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Yuan NDF |
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With the tight trading band imposed by the Chinese government, the only way for corporations to hedge and traders to speculate on the future direction of the Yuan is through non-deliverable forwards (NDF). NDFs are over the counter foreign exchange derivative products that are cash settled based upon the difference between the agreed forward exchange rate and the subsequently realized spot |
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fixing in a convertible currency (typically the US dollar) and not the underlying currency (in this case, the Yuan). The NDF market offers an alternative hedging tool for foreign investors with local currency exposure or a speculative instrument for them to take positions offshore in the local currency. The use of Asian NDF markets by nonresidents in part reflects restrictions on their access to domestic forward markets. |
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Critical Role of Yuan NDF |
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The Yuan (Renminbi) trades on the over the counter (OTC) markets, where dealers provide bid and offers for the contracts. The contract size is on average, 5-10 million Yuan with typical expiration of 3 months to 1 year. Unlike regular forwards where final delivery of the underlying currency takes place, the difference between original and settlement price are settled in dollars or another agreed upon currency. The type of non-deliverable settlement is similar to cash settlement in futures markets, where participants settle in cash the difference in value when the contract expires. |
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The Yuan NDF works by applying premium/discount of the present exchange rate into the future to reflect the present market consensus of what the future exchange rates will be at certain point in time. Example: current USD/CNY is fixed at 8.3; the six-month and one-year forwards are pricing the possible six-month rate at 7.9 and one-year rate at 7.3, implying that the current consensus is for the Yuan exchange rates to appreciate against the dollar within a year. It also reflects the market's expectation that China would move to a less rigid exchange rate regime over the next 12 months. |
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Speculation and Hedging |
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The Yuan NDF is playing a critical role in foreign exchange market, as it is used for both speculation and hedging purposes. Typically in a controlled market environment where one currency is fixed against another, as in the case of the USD/CNY peg, market participants will find a way to price the currency as if it has free-floating exchange rate mechanism. In this case, NDFs are used to approximate a true market value of the pegged Yuan or for that matter any |
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other pegged or fixedexchange rate currency. Speculators use these OTC derivatives to speculate on the possible future exchange rates fluctuations when the currency pegs will be lifted. Hedgers, such as large multinationals and import-export related businesses, use the NDF to hedge their exposure to future potential liabilities in case of hyperinflation, default or any other potential financial disasters that can occur within an emerging economy. |
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The Basics: Currency forwards |
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NDF Non-deliverable Forwards |
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A forward contract is an agreement for foreign exchange transaction of a fixed amount of a foreign currency at a fixed exchange rate and time. In the inter-bank market, the contract amount is usually a multiple of one million US$. The common contract terms are one week, one month, two months, three months, and six months. In the retail market (between banks and customers), the contract specification (the maturity date and transaction amount) depends on the customer's needs. |
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An NDF is a short-term committed forward 'cash settlement' currency derivative instrument. It is essentially an outright (forward) FX contract whereby on the contracted settlement date, profit or loss is adjusted between the two counterparties basing on the difference between the contracted NDF rate and the prevailing spot FX rates on an agreed notional amount. |
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The NDF rate |
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Specific Notional Sum |
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This is the rate agreed between the two counterparties on the transaction date. This is essentially the outright (or forward) rate of the currencies dealt. |
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The notional amount is the 'face value' of the NDF, which is agreed between the two counterparties. It should again be noted that there is never any intention to exchange the two currencies' principal sums; the only movement is the difference between the NDF rate and the prevailing spot market rate and this amount is settled on the settlement date. |
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Fixing and Settlement Date |
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Every NDF has a fixing date and a settlement (delivery) date. The fixing date is the day and time whereby the comparison between the NDF rate and the prevailing spot rate is made. The settlement date is the day whereby the difference is paid or received. Depending on the currencies dealt, there are variations whereby for some currencies, the fixing date |
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is one good business day before the settlement date and for other currencies, the fixing date is two good business days before the settlement date. Generally, the fixing of spot rate is based on a reference page on Reuters or Telerate with a fallback of calling four leading dealers in the relevant market for a quote. |
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Product Features |
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As it is a 'cash-settlement' instrument, there is no movement of the principal amounts of the two currencies contracted. The only movement is the settlement amount representing the difference between the contracted NDF rate and prevailing spot rate. Hence NDFs are 'non-cash' products that are off-the-balance-sheet and as the principal sums do not move, possess very much lower counterparty risks.
NDFs are committed short-term instruments. Both the counterparties are committed and are obliged to honor the deal. |
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Of course, the user can cancel an existing contract by entering into another offsetting deal at the prevailing market rate. The more active banks quote NDFs from between one month to one year, although some would quote up to two years upon request. Apart from the standard tenors (1, 2 and 3 months) banks also offer odd-dated NDFs. It should also be noted that NDFs are quoted with the USD as the reference currency, which is they are quoted in terms of USD against other third currencies and the settlement amount is also in USD. |
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