Non-Deliverable Forward
What Is A Non-Deliverable Forward?
A non-deliverable forward (NDF) is a contract to buy or sell a specific currency at a specified price in which the settlement of the contract at expiration doesn't involve the physical delivery of the currency, hence the name.
In general, NDFs are used to hedge or speculate in local currencies in emerging markets where the currency has low liquidity, is not freely convertible, or where there are restrictions on capital flows. Most commonly, they involve currencies of Latin American, Asian, and East European countries. NDF activity generally recedes as a currency evolves into full convertibility.
NDF transactions are handled offshore and outside the country whose currency is being traded. They also occur at an international financial center, such as New York, London and Singapore. The market is over-the-counter rather than being an exchange-traded market.
NDFs are usually settled in U.S. dollars or another freely convertible currency, such as the euro, the Japanese yen, or the British pound, while the other currency is "non-deliverable." The two parties in the transaction agree to settle at the difference between the exchange rate listed in the contract and the prevailing spot rate, with one party paying the difference to the other.
NDFs became commonly used by multinational corporations in the 1990s to hedge their risk in currency fluctuations. Now most of the activity is from hedge funds, traders, and investors to speculate on the value and direction of currencies. As a result, this type of trading tends to be volatile.
NDFs are not limited to non-convertible or illiquid currencies. They can be also used by parties looking to hedge or speculate in a particular asset but are not interested in taking delivery of it.
Summary
A non-deliverable forward (NDF) is a contract to buy or sell a specific currency at a specified price in which the settlement of the contract at expiration doesn't involve the physical delivery of the currency. NDFs are most often used to hedge or speculate in illiquid or nonconvertible currencies.
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