In this article I have discussed the uses of non-deliverable forward.

Synthetic Foreign Currency Loans

A foreign currency loan can be created in a currency which may not be of interest to the lender and this can be done by using NDFs.

Here I explain you with example, there is a borrower who wants dollars but he is willing to make repayments in a second currency. So, a dollar sum will be received by the borrower and still the repayments will be calculated in dollars, but the borrower will make the payment in another currency using the current exchange rate at time of repayment.

The lender is willing to lend dollars and wants to receive repayments in dollars. So, while disbursing the dollar sum to the borrower,simultaneously the lender enters into a non-deliverable forward agreement with a counterparty (for example, on the Chicago market) that matches the cash flows from the foreign currency repayments.

Effectively, the borrower is having a (synthetic) second currency loan; while the lender is having a (synthetic) dollar loan; and the counterparty has got an NDF contract with the lender.

Under certain circumstances, the rates that are achieved by using synthetic foreign currency lending might be lower than the rates that a borrower get when he is borrowing in the foreign currency directly, if we imply that then there is a possibility for arbitrage. Although this is theoretically similar to a second currency loan (with settlement in dollars), basis risk may be faced by the borrower. The basis risk is the possibility that a difference might arises between the swap market’s exchange rate and the exchange rate on the home market. Counterparty risk is also faced by the lender.

In theory, the borrower is able to enter into NDF contracts directly and borrow in dollars separately and then also he will achieve the same result. However, NDF counterparties, might prefer to work with a limited range of entities such as those that are having a minimum credit rating.

Speculation

According to an estimate, between 60 to 80 per cent of NDF trading is speculative. Between the outright forward deals and the non-deliverable forwards the main difference is that the settlement is made in dollars as the dealer or counterparty can not settle in the alternative currency of the deal.

People who liked this Post also read

• Currency futures: History and Uses of Currency Futures
  A currency future, which is also referred to as FX future or foreign exchange future, is a futures contract. It is used to exchange one currency for another at a specified date in the future at a price (exchange rate) that is......
• Dollar gains; higher-yielding currencies lose shine
  On Friday the dollar rise, giving an extension to the previous day's gains as investors retreated from riskier assets, taking the shine off higher-yielding currencies such as the Australian dollar.Today Tokyo's Nikkei average fell 0.5% and after the U.S. ...
• What do you understand by Pip (Percentage in Point)?
  In finance, the smallest price change that a given exchange rate can make is referred to as percentage in point also known as pip or point. Since most major currency pairs are priced to four decimal places, so the smallest change is......
• Option Style: Exotic Options with Standard Exercise Styles
  These options provides an opportunity that they can either be exercised as European style or as American style; they differ from the plain vanilla option only in a way......
• Exchange Rates:What do you understand by Quotations in Exchange Rate System?
  A quotation of exchange system is given by stating the number of units of "term currency" (that is also known as "price currency" or "quote currency") that can be bought in terms of ......