.

The larger stock of positions in Chile declined by $9 billion between end-April and end-June 2013. The smaller position in Peru declined by $2 billion between end-May and end-August. NDFs were used to reduce net exposures, while the Peruvian data show a decline in turnover consistent with the London data for October 2013 discussed below. NDF turnover grew rapidly in the five years up to April 2013, in line with emerging market turnover in general (Rime and Schrimpf (2013)). Following Bech and Sobrun (2013), we examine partial data since April 2013, which raise the question of how much the growth through April reflected a search for yield.

In order to avoid the restrictions imposed by the foreign currency in question, NDF is settled in an alternative currency. Usually, the forward trade provider will act as a third party in the exchange, handling the transfer of money between the business and the counterparty which is making the payment to them. Also known as an outright forward contract, a normal forward trade is used to lock the exchange rate for a future date. NDFs traded offshore may not be subjected to the same regulations as onshore currency trading. Since there is no principal exchanged, the holder of an NDF contract is reliant on the credit quality and financial standing of the counterparty bank or dealer to fulfill their payment obligations.

Working with reputable banks and monitoring credit standing is key to risk management. Settlement of NDF contracts is subject to timing mismatches or errors, creating risk around execution of payments. This binding contract locks in an exchange rate for the sale of the purchase of a specific currency on a predetermined future date. In other words, it is a customizable currency-hedging tool without upfront margin payment. Although businesses can use NDF liquidity and other benefits to enter into emerging markets by managing their currency, it does contain an element of risk. Investors can execute a contract before or at the expiration date in case they agree on a flexible forward.

The NDF effectively locked in BASF’s targeted MXN/EUR rate, eliminating the uncertainty of currency moves over the 90 day period. Settlement was seamless in a convertible currency without executing FX trades or transfers. In addition to market-driven factors, the counterparty credit risk is also factored into NDF pricing by dealers. More uncertain and volatile FX markets command a higher risk premium, leading to wider differentials in NDFs compared to stable currency pairs. NDFs for longer tenors will have wider differentials between the contract rate and spot rate compared to short-term NDFs. The largest NDF markets are in the Chinese yuan, Indian rupee, South Korean won, Taiwan dollar, and Brazilian real.

Deliverable forwards opened up in 1983, but the NDF continued to trade, lingering until 1987. BASF enters a 90-day MXN/EUR NDF contract with Deutsche Bank to sell 300 million MXN at an NDF rate of 21 MXN per EUR. We introduce people to the world of trading currencies, both fiat and crypto, through our non-drowsy educational content and tools. We’re also a community of traders that support each other on our daily trading journey. Forex trading involves significant risk of loss and is not suitable for all investors.