Financial markets are complex and influenced by factors like supply and demand, liquidity levels, and technological developments. Traders often use risk-mitigating strategies, such as investing in low-volatility securities or hedging tactics to minimise losses during market uncertainty. Each financial instrument responds differently to these factors.
Non-deliverable forwards (NDFs) are a common practice to mitigate risks associated with trading currencies or other tradable securities, allowing investors to receive better trading conditions in the near future.
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What Are NDFs
NDFs are contracts between two parties that agree on a specific price and day for a trade in foreign exchange, stocks, or commodities. They involve receiving or paying the net difference between the security’s prices on the agreed exchange date without transferring the subject product.
An NDF contract requires both parties to agree on the product, date, and price, which allows traders to avoid supply fluctuations by focusing on price differences, reducing the impact of market volatility.
On the other hand, deliverable forwards (DFs) require the transfer of the principal product upon the exchange date, which can be problematic if market shortages or supply changes occur and the liquidity level drops.
NDF markets were once limited since it was difficult to find counterparties, and there were few providers and brokers. Technological advancements have facilitated NDF trading, making accessing and conducting NDFs easier.
NDF trading is popular today, accounting for over $200 billion in daily transaction value, according to the Bank for International Settlements.
How NDFs Work
NDFs are a short-term method for settling currency exchanges between counterparties. They involve an agreed-upon settlement date and a notional amount, a face value for the NDF, to settle the imbalance between loss and profit.
NDFs have several features, including a fixed date for comparing spot and NDF rates, a settlement date, an agreed-upon NDF rate, and a spot rate, which is the most up-to-date rate provided by the central bank.
NDFs are settled with cash, meaning the notional amount is never physically exchanged. The only cash that actually switches hands is the difference between the prevailing spot rate and the rate agreed upon in the NDF contract.
How Are NDFs Regulated
NDF trading is unregulated in some regions and is often conducted over the counter, where both parties agree on the exchange of price due to their volatility and inconsistency.
Global restrictions limit the legal pairing of certain currencies, limiting FX traders to a predetermined set. However, investors can exploit the opportunity to pair distantly related currencies for significant gains.
Offshore jurisdictions offer lenient regulations for traders to conduct NDF transactions, allowing flexibility and financial freedom. This growth has allowed investors to explore a broader range of tradable securities, mitigating risks and enhancing gains in classic markets.
What Are The Advantages of NDFs
NDFs are used for hedging against currency risks, especially in emerging markets where currency conversion or transferability is not readily available. They are cost-effective due to the absence of underlying physical currency and conversions.
NDFs can be customised to meet parties’ needs, allowing for adjustments to the amount, reference exchange rate, and settlement date. Most financial centres worldwide use NDF, providing transparency and liquidity to businesses and individuals.
However, NDFs carry an element of risk, so cautious use is necessary. Overall, NDFs offer numerous benefits for businesses entering emerging markets.
How NDFs Can Mitigate Risks
Due to their highly fluctuating and complex nature, NDFs are typically conducted in the currency context.
The FX and crypto markets experience volatility due to various factors, such as economic, geo-political, national economic, and commercial factors, which can lead to unpredictable outcomes, particularly during war and uncertainty.
NDF agreements help traders reduce liquidity impact on currency pairs by netting price differences between currencies. While most FX pairs use USD as the most popular currency, NDF allows traders to pair up any two currencies without limitations, allowing them to explore opportunities not typically available in the classic market.
Final Thoughts
NDFs are OTC transactions that allow traders to trade a security at a specific price without transferring ownership. They are becoming increasingly popular due to their safety, ability to exchange various currencies, and ability to mitigate volatility and liquidity risks.