Non-Deliverable Forwards (NDFs) Key Characteristics
- 04:11
The key characteristics of NDFs are outlined here, emphasizing their role in risk management and cash settlement in markets with currency restrictions.
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Transcript
Let's take a closer look at the key characteristics of non-deliverable forwards or NDFs, and understand what makes them unique and useful in certain markets.
First risk management, NDFs are an effective tool for hedging FX risks in markets where currency regulations would otherwise prevent the use of standard forward contracts. For instance, if a company operates in a country with capital controls or restrictions on currency convertibility, an NDF allows them to manage exchange rate risk without violating these regulations. This makes NDFs particularly valuable for companies navigating markets with limited currency flexibility.
Next is cash settlements. Unlike standard forwards that require physical delivery of the currency, NDFs settle only the gain or loss in cash. Typically in a major currency like the US Dollar. This structure is critical because it avoids the need to physically deliver restricted or non-convertible currencies. Sidestepping regulatory hurdles while simplifying transactions. By settling in a freely traded currency, NDFs reduce logistical challenges and associated costs for businesses.
Next, let's discuss the OTC nature of NDFs being OTC or over-the-counter contracts, NDFs can be tailored to meet specific needs such as the notional amount and settlement dates. This customization allows businesses to align the terms of the NDF with their precise hedging or speculative requirements. However, as with all OTC derivatives, this flexibility comes with counterparty risk. In other words, there's always the possibility that the other party in the contract may default on their obligations. This is an important consideration for businesses when deciding whether to use NDFs.
Now onto market risk.
Many currencies traded via NDFs are from emerging markets where volatility is higher. This volatility is often driven by factors like local economic conditions, political instability, or shifts in foreign investment flows.
As a result, the underlying currency movements can be unpredictable, adding another layer of risk for NDF users.
Companies using NDFs need to stay vigilant about these factors as they can significantly impact the effectiveness of their hedging strategies.
Finally, let's talk about liquidity. Because NDFs focus on less commonly traded currencies and operates in the OTC markets, they don't benefit from the same level of trading activity as major currency forward markets.
This can make it harder to find counterparties for large transactions or to unwind positions without affecting market prices.
Additionally, the bid asks spread in NDF markets tends to be wider than in more liquid forward markets. It's worth noting that these spreads can vary significantly depending on the currency pair. Currencies with higher demand or greater trading volumes may see tighter spreads. While those with lower activity may have much wider spreads.