Non-Deliverable Forward

A non-deliverable forward (NDF) is an over-the-counter currency contract between two parties that locks in an exchange rate for a future date but settles in cash rather than by physical currency delivery. NDFs are used primarily in emerging markets where governments impose capital controls or restrict the convertibility of their currency, making it impossible or impractical to exchange the actual currencies at maturity. The buyer pays or receives the difference between the contracted rate and the spot rate on settlement day, measured in a hard currency like the US dollar.

Why physical delivery is impossible in some markets

Some governments restrict the free conversion and movement of their currency abroad, either to preserve foreign reserves, defend the exchange rate, or prevent capital flight. The Chinese renminbi (CNY), Indian rupee (INR), and many others face such restrictions. A company operating in China that earns renminbi revenues and wants to hedge its exposure to a weakening renminbi cannot easily enter a standard forward contract where it would deliver renminbi and receive dollars at maturity—the Chinese government limits how much renminbi can be converted and moved outside the country.

An NDF solves this problem by avoiding physical delivery altogether. The contract is settled purely in cash: on the maturity date, the two parties calculate the difference between the agreed rate and the actual market rate and one party pays the other that difference in dollars (or another agreed reference currency). No restricted currency changes hands, and no government approval is needed.

How an NDF is structured

An NDF begins with a notional principal amount (e.g., $10 million equivalent in Chinese renminbi) and an agreed rate (e.g., CNY 6.50 per dollar). At maturity—say, three months later—the fixing rate is determined using an agreed-upon reference (often the official central bank rate or a volume-weighted average price from Reuters or Bloomberg). If the actual rate is CNY 6.60 per dollar, the renminbi has weakened and a US importer earning renminbi (who bought the NDF as a hedge) benefits. The NDF seller pays the buyer the difference: $10 million × (6.60 − 6.50) / 6.50, or approximately $153,846, in US dollars.

The contract is denominated in the reference currency (dollars) even though the underlying exposure is to the restricted currency. This avoids any need for the restricted currency to move across borders.

The offshore vs. onshore structure

Most NDFs are traded offshore between major international banks and their clients. Because the restrictions apply within the country of issue, an offshore derivative market in that currency naturally develops. For the Chinese renminbi, there is an active offshore market in Hong Kong, Singapore, and London where banks quote NDFs for major international corporates and funds. These offshore rates often differ from rates available to domestic onshore participants, reflecting the scarcity and regulatory friction of the offshore market.

A large multinational operating in both China and the rest of the world might use onshore forwards for internal hedging of renminbi balances held in China, and offshore NDFs for hedging foreign renminbi revenue expected to remain outside China. The two markets are segmented by capital controls and are not perfectly arbitraged.

Common uses in emerging-market exposures

A multinational corporation with operations in Brazil, Russia, or Vietnam often earns local currency revenues or faces local currency costs and wants to hedge those exposures. Because some of these currencies are subject to capital controls or are illiquid in offshore markets, an NDF is the practical hedging tool. An investor expecting to invest in Indian stocks (INR-denominated) can use an NDF to lock in the exchange rate at which returns will be converted back to dollars, even though the rupee cannot freely be repatriated.

NDFs are also used by hedge funds and trading desks to speculate on emerging-market currencies. The leverage available in the NDF market (often 10:1 or higher) and the lack of daily margin requirements in some jurisdictions made NDFs a popular instrument for carry trades and currency bets until regulatory tightening after the 2008 crisis.

Pricing and the offshore-onshore spread

The price of an NDF reflects the interest rate differential between the two currencies (via uncovered interest parity), expectations of devaluation, perceived counterparty risk on the bank quoting the NDF, and the scarcity of the offshore market. An NDF on the Chinese renminbi will reflect the interest rate differential between dollar rates and onshore Chinese rates, plus a premium for the legal and regulatory risk of an offshore derivative on a restricted currency.

If onshore interest rates are higher than offshore dollar rates, the NDF rate will typically be wider (CNY per dollar higher) than the current spot, reflecting the interest advantage of holding the currency domestically. Over time, this interest differential is also a component of the forward premium or discount in the NDF market.

Regulatory and credit considerations

NDFs are over-the-counter derivatives and therefore carry full counterparty risk. The buyer of an NDF is dependent on the solvency of the bank quoting it. Most large international banks manage this by requiring collateral or by matching their NDF sales to clients with NDF purchases elsewhere (running a balanced book). Since the 2008 financial crisis and the introduction of central clearing requirements, some standardised NDFs are now eligible for clearing, reducing counterparty risk—but most bilateral NDF trades remain uncleared.

The use of NDFs for speculative bets on emerging-market currencies has drawn regulatory attention in countries trying to manage their exchange rate. China, for instance, has periodically clamped down on offshore NDF trading by offshore banks with Chinese counterparties, viewing large short positions in the renminbi as destabilising.

Distinguishing from deliverable forwards

The key difference between an NDF and a standard deliverable forward is precisely what the name suggests: an NDF does not deliver the currency. A standard forward on the euro or British pound allows (and typically requires) physical delivery of the currency at maturity. An NDF is cash-settled and, in principle, cannot be settled by currency delivery. In practice, some emerging-market currencies have both a deliverable forward market (for permitted market participants) and a non-deliverable forward market (for offshore and restricted counterparties).

See also