Structure and Features
An NDF is a short-term, cash-settled currency forward between two counterparties. On the contracted settlement date, the profit or loss is adjusted between the two counterparties based on the difference between the contracted NDF rate and the prevailing spot FX rates on an agreed notional amount.
The features of an NDF include:
- notional amount: This is the "face value" of the NDF, which is agreed between the two counterparties. It should again be noted that there is never any intention to exchange the notional amounts in the two currencies
- fixing date: This is the day and time whereby the comparison between the NDF rate and the prevailing spot rate is made.
- settlement date (or delivery date): This is the day when the difference is paid or received. It is usually one or two business days after the fixing date.
- contracted NDF rate: the rate agreed on the transaction date, and is essentially the outright forward rate of the currencies dealt.
- prevailing spot rate (or fixing spot rate): the rate on the fixing date usually provided by the central bank, and commonly calculated by calling a number of dealers in the market for a quote at a specified time of day, and taking the average. The exact method of determining the fixing rate is agreed when a trade is initiated.
Because an NDF is a cash-settled instrument, the notional amount is never exchanged. The only exchange of cash flows is the difference between the NDF rate and the prevailing spot market rate—that is determined on the fixing date and exchanged on the settlement date—applied to the notional, i.e. cash flow = (NDF rate – spot rate) × notional.
Consequently, since NDF is a "non-cash", off-balance-sheet item and since the principal sums do not move, NDF bears much lower counter-party risk. NDFs are committed short-term instruments; both counterparties are committed and are obliged to honor the deal. Nevertheless, either counterparty can cancel an existing contract by entering into another offsetting deal at the prevailing market rate.
Read more about this topic: Non-deliverable Forward
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