Let's walk through an example to understand how an NDF works in action, including the calculations and the impact on the effective exchange rates. Here's the scenario. A US company expects to receive 50 million Indian Rupees or INR, in six months from its operations in India, concerned about the potential depreciation of the Rupee against the US Dollar. The company enters into an NDF contract with the following terms. The contract date is April 20, and the settlement date is October 20. The contracted NDF rate is one US Dollar equals 69 Indian Rupees, and the contracted amount is 50 million Rupees. At the time of settlement, the spot rate for Dollar Rupee is 74. So we need to answer two key questions. What is the settlement payment? And will the company need to pay or receive the difference? And what is the effective exchange rate when the Rupee is converted? Let's start with the first step calculating the US Dollar value based on the NDF contracts. Under the terms of the NDF, the company has effectively sold 50 million Rupees at a rate of 69.

To find the equivalent US Dollar amount, we divide 50 million Rupees by the contracted rate of 69, giving us $724,637.68.

This is the amount of Dollars locked in under the NDF. Now, let's calculate the Dollar value based on the prevailing spot rate at settlement, which is 74.

If the company were to exchange the same 50 million Rupees at this rate, we divide 50 million Rupees by 74 to give us 675,675.68. This is the amount in Dollars the company would receive at the spot rate.

Now we calculate the difference between the $2 amounts to determine the settlement payments of the NDF subtracting. The spot value from the NDF value gives $8,962.01. Since the Rupee weakened relative to the contracted rates. The company would've received fewer Dollars at the spot rate. To offset this, the NDF results in the company receiving a payment of $48,962.01 from the counterparty.

Finally, let's calculate the effective exchange rates. If the company sells the Rupees in the spot market at 74.

At the spot rates, the company would receive 675,675.68 US Dollars. Adding the $48,962.01 received from the NDF settlement gives us $724,637.69.

Now to determine the effective exchange rates, we divide the original 50 million Rupees by the total Dollar amount, 50 million into Rupees divided by $724,637.69 equals 69 Rupees per Dollar.

By combining the spot transaction with the NDF settlement, the company effectively locks in the agreed exchange rate of 69, even though the spot rate moved to 74.