A non-deliverable forward (NDF) is a financial derivative used to hedge or speculate on foreign exchange risk in currencies that have restrictions or limited liquidity, settled in cash rather than by physical delivery.
A Non-Deliverable Forward (NDF) is a type of forward contract where two parties agree to exchange the difference between the contracted forward rate and the prevailing spot rate at maturity, without the actual delivery of the underlying currency. These contracts are primarily used for currencies that are not freely tradable or have restrictions in their exchange markets, often in emerging or frontier markets. The settlement is done in a convertible currency, typically US dollars, making it a cash-settled contract. In finance and wealth management, NDFs serve as important tools for managing currency risk exposure in environments where conventional spot or forward FX transactions are not possible. Family offices and wealth managers utilize NDFs to hedge foreign currency positions or exposures related to investments denominated in restricted currencies. Since no physical delivery is made, the parties only settle the net cash difference, reducing the need for carrying the actual foreign currency.
Managing currency risk in restricted or less liquid foreign exchange markets is critical for preserving wealth and optimizing investment returns. Non-deliverable forwards provide an efficient mechanism to hedge currency risk without the complications of currency controls or capital restrictions that can affect physical foreign exchange transactions. In the context of investment strategy and reporting, NDFs help maintain accurate valuation and risk metrics by mitigating adverse currency movements that could erode portfolio value. Tax planning may also benefit from the cash-settlement feature, as it enables clear gain or loss recognition timing without the complexities of foreign currency settlements. Additionally, governance and compliance efforts are supported by the transparency and standardized nature of NDF contracts in otherwise opaque currency markets.
Suppose a US-based family office expects to receive 10 million in Brazilian reais (BRL) in 3 months but wants to hedge against the risk of BRL devaluation. Since BRL has capital controls, the family office enters an NDF agreement to lock in an exchange rate of 5 BRL/USD. At settlement, if the spot rate is 5.2 BRL/USD, the family office receives a cash settlement calculated as: (Spot rate - NDF rate) x Contract amount / Spot rate = (5.2 - 5)×10,000,000/5 = 400,000 USD, compensating for currency loss without actual BRL delivery.
Forward Contract
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today, involving the physical delivery of the asset or currency. Unlike NDFs, forward contracts typically settle by actual delivery and are commonly used in freely tradable currency markets.
What currencies typically use non-deliverable forwards?
NDFs are commonly used for currencies with exchange controls or limited convertibility, such as the Chinese yuan (offshore), Brazilian real, Indian rupee, Korean won, and many other emerging market currencies.
How is settlement handled in an NDF transaction?
Settlement of an NDF is done in cash, usually in a major convertible currency like the US dollar, by exchanging the difference between the contracted forward rate and the prevailing spot rate at the time of settlement.
What are the risks involved with non-deliverable forwards?
Risks include counterparty risk since NDFs are over-the-counter contracts, market risk from currency rate movements, and potential regulatory risk in jurisdictions with strict currency controls.
