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A non-deliverable forward is a forward contract which is settled in your local currency.
Like standard forward contracts — or currency forwards, as they’re known on the forex markets — non-deliverable forwards are agreements to buy or sell X amount of a certain currency at a predetermined exchange rate on X date in the future.
However, the exchange doesn’t actually happen, which is why this forward is called ‘non-deliverable’. Instead, you pay or get paid the difference between the exchange rate in the contract and another exchange rate called the fixing rate. The fixing rate is typically the spot rate — the market exchange rate — on a pre-agreed date called the fixing date.
Non-deliverable forwards are useful if you want to hedge against fluctuations in the exchange rates of non-convertible currencies. These are currencies that aren’t freely traded on the forex markets due to government restrictions.
Imagine you’re a UK business that sells goods in Argentina. You’ve just sold a consignment worth ARS$1,000,000. But because you’re headquartered in the UK, you need to convert this revenue from Argentine Pesos to British Pounds.
If the Peso to Pound exchange rate becomes unfavourable, it could reduce your profits or create a loss. Unfortunately, because the Peso is non-convertible, you can only exchange it for Pounds at an Argentine bank. As a result, you can’t use currency forwards, options, or other types of hedging instruments that rely on the open market.
A non-deliverable forward allows you to get around this.
Let’s say you enter a contract to sell ARS$1,000,000 for British Pounds on a certain date at an exchange rate of 132. In other words, you’ll get £1 for every ARS$132.
The contract will also specify a fixing date when you’ll compare this exchange rate to the one the Argentine central bank has set. The fixing date could be the date on which the non-deliverable forward is due, or a prior date.
Two things can happen on the fixing date:
● The Argentine central bank’s exchange rate is 138. This is worse than the rate in your non-deliverable forward, so you’ll get paid the difference. This will make up for the loss you’ll incur when you exchange Pesos for Pounds at an Argentine bank
● The Argentine central bank’s exchange rate is 129 — better than the rate in your forward. Here, you’ll pay the difference
In each case, the effect is the same. The non-deliverable forward cancels out the fluctuation, ‘fixing’ the exchange rate and giving you certainty.
- Many countries with non-convertible currencies have economies that are very vulnerable to market movements, for example because they’re reliant on exports of commodities like oil. Making their currencies non-convertible prevents money and other assets from being moved overseas if things go wrong, as this worsens economic difficulties.
- The Chinese Yuan is the most commonly featured currency in non-deliverable forwards. Other popular currencies are the Indian Rupee, South Korean Won, New Taiwan Dollar, Brazilian Real, and Russian Ruble.
- Some of these currencies, most notably the Yuan, also have a standard forward market. But these markets are subject to stringent rules and, so, trade is quite restricted.
- Because many non-convertible currencies are in emerging markets, non-deliverable forwards are popular with speculators. Emerging markets tend to be very volatile, which creates the potential for huge returns… and equally huge losses.
Want to know more?
- This article explains capital flight and its consequences for countries’ economies in greater detail without getting too technical.
- If you want to delve deeper into non-deliverable forwards, this working paper by the International Monetary Fund focuses on Asia, including how different countries’ policy approaches have affected individual economies and the market as a whole.
Assure Hedge’s perspective:
“‘Emerging markets are as risky as they are lucrative, especially in countries with strict fiscal policies and non-convertible currencies. Non-deliverable forwards are an inexpensive way to hedge your risk, so you can take advantage of the incredible opportunities in these markets while having the peace of mind that you won’t suffer outsize losses should things go wrong.”
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DISCOVER OTHER CONCEPTS IN OUR CURRENCY HEDGING GLOSSARY
A knock-in option is an option that only comes into force — or knocks in — if the underlying asset reaches a certain price. In foreign exchange, the underlying asset is an exchange rate.
Leverage means investing using money you’ve borrowed, usually from a broker. When you trade on leverage, you pay your broker a sum of money called initial margin.
Mark-to-market is the accounting process that measures the real-world value of foreign exchange trades. It shows whether you’ve made a profit or a loss on a trade and whether your broker should credit your trading account or make a margin call.