Let's look at non-deliverable forwards or NDFs, which are foreign exchange derivatives designed to help hedge or speculate on currencies that are not freely convertible or that are subject to exchange controls. These restrictions often prevent the use of standard FX forwards, which makes NDFs a valuable alternative under such circumstances.

The primary reason for NDF usage lies in the restrictions and regulations imposed by certain countries.

These regulations can take various forms such as limits on currency, convertibility capital controls that prevent the free movement of money outside the country, or regulatory barriers that limit participation in global Forex or foreign exchange markets.

Because of these restrictions, a standard deliverable forward contract isn't feasible. This is where NDFs come in, offering a way to manage FX risk while working around these limitations. Some currencies that are frequently traded via NDFs are Chinese Yuan, Indian Rupee, Korean Won, and Brazilian Real. NDFs operate differently from standard forward currency contracts. Unlike traditional forwards, which involve the physical delivery of the underlying currencies, NDFs settle entirely in a major convertible currency such as the US Dollar. The settlement amount is based on the difference between the contracted NDF rates and the prevailing spot rate at the time of settlement.

Let's say you enter into a one month NDF today, on the fixing date at the end of the NDFs contracted term, which is usually a day or two before the settlement date, the contracted NDF rates is compared to the prevailing spot rates. This comparison determines whether there is a profit or loss. Then at settlement, the difference is paid or received in US dollars or whichever major currency is agreed upon in the contracts.

And who uses NDFs? Well, they serve both hedging and speculative purposes. For corporations, NDFs provide a way to hedge FX risks tied to restricted currencies. For example, a company operating in Brazil might use an NDF to hedge its exposure to the Brazilian Real, ensuring it can manage exchange rate fluctuations effectively. On the other hand, speculators use NDFs to bet on currency movements without requiring physical delivery of the underlying currency. Allowing them to navigate markets that would otherwise be inaccessible. Finally, it's worth noting that the settlement of NDFs almost always happens in a major currency, most commonly the US dollar. This ensures liquidity and simplifies the transaction given the limited convertibility of the underlying currencies.