You must have been hearing and or reading about ‘forwards’ and ‘non-deliverable forward contracts’ but you cannot differentiate between the two or seem to get hold of it in practical terms and how it can be useful to you and your business.
PageOne Markets team have adapted this piece from FMDQ OTC Learning, it will answer all questions on forwards and how it is used in business to hedge against certain risks.
For instance, a company requiring a certain amount of foreign currency at a predetermined future date, faces the risk that the exchange rate may move in an adverse direction by the time the requirement falls due.
In order to mitigate this risk, it can enter into an agreement called a Forward Contract (often referred to as a forward). A Forward Contract is an agreement to buy or sell an asset at a certain future time for a certain price.
In essence, the forward contract allows a company to buy the foreign currency at a specified point in the future, at a price fixed today. The company may, also enter into a Non-Deliverable Forward (NDF) contract.
An NDF, although broadly similar to a forward, is a cash-settled, short-term forward or futures contract where parties agree to a rate/price for a predetermined date in the future, without the obligation to deliver the notional amount on maturity. The NDF is settled at maturity for the difference in the Spot FX rate and the NDF rate.
As settlement was done in cash, one party compensates the other with an amount reflecting the difference between the contracted forward rate and the value of the designated ‘fixing’ rate (the representative spot market rate), as is the case with the “Naira-settled OTC FX Futures” traded on FMDQ OTC Securities Exchange.
These contracts [Naira-settled OTC FX Futures] are NDFs where parties agree to an exchange rate for a predetermined date in the future, without the obligation to deliver the underlying US Dollars (the notional amount) on the maturity/settlement date. On the maturity date, it will be assumed that both parties would have transacted at the Spot FX market rate, which will be the FMDQ Spot FX Rate Benchmark -Nigerian Inter-Bank Foreign Exchange Fixing (NIFEX), an independent fixing of the interbank FX market, used for settlement.
The party that would have suffered a loss with the Spot FX rate will be paid a settlement amount in Naira. This ensures that both parties enjoy the rate that had been guaranteed to each other through the OTC FX Futures.
What Are the Components to an NDF?
- Notional – This is the face value of the NDF to be transacted
- Fixing Date – This is the date at which the difference between the prevailing Spot market exchange rate and the agreed upon NDF rate is calculated.
- Settlement Date – This is the date on which the payment of the difference between the NDF and spot rate is paid.
- Effective Date – This is the date when the NDF contract takes effect, usually the trade date.
- Maturity Date – This is the date the contract expires.
Uses of NDFs
- The demand for NDFs arises principally out of regulatory and liquidity issues in the underlying currency, where overseas players are essentially barred from access to the domestic market.
- They are typically utilised by banks, multinational corporations, investment managers, and proprietary traders to hedge currency risk.
- They are used in managing the currency risks associated with exporting or importing products purchased in foreign currency, investing or borrowing overseas, repatriating profits, or settling other FX contractual arrangements.
- They are also used as a tool to facilitate locking in the enhance yields of currencies.
Key Benefits of NDFs
- There are no up-front costs
- They provide protection against unfavourable foreign exchange rate movements between the time an NDF contract is executed and the maturity date
- They are flexible and the maturity date and contract amount can be tailored to meet specific requirements
- They help improve planning and capital budgeting as companies can make forecasts on budgets and investments with a greater degree of certainty
- They improve management of foreign exchange risk as companies can hedge against cash flow shortfalls
- They increase predictability of financial results as hedging enables companies deliver more predictable earnings by aligning their corporate hedging strategy to future FX cash flows in order to reduce the impact of currency volatility
- They serve as hedging tools for foreign investors with local currency exposure, allowing corporates and other investors hedge or take investment positions offshore on local currency movements without actually dealing in the underlying.
Risks associated with NDFs
- They are not perfect hedges against exposures, as any benefit of a favourable exchange rate movement, between the time the NDF is executed and the maturity date, may be foregone
- There is some exposure to counterparty and credit risks. In the event that a party to the contract is unable to perform their obligations under the NDF contract, the other party may be exposed to market exchange rate fluctuations as if the NDF contract was not executed
- There are charges for any cancellations or adjustments to the contract
- There is potential for limited liquidity in this specialised product
An NDF is indeed a useful risk management tool used to hedge currency fluctuations and should ideally be used where you have a genuine commercial need to manage currency risk associated with a particular currency pair and not for speculative purposes.
Disclaimer
Content on this site, including news, quotes, data and other information, is sourced by PageOne.ng from official and public sources and other third party content providers for your personal information only, and is not intended for trading purposes. Content on this site is not appropriate for the purposes of making a decision to carry out a transaction or trade. Nor does it provide any form of advice (investment, tax, legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments or products.
