A usually short-term forward contract which is cash-settled is referred to as a non-deliverable forward (NDF). Since the notional amount is never transferred, the asset is referred to as ‘non-deliverable’. For an agreed-upon sum of money, or in the case of currency NDF, at a specified rate, two parties agree to take opposite sides in a transaction. It means that the difference between the contracted NDF price and the current spot price is settled between the counterparties. The difference between the agreed upon rate and the spot rate at the time of settlement is used as the factor to determine the profit and loss on the notional amount of the agreement.
The total value of the asset that is being traded in a contract is referred to as the notional value by derivatives traders. This value could be the total worth of a position, the amount of value a position controls, or a contract’s predetermined sum. Basically, payments on financial assets are calculated based on their face value. The term ‘notional value’ is used mainly while referring to derivative contracts in the options, futures, forwards and currency markets. Notional value is the same face value used to determine payments on a financial asset. Because the leverage is used, the notional value of derivatives contract is substantially higher than the market value. Notional value is an important factor that should be taken into account while determining hedge ratios to reduce portfolio risk. Interest rate swaps, total return swaps, equity options and foreign currency derivatives could all be subject to notional value.
Forward Contract
A forward contract is a derivative contract that may be negotiated between two parties for the purchase or sale of an asset at an agreed-upon price on a future date. Commodities traded could be grains, precious metals, natural gas, oil, poultry, etc. Forward contracts, can be settled on a cash or delivery basis. Such contracts are flexible and could be customised for a particular commodity, amount, and delivery date. NDFs are regarded as over-the-counter (OTC) instrument as they are not traded on a centralised exchange. Forward contracts, for instance, could be used to help users of agricultural products hedge against changes in the price of the underlying assets or commodities. In comparison to contracts that are usually marked-to-market regularly, financial institutions that initiate forward contracts are more vulnerable to settlement and default risk. Due to their possibility for default risk and lack of centralised clearing house, forward contracts are less accessible to retail investors than future contracts.
An NDF could be compared to a standard forward foreign exchange contract. However, on maturity, it calls for the actual delivery of any currency, that is agreed upon between the parties. It is a commitment to buying or selling a specific currency on the settlement date for a price that has been agreed upon between the parties on the date of the contract or the trade date.
NDF Market in India
In March 2020, the Reserve Bank of India (RBI) decided to allow banks in India, which operate International Financial Services Centre (IFSC) Banking Units (IBUs) to part take in the NDF market with effect from June 1, 2020. (An IBU is a bank permitted by the RBI to operate from an IFSC). This gave banks the leverage to trade NDF contracts with foreign entities between themselves in the IFSC. Since June 2020, banks in India with IBU were permitted to transact in Indian rupee non-deliverable foreign exchange derivative contracts with non-residents, banks, and other eligible banks having IBUs.
In fact, the Task Force on Offshore Rupee Markets, which was set up by the RBI, had proposed that Indian banks should not be permitted to participate in NDF. However, RBI examined all the aspects of the issue in detail and came to the conclusion that it was appropriate to remove segmentation between onshore and offshore markets to improve efficiency of price discovery.
In April 2023, the RBI announced that it would allow banks with IFSC banking units to offer non-deliverable forex derivative contracts involving the Indian rupee to local residents also. The RBI would also set out guidelines for the new NDF framework. It would clarify whether residents have to provide proof of exposure to foreign exchange. As per the RBI, the same conditions that exist presently for hedging in the OTC would apply for NDF too. According to the present guidelines, evidence for forex exposure has to be submitted to banks to access the OTC market.
The need behind the expansion of NDF access has been to pave the way for a market that is available beyond OTC hours and which would provide more flexibility with hedging. Additionally, it would enable banks to offer enhanced currency hedging opportunities to their customers. This would boost the onshore-offshore arbitrage in a big way. Further, this would give options to the corporates that they could simply hedge and not take or give delivery.
India is one of the world’s fastest-growing major economy, and this is another example of India’s continued financialisation. This could prove to be a valuable tool for the RBI to maintain the stability of the Indian rupee against the US dollar.
Drawbacks of NDF
Any unfavourable changes in the currency markets at the time of paying the net difference are not protected by NDF. The markets are inevitably less liquid and more susceptible to fluctuations when an NDF involves currencies from emerging markets and the markets with major currencies. In such scenarios, one would be unable to benefit from the increase in the spot rate, and costs could be incurred due to cancelations or modifications.
Forward Contracts and Future Contracts
Both forward and future contracts involve the agreement to buy or sell a commodity at a set price in the future. However, unlike future contracts, forward contracts are not traded in a centralised exchange. Settlements for the forward contract takes place at the end of the contract while the future contracts are settled on a daily basis. Moreover, future contracts are not customised between two counterparties and it exists as standardised contracts.
© Spectrum Books Pvt. Ltd.