Non-Deliverable Forwards - Are They Helpful in Mitigating Risks?
Non-deliverable forwards are one of the common practices to mitigate the risks associated with trading currencies or any other tradable security.
Financial markets are complicated and highly dependent on several factors, such as supply and demand, liquidity levels, technological developments, etc. These factors influence the trader’s strategy and how they shall approach the trading market.
In times of market uncertainty, traders seek risk-mitigating strategies, investing in low-volatility securities or other hedging tactics that minimise their losses. Also, each financial instrument responds differently to a given factor, whether it is liquidity, demand, developments, etc.
Non-deliverable forwards are one of the common practices to mitigate the risks associated with trading currencies or any other tradable security. This strategy allows investors to receive better trading conditions in the near future. How does it work? Let’s discuss.
Understanding NDF
Non-deliverable forwards are contracts between two parties that agree on a specific price and day to conduct a trade, whether in Forex, stocks, commodities or other markets at predetermined conditions. However, the twist here is that neither party transfers the subject product. Instead, NDFs entail receiving or paying the net difference between the prices of the security in question on the agreed date of exchange.
This way, traders can avoid fluctuations in the supply levels by focusing on the price difference, which mitigates the impact of market volatility. Conducting an NDF contract requires both parties to sign on the agreed product, date and price.
Unlike deliverable forwards (DFs) that require the transfer of principal product upon the exchange date, which can be problematic if the investor predicts a potential shortage in the market or if an unpredicted supply change occurs and the liquidity level drops.
NDF markets used to be limited, and a trader would find it difficult to locate a counterparty to agree and sign the NDF. Also, there were only a few providers and brokers working in this market. However, technological developments facilitated NDF trading and made it easier to access and conduct non-deliverable forwards.
NDF trading is becoming increasingly popular, and according to the Bank for International Settlements, these forwards account for over $200 billion in daily transaction value today.
NDF Regulations
Non-deliverable forwards are still unregulated in several regions, and some jurisdictions do not allow NDF trading because they are highly volatile and inconsistent. Therefore, most of these forwards are conducted over the counter, where both parties agree directly on the exchange of price mentioned in the agreement.
Moreover, due to some global restrictions and regulations, some currencies cannot be legally paired together, and Forex traders are usually restricted to a predetermined set of currency pairs. However, investors may find lucrative opportunities in pairing two distantly related currencies to net some significant gains.
Therefore, traders use the lenient regulations provided by offshore jurisdictions, which allow a degree of flexibility and financial freedom to conduct NDF transactions, exchanging various currencies and securities.
The growth of NDF allowed investors to explore an extended range of tradable securities that are not usually allowed in classic markets, enabling traders to mitigate risks and amplify their gains.
How NDFs Work in Risk Mitigation?
Non-deliverable forwards are usually conducted in the currency context, whether in Forex or cryptocurrencies, because they are one of the most fluctuating and complex markets.
The market volatility in the foreign exchange market and cryptos stems from the wide range of factors that affect the prices. For example, the most famous pair, EUR/USD, is highly affected by economic factors, geo-political factors, national economic factors in the US and commercial factors. Therefore, these markets are highly unpredictable, especially in times of war and uncertainty.
Therefore, traders engage in NDF agreements to minimise the influence of liquidity on the agreed currency pairs, focusing on netting the price difference between the two currencies between the agreement and exchange days.
Moreover, most Forex currency pairs involve the USD as the most popular and powerful currency in the world. However, with NDF, traders can pair up any two currencies without limitation, allowing them to explore opportunities that are not usually available in the classic market.
Final Thoughts
Non-deliverable forwards entail agreeing on a given date and price to conduct trade of a security. However, this exchange involves the price difference and does not involve transferring ownership of the subject security.
NDFs are over-the-counter transactions and are becoming increasingly popular, allowing traders to engage in a safer Forex environment, exchange various currencies, and mitigate volatility and liquidity risks.
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