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Hedging currency risk in markets with limited currency convertibility  
by Kong Yoon Kee

Currency fluctuations are an inevitable risk that companies and investors bear when they seek greater fortunes beyond their shores. Those that find their opportunities in emerging markets with limited currency convertibility face a further challenge: the absence of foreign exchange (FX) forward contracts as a hedging tool. Here is where Non-Deliverable Forwards (NDFs) become invaluable.

Like regular FX forward contracts, NDFs lock in a forward exchange rate, but they differ as there is no exchange of the two currencies at maturity. Instead an NDF contract is settled with cash in a predetermined convertible currency, typically the US dollar, when it matures. The settlement amount is derived from the difference between the contracted NDF rate and the prevailing spot rate at maturity, called the Fixing Rate. As there is no exchange of the principal amount in the two currencies, counter-party risk is reduced for NDF transactions.

NDF prices are provided by a number of major international and local banks, and are quoted for Asian currencies like the Chinese Renminbi (CNY), Malaysian Ringgit, Indonesian Rupiah, South Korean Won, Taiwan Dollar, Philippine Peso and Indian Rupees. Non-Asian NDF currencies include the Argentine Peso, Brazilian Real, Egyptian Pound and Russian Rouble.

NDFs are traded over the counter and quotations can be obtained from most major banks. Singapore is Asia’s NDF hub and handles a significant portion of hedging requirements for Asian currency NDFs from hedge funds, unit trusts, asset managers, importers and exporters. Besides hedging needs, speculative demand contributes significantly to the liquidity of the NDF market.

Prices for NDFs are available for maturity up to five or 10 years, but the more liquid markets tend to be those for one- to two-year maturities, depending on the currency. The bid-offer spread, the difference between the bank’s buying and selling price, tends to increase with the maturity period of the NDFs.  

How does an NDF work?
Let us take the example of a company, ABC, which imports textiles from Indonesia and is required to make a US dollar payment to its supplier in six months’ time, equivalent to 12 billion Indonesian Rupiah (IDR). The US dollar equivalent amount is based on the exchange rate prevailing on the due date. To hedge against a higher US dollar payment at the end of this period, arising from the IDR appreciating significantly, ABC contracts an NDF with a bank where it “buys” a principal of IDR 12 billion at a six-month NDF rate of US$1 = IDR 11,700. Based on this NDF rate, the equivalent US dollar amount is equal to US$1,025,641.

The contracted NDF rate of IDR 11,700 will be compared with the Fixing Rate at the end of six months. Depending on the value of the Fixing Rate, ABC will receive or pay the NDF Settlement Amount to the bank.

We analyse three scenarios of the Fixing Rate at the maturity of the NDF:

   Scenario 1  Scenario 2  Scenario 3
Fixing Rate: US$ 1 = IDR 11,000 US$ 1 = IDR 11, 700 US$ 1 = IDR 12,400
US$ amount payable to supplier# 12,000,000,000/11,000
= US$1,090,909
US$ 1,025,641 12,000,000,000/12,400
= US$967,742
NDF settlement amount* (12,000,000,000/11,000) - (12,000,000,000/11,700)
= US$65,268
US$ 0

(12,000,000,000/12,400) - (12,000,000,000/11,700)
= - US$57,899

Effective US$ amount payable US$1,090,909 - US$65,268
= US$1,025,641
US$1,025,641  US$967,742 + US$57,899
= US$1,025,641

# Assume that IDR can be purchased in the spot market at the Fixing Rate
* If positive, ABC will receive US$ from the bank, and will pay US$ to the bank if the NDF Settlement Amount is negative.

In Scenario 1, IDR has appreciated and the US dollar amount equivalent to IDR 12 billion that ABC needs to pay his supplier has increased. But from the NDF, ABC will receive a US$65,268 settlement. Combining the two, ABC effectively pays US$1,025,641.

In Scenario 3, IDR has depreciated and the US dollar amount equivalent to IDR 12 billion that ABC needs to pay his supplier has decreased. From the NDF, ABC will pay a US$57,899 settlement.  Combining the two, it effectively pays US$1,025,641.

In all three scenarios, ABC effectively pays US$1,025,641, which is the US dollar equivalent of IDR 12 billion, converted at the NDF rate of 11,700. The NDF has helped ABC lock in the amount of US dollars it needs to pay its supplier.

As most NDFs are settled in US dollars, and hence help a user lock in the amount of US dollars needed for conversion to or from the NDF currency, the user would still need to convert this amount of US dollars to his home currency. This conversion can be easily done via a US dollar FX forward contract to convert the “fixed” US dollar amount, locked in using NDF, into his home currency.

Future of NDF Markets
Looking ahead, China, which has taken initial steps in currency liberalisation, presents insights into how the NDF market may develop. In seeking to internationalise its currency and promote its use to settle international trades, the mainland has approved selected banks in Hong Kong, Taiwan and Singapore as clearing institutions for offshore Renminbi (CNH). This has led to rapid growth of an offshore deliverable forwards market over the past few years. There has been a significant shift out of CNY NDFs to CNH forwards, which allow for actual delivery of offshore Renminbi. Non-Chinese individuals and corporations can now have ready access to Renminbi deposits, CNH-denominated bonds, called dim-sum bonds, and gain exposure to its exchange rate movements.

Beyond China, other emerging markets are likely to relax currency controls progressively as their economies mature. This may lead to further development of onshore currency markets. Trading is expected to shift towards onshore FX forwards markets as ease of access and liquidity improves. Central banks in emerging countries may encourage greater migration towards onshore market transactions as they are more readily subjected to their governance. Over time, there will be greater convergence of onshore FX forwards and offshore NDF markets as their differences decrease with currency liberalisation. When there is complete removal of currency controls, NDF markets will no longer be needed. 

However, the liberalisation of capital and currency controls for many emerging economies is expected to take a long time, as there are still lingering concerns over the disruptive effects of speculative capital flows in and out of their economies. NDFs are thus likely to remain a very important hedging tool for many years to come.

About the author
Dr Kong is a senior lecturer of banking and finance at NTU’s Nanyang Business School.

Published in The Business Times on 3 June 2014. This is part of an ongoing series View from an NTU professor.

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