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, except in transactions that are in Non-Deliverable Forward Market. 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?

  • If there is a physical need for a currency, then the deliverable forward is preferable to the non-delivery transaction. When a hedging company enters a Forward transaction, the company will pay a Bid/Ask spread. At expiration, the cash flow is just the exchange rate differences and not the forward notional amount.

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).

  • If there is no physical need for the currency, then the non-deliverable transaction is preferable to the deliverable transaction.

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.

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).

In the non-deliverable market, the payout is not always in the second currency. It depends on whether it is an offshore or onshore transaction. A local market entity can execute a regular Forward (for delivery), but a non-local entity can only execute an NDF in the offshore market. That is because the local currency can’t be taken out of the country. NDF payout in an offshore market is in the major currency (usually USD), and the fixing is done two business days before the value data.

For example, Non-deliverable forward Indian rupee vs. USD:

  • Buy Forward USD/INR

  • Notional: 1,000,000 USD

  • Forward rate: 74.00

  • Fixing rate: 75.11

Payout at value date (from the FW buyer point of view) = 1,000,000 * (75.11 - 74.00) / 75.11 = 14,778.33 USD

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