The Fundamentals of Deliverable vs. Non-Deliverable Forward Contracts
Understanding the principles of a deliverable forward vs. non-deliverable forward contract can help you leverage your investments in the foreign exchange market. Both are forward contracts but with different provisions, and it’s important to be able to distinguish between them.
In fact, to understand the fundamentals of non-deliverable forward vs. forward-deliverable contracts, you must know what forward contracts are. So, this guide will first elaborate on what forward contracts as well as the differences between deliverable and non-deliverable forward contracts.
What is a Forward Contract?
A forward contract is a mutual agreement in the foreign exchange market where a seller and buyer agree to sell or buy an underlying asset at a pre-established price at a future date. That’s why it’s also known as a forward foreign exchange contract (FEC).
This binding contract locks in an exchange rate for the sale of the purchase of a specific currency on a predetermined future date. In other words, it is a customizable currency-hedging tool without upfront margin payment.
Another good thing about forward contracts is that it operates under non-standardized terms. That means the involved parties can tailor them to a specific amount and for any delivery period or maturity. So, it’s different from the exchange-traded currency futures.
Notably, there are two types of forward contracts: deliverable and non-deliverable. Both options can serve as hedging tools and operate within customized terms. However, they are different since a deliverable forward contract involves an asset’s physical exchange or delivery, while a non-deliverable forward contract doesn’t. It could be the currency.
The Basics of Non-Deliverable Forward Contracts
Unlike a deliverable forward contract which involves the exchange of assets or currency at an agreed rate and future date, a non-deliverable forward (NDF) requires cash flow, not tangible assets. Notably, NDFs are short-term forward contracts.
In other words, a non-deliverable forward contract is a two-party contract to exchange cash flows between an NDF and a prevailing spot rate. The spot rate is the most recent rate for an NDF, as issued by the central bank. Notably, NDFs are cash-settled.
Two parties must agree and take sides in a transaction for a specific amount of money, usually at a contracted rate for a currency NDF. So, the parties will settle the difference between the prevailing spot rate and the predetermined NDF to find a loss or profit.
The loss or profit gets calculated depending on the notional amount of the agreement. That’s the difference between the spot and pre-agreed rates upon settlement. However, the notional amount in a non-deliverable forward contract is never exchangeable.
One party pays another the difference between the NDF rate and the spot rate; the payment is usually in U.S. dollars. Besides, NDFs get traded over the counter (OTC), encouraging the flexibility of terms to satisfy the needs of both parties involved.
Another fact is that an NDF is usually an offshore forward contract. It goes beyond the locational boundaries of untraded or illiquid currency. For example, if a country’s currency gets restricted from moving offshore, settling transactions in that currency won’t be easy in another foreign country.
Thankfully, both parties involved in the non-deliverable contract can settle the contract by converting all losses or profits to a freely traded currency, such as U.S. dollars. So, they can pay one another the losses or gains in the freely traded currency.
How Non-Deliverable Forward Contracts Work
Non-deliverable forward contracts for currency pairs involve various parameters you must know to understand how the NDFs operate. Some of the terminologies include:
- Fixing Date: The day the difference between the agreed-upon rate and the prevailing spot market rate gets calculated.
- NDF Rate: The rate agreed upon on the transaction date. In other words, it’s the straightforward rate for the currencies involved in the NDF contract.
- Notional Amount: Refers to the nominal or face amount used to calculate payments made on a specific financial instrument and does not always change.
- Trade Date: The date when the NDF contract agreement initiates.
- Reference Rate: The future spot exchange rate when the NDF contract matures.
- Cash Settlement: The difference between an NDF and the reference rate
- Settlement Date: The date of cash settlement.
- NDF Cash Flow: Cash flow = (NDF Rate – Spot Rate) * Notional amount
Now that you understand the terminologies used in non-deliverable forward contracts, it’s essential to learn how the NDF contract works. Here is how it operates:
- Step 1: Two parties agree on the currency pair and notional amount of the NDF contract.
- Step 2: They agree upon the NDF rate and choose a favorable fixing date and settlement date.
- Step 3: When it reaches the fixing date, the parties check the spot rate from the central bank against the agreed rate in the contract.
- Step 4: The difference gets paid in a chosen currency on the agreed settlement date. That depends on whether the rate has increased or decreased.
Advantages of Non-Deliverable Forward Contracts
The good thing about NDFs is that they are available in a vast range of currencies and offer means of hedging foreign exchange risk in markets that don’t support the physical delivery of money. Here are the other advantages of non-deliverable forward contracts.
- Non-deliverable forward contracts operate like regular forward contracts but don’t involve the physical delivery of the underlying assets or currency pairs.
- NDFs are customizable, so you can tailor them to fulfill your needs. In addition, you can choose a fixed date and notional amount.
- Non-deliverable forward contracts offer protection against adverse fluctuations in the exchange rates of the currencies paired during the entire term of the contract.
Disadvantages of Non-Deliverable Forward Contracts
Like other financial instruments, non-deliverable forward contracts also have setbacks. So, here are some disadvantages you should know.
- Non-deliverable forward contracts offer no protection against adverse fluctuations of the currency markets when paying the net difference.
- When the contracts involve emerging market currencies, the markets will be less liquid and more exposed to fluctuations than major currencies’ markets.
- You won’t be able to participate in favorable movements at the spot rate. Besides, adjustments or cancellations of the contracts may cost you a lot.
How Deliverable Forward Contracts Operate
So far, you understand how non-deliverable forward contracts work and how investors can benefit from them. However, how do they differ from their counterpart deliverable forward contracts? Well, the difference lies in the deliverability of the agreed currency.
As the name suggests, a deliverable forward contract involves the delivery of an agreed asset, such as currency. So, for example, in a forward contract involving a currency pair of USD/AUD, there would be a physical exchange of USD equivalent to AUD.
Unlike in an NDF contract in which the difference between the NDF rate and the fixing rate gets settled in cash, a deliverable forward currency involves the delivery of the settlement currency when the contract matures. However, NDFs are more common.
Now that you know the fundamentals of deliverable forward vs. non-deliverable forward contracts, don’t confuse the two options. NDFs involve the cash settlement of the difference between the NDF and the spot rate, while a deliverable forward contract involves the physical exchange of the agreed amount.