Amity Institute of Advanced Legal Studies

Amity University Uttar Pradesh

Subject: Business Law – I (Contracts in General)

Topic of Assignment:

Non Deliverable Forward Contracts

Submitted to:
Dr. Sachin Rastogi

Submitted By:
Ryan Sinha
LLM (Business Laws)
Enrolment No. A0319321059
Batch: 2021-22
 TABLE OF CONTENTS

INTRODUCTION....................................................................................................................3

WHAT IS A FORWARD CONTRACT?..............................................................................4

FORWARD CONTRACTS VS. FUTURES CONTRACTS................................................................4

WHAT ARE THE VARIOUS TYPES OF FORWARD CONTRACTS?...............................................4

Window Forwards..............................................................................................................4

Long-Dated Forwards.......................................................................................................5

Non-Deliverable Forwards (NDFs)...................................................................................5

Flexible Forward...............................................................................................................6

Closed Outright Forward..................................................................................................6

Fixed Date Forward Contracts..........................................................................................7

Option Forward Contract..................................................................................................7

NON DELIVERABLE FORWARD CONTRACTS (NDF).................................................7

STRUCTURE AND FEATURES...................................................................................................8

USES OF AN NDF....................................................................................................................9

1. Synthetic Foreign Currency Loans............................................................................9

2. Arbitrage Opportunity...............................................................................................9

3. There are no sources in the current document.Speculation....................................10

CONCLUSION.......................................................................................................................10

REFERENCES.......................................................................................................................12
ABSTRACT

The paper focuses on the concepts of Forward Contracts and delves specifically into the
paradigm concerning Non-Deliverable Forward Contracts (NDF). An NDF contract has
become one of the most common place practices in the financial world. With the help of
revisiting some important basic features of an NDF the paper aims to highlight the reason
why an NDF has soared into such popularity and why it has assumed such an important status
in the current financial as well as fiscal scenario.

INTRODUCTION

Forward contracts have become a standardized practice in today’s financial scenario. The
reason for their increasing popularity is the lack of standardization of practice and regulations
to curtail or delimit the contract in any manner. Forward contracts today have assumed more
significance due to dynamism of trade and the paradigm shift in trading perspective.

The earliest trade practices involved barter and therefore strictly in terms of contract it was a
veritable like-for-like exchange. However, as business and commerce flourished means of
trade and their objectives too have undergone significant changes. In a barter, the most
important thing is value. Incidentally, value or consideration is one of the most essential
elements of a valid contract. Thus, a barter or an exchange would generally mean exchange
of commodities of same or higher value, which would become a valid consideration unto
itself. As trade grew more and more complex, this system started revealing its many obvious
flaws.

The complexity of trade brought with it a complexity of transactions along with a diverse
range of commodities. This created hassles in correctly estimating price or putting a value
value on the commodity for the purpose of contract and/or trade. The resulting effect was loss
born to either party. Therefore, it was inevitable that commercial practice would continue to
grow with the sole objective of maintaining a parity of value of the consideration and the
mitigation of losses, prospective or future. Current day trends in business and commerce have
ensued a rise in practices whereby contracting parties can fixate a particular value today for a
sale tomorrow. This simply means the modalities as to price and quantities of sale are
contracted at a present day for a sale that has to happen in future. This is done in order to curb
the losses resulting from market volatilities and protect financial interest of the parties. Such
a contract is known as a Future Contract.

WHAT IS A FORWARD CONTRACT?

A forward contract is a type of derivative instrument. This is an agreement between two

investing parties wherein the parties agree to buy or sell an underlying asset or security at a
future date at an agreed rate in the agreed quantity. These contracts trade OTC (over the
counter), and thus they do not face many regulations and are not standardized.

Traders primarily use forward contracts to protect themselves from the volatility in the
currency and commodity markets. However, forward contracts can involve other assets as
well, including equity, treasury, real estate, and more. Forward contracts are useful as a
hedging instrument. However, it is also used by investors for speculation purposes to earn
profits from the movement of the security prices.

Forward Contracts vs. Futures Contracts

Both forward and futures contracts involve the agreement to buy or sell a commodity at a set
price in the future. But there are slight differences between the two. While a forward contract
does not trade on an exchange, a futures contract does.1

Settlement for the forward contract takes place at the end of the contract, while the futures
contract settles on a daily basis. Most importantly, futures contracts exist as standardized
contracts that are not customized between counterparties.

What Are the Various types of Forward Contracts?

Since currencies account for the bulk of forward contracts, most types of forward contracts
are specific to currencies. Following are the types of forward contracts:2

WINDOW FORWARDS

1
Ma, Guonan; Ho Corrinne; McCauley, Robert N., The Markets for Non-Deliverable Forwards in Asian
Currencies, BIS Quarterly Review (2004).
2
Types of Forward Contracts – All You Need to Know, eFinance Blog (2020) accesed at:
https://efinancemanagement.com/derivatives/types-of-forward-contracts.
Such forward contracts allow investors to buy the currencies within a range of settlement
dates. Basically, such contracts allow investors to get a more favorable and convenient
exchange rate than what they would get by using a standard forward contract.

For example, X is supposed to make a settlement with his overseas supplier after two months.
However, the date is not fixed. Therefore, X may opt for a window forward contract where he
can trade on any day from 1st to 30th of the upcoming 3rd month but not later than 30th.

LONG-DATED FORWARDS

As the name suggests, the settlement period of such contracts is much more than the usual
forward contracts. A standard forward contract usually has an expiry date of up to 12 months.
In contrast, long-dated forwards can have a maturity date of up to 10 yrs. Except for a longer
settlement date, all other features of long-dated forwards are the same as standard forward
contracts.

NON-DELIVERABLE FORWARDS (NDFS)

Such types of forward contracts are very different from standard forward contracts. As in
such contracts, physical delivery of the security/asset of funds does not take place. Rather, at
the time of the settlement, the parties just exchange the difference amount. The difference
amount is on the basis of the contract rate and the market rate at the time of the settlement.
Generally, investors who do not have enough funds or do not want to commit funds or block
huge funds, go for such types of forward contracts.3

Suppose, M/s XYZ Ltd. will receive Rs. 1 crore after 2 months for a sale made in the current
month. It goes to a bank in order to enter into a forward contract of selling its one crore
rupees after 2 months at a rate of INR 4 for $1.

Now, there are 2 possibilities:

Case 1: After 2 months, $1 = Rs. 3.7, or

Case 2: After 2 months, $1 = Rs. 4.25.

3
Asian Non-Deliverable Forward (NDF), Managing FX Exposures Against Non-Convertible Currencies, UOB
Blog, United Overseas Bank Limited, Singapore (2020), accessed at:
https://www.uob.com.sg/corporate/corporate-banking/treasury/asian-non-deliverable-forward.page
XYZ Ltd. would receive $250,000 for sure because of entering into an NDF contract.

In case 1, amount to be received by XYZ Ltd. = $270,270 (Rs.1,00,00,000 / 3.7). Here, the
spot price turns favorable for XYZ Ltd. Now the bank will pay the difference of spot rate and
forward rate to XYZ Ltd. which is $20,270 (i.e., 270,270 – 250,000).

In case 2, amount to be received = $235,294 (Rs.1,00,00,000/ 4.25) which is less than

$250,000. Here, spot price is unfavorable for XYZ Ltd. Now the difference paid by the bank
is $14,706 (i.e., 250,000 – 235,294).

In case 2, amount to be received = $235,294 (Rs.1,00,00,000 / 4.25) which is less than

$250,000. Here, spot price is unfavorable for XYZ Inc. Now the difference paid by the bank
is $14,706 (i.e., 250,000 – 235,294).

FLEXIBLE FORWARD

Such type of forward contract gives investors flexibility in exchanging the funds. Or, we can
say that investors using such a contract have an option to exchange the funds prior to the
settlement date.4 Using this contact, parties can either exchange the funds outright or choose
to make several payments prior to the settlement date.

Assume that Mr. X imports goods in India worth $500,000 from a US-based exporter. Being
aware of exchange rate fluctuation, he enters into a flexible forward contract. This will help
him to make payments at different points of time during the period of the contract, whenever
the exchange rates are favorable to him.

CLOSED OUTRIGHT FORWARD

This is the simplest type of forward contract. We can also call such forward contracts as
European contracts or Standard Forward Contracts. Such types of contracts allows to
investors to exchange the underlying asset at a specific future date.

Say, for example, you have entered into a trade with a foreign exporter. And, the date of
payment is the 24th of next month. You can lock in the exchange rate by entering into a
closed outright forward contract for the 24th of next month.

4
Dhir, Rajiv, reviewed by Scott, Gordon, Understand Forward Contracts: Types of Forward Contracts, (2021)
accessed at: https://www.investopedia.com/terms/f/forwardcontract.asp
FIXED DATE FORWARD CONTRACTS

In this type of forward contract, the parties exchange the underlying asset only at specific
maturity date. Or, we can say, such contracts have a fixed maturity date. Most forward
contracts are fixed-date forward contracts only.5

OPTION FORWARD CONTRACT

These types of forward contracts are similar to flexible forward contracts. An option forward
contract allows parties to exchange the underlying security on any date during a specific
period.

NON DELIVERABLE FORWARD CONTRACTS (NDF)

In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in

which counterparties settle the difference between the contracted NDF price or rate and the
prevailing spot price or rate on an agreed notional amount. It is used in various markets such
as foreign exchange and commodities. NDFs are also known as forward contracts for
differences (FCD).6 NDFs are prevalent in some countries where forward FX trading has
been banned by the government (usually as a means to prevent exchange rate volatility).

The NDF market is an over-the-counter market. NDFs began to trade actively in the 1990s.
NDF markets developed for emerging markets with capital controls, where the currencies
could not be delivered offshore. Most NDFs are cash-settled in US dollars (USD).7

The more active banks quote NDFs from between one month to one year, although some
would quote up to two years upon request. The most commonly traded NDF tenors are IMM
dates, but banks also offer odd-dated NDFs. NDFs are typically quoted with the USD as the
reference currency, and the settlement amount is also in USD

5
Handbook on Currency Dealing and Financial Derivative Contracts, Chapter 28 – Forward Contracts, Risk
Management Policy Forward Contracts, Union bank of India, pp. 4-10 (2018).
6
Shaik, Khader, Managing Derivatives Contracts: A Guide to Derivatives Market Structure, Contract Life
Cycle, Operations, and Systems, pp 48-, Apress (2014)
7
Lipscomb, Laura, An Overview of Non-Deliverable Foreign Exchange Foreign Markets, Federal Reserve Bank
of New York (2005).
Structure and Features

An NDF is a short-term, cash-settled currency forward between two counterparties. On the

contracted settlement date, the profit or loss is adjusted between the two counterparties based
on the difference between the contracted NDF rate and the prevailing spot rates on an agreed
notional amount.8

The features of an NDF include:

 Notional Amount: This 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 notional amounts in the two currencies

 Fixing Date: This is the day and time whereby the comparison between the NDF rate
and the prevailing spot rate is made. This is essentially 2 days before the settlement
day.

 Settlement Date (or Delivery Date): This is the day when the difference is paid or
received. It is usually one or two business days after the fixing date.

 Contracted NDF Rate: the rate agreed on the transaction date, and is essentially the
outright forward rate of the currencies dealt.

 Prevailing Spot Rate (or Fixing Spot Rate): the rate on the fixing date usually
provided by the central bank, and commonly calculated by calling a number of dealers
in the market for a quote at a specified time of day, and taking the average. The exact
method of determining the fixing rate is agreed when a trade is initiated.

Because an NDF is a cash-settled instrument, the notional amount is never exchanged. 9 The
only exchange of cash flows is the difference between the NDF rate and the prevailing spot
market rate—that is determined on the fixing date and exchanged on the settlement date.

8
Ganti, Akhilesh, reviewed by Boyle, Michael J., Understanding Non Deliverable Forward Contracts (2021),
accessed at: https://www.investopedia.com/terms/n/ndf.asp
9
Roy, Anup, Indian Banks Start Tradeing in Non-Deliverable Forward Markets for the First Time, Business
Standard (2020), accessed at: https://www.business-standard.com/article/finance/indian-banks-can-trade-in-non-
deliverable-forward-markets-for-first-time-120060101623_1.html
Consequently, since NDF is a "non-cash", off-balance-sheet item and since the principal
sums do not move, NDF bears much lower counter-party risk. 10 NDFs are committed short-
term instruments since both parties are committed and are obliged to honor the deal.
Nevertheless, either counterparty can cancel an existing contract by entering into another
offsetting deal at the prevailing market rate.

Uses of an NDF

1. SYNTHETIC FOREIGN CURRENCY LOANS

NDFs can be used to create a foreign currency loan in a currency, which may not be of
interest to the lender.11

For example, the borrower wants dollars but wants to make repayments in rupees. So, the
borrower receives a dollar sum and repayments will still be calculated in dollars, but payment
will be made in rupees, using the current exchange rate at time of repayment.

The lender wants to lend dollars and receive repayments in dollars. So, at the same time as
disbursing the dollar sum to the borrower, the lender enters into a non-deliverable forward
agreement with a counterparty that matches the cash flows from the foreign currency
repayments.

Effectively, the borrower has a synthetic Indian rupee loan; the lender has a synthetic dollar
loan; and the counterparty has an NDF contract with the lender.

2. ARBITRAGE OPPORTUNITY

Under certain circumstances, the rates achievable using synthetic foreign currency lending
may be lower than borrowing in the foreign currency directly, implying that there is a
possibility for arbitrage.12 Although this is theoretically identical to a second currency loan

10
Misra, Sangita; Behera, Harendra, Non Deliverable Foreign Exchange Forward Market: An Overview, 27 (3)
Reserve Bank of India Occasional Papers (2006).
11
Credit Suisse, Emerging Markets Currency Guide, Swiss Edition, pp. 14-39, Credit Suisse Standard
Publication (2013) accessed at: https://www.credit-
suisse.com/media/production/pb/docs/unternehmen/kmugrossunternehmen/en/em-currency-handbook-2013.pdf
12
Williams, Brad & Schelsnazki, Hubert, Currency Inflexion, volatility and adjustment in Future Contracts for
Arbitrage, HSBC (2018), accessed at: https://www.research.hsbc.com/midas/Res/RDV?
p=pdf&key=3UGWxKwFIE&n=286681.PDF
(with settlement in dollars), the borrower may face basis risk: the possibility that a difference
arises between the swap market's exchange rate and the exchange rate on the home market.
The lender also bears counterparty risk.

The borrower could, in theory, enter into NDF contracts directly and borrow in dollars
separately and achieve the same result. NDF counterparties, however, may prefer to work
with a limited range of entities (such as those with a minimum credit rating).

There are no sources in the current document

3. SPECULATION

It is estimated that between 60 and 80 per cent of NDF trading is speculative. 13 The main
difference between the outright forward deals and the non-deliverable forwards is that the
settlement is made in dollars since the dealer or counterparty can not settle in the alternative
currency of the deal.

CONCLUSION

The market for forward contracts is huge since many of the world’s biggest corporations use
it to hedge currency and interest rate risks. However, since the details of forward contracts
are restricted to the buyer and seller—and are not known to the general public—the size of
this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean that it may be
susceptible to a cascading series of defaults in the worst-case scenario. While banks and
financial corporations mitigate this risk by being very careful in their choice of counterparty,
the possibility of large-scale default does exist.

Another risk that arises from the non-standard nature of forward contracts is that they are
only settled on the settlement date and are not marked-to-market like futures. What if the
forward rate specified in the contract diverges widely from the spot rate at the time of
settlement?

13
Morgenthau, Karli, Ramifications of NDF Trading, Speculation and Forward Markets Phenomemnon,
accessed at:
https://www.morganstanleyclientserv.com/products_services/other_investments/foreign_exchange/fxcurrencies.
html (2009).
In this case, the financial institution that originated the forward contract is exposed to a
greater degree of risk in the event of default or non-settlement by the client than if the
contract were marked-to-market regularly. Given the current scenario, parties must be wary
of the market volatility. There exist various types of forward contracts that investors have at
their disposal. Thus, they must select one or more forward contracts depending on their
position, risk appetite, as well as the current market scenario.
 REFERENCES

HANDBOOKS

Credit Suisse, Emerging Markets Currency Guide, Swiss Edition, pp. 14-39, Credit Suisse
Standard Publication (2013) accessed at: https://www.credit-
suisse.com/media/production/pb/docs/unternehmen/kmugrossunternehmen/en/em-
currency-handbook-2013.pdf-------------------------------------------------------------------------8

Handbook on Currency Dealing and Financial Derivative Contracts, Chapter 28 – Forward

Contracts, Risk Management Policy Forward Contracts, Union bank of India, pp. 4-10
(2018).---------------------------------------------------------------------------------------------------6

ARTICLES AND BLOGS

Lipscomb, Laura, An Overview of Non-Deliverable Foreign Exchange Foreign Markets,

Federal Reserve Bank of New York (2005).-------------------------------------------------------6

Morgenthau, Karli, Ramifications of NDF Trading, Speculation and Forward Markets

Phenomemnon, accessed at:
https://www.morganstanleyclientserv.com/products_services/other_investments/foreign_ex
change/fxcurrencies.html (2009).--------------------------------------------------------------------9

Roy, Anup, Indian Banks Start Tradeing in Non-Deliverable Forward Markets for the First
Time, Business Standard (2020), accessed at: https://www.business-
standard.com/article/finance/indian-banks-can-trade-in-non-deliverable-forward-markets-
for-first-time-120060101623_1.html----------------------------------------------------------------7

Types of Forward Contracts – All You Need to Know, eFinance Blog (2020) accesed at:
https://efinancemanagement.com/derivatives/types-of-forward-contracts.--------------------3

Williams, Brad & Schelsnazki, Hubert, Currency Inflexion, volatility and adjustment in
Future Contracts for Arbitrage, HSBC (2018), accessed at:
https://www.research.hsbc.com/midas/Res/RDV?
p=pdf&key=3UGWxKwFIE&n=286681.PDF----------------------------------------------------9

ONLINE RESOURCES
Asian Non-Deliverable Forward (NDF), Managing FX Exposures Against Non-Convertible
Currencies, UOB Blog, United Overseas Bank Limited, Singapore (2020), accessed at:
https://www.uob.com.sg/corporate/corporate-banking/treasury/asian-non-deliverable-
forward.page--------------------------------------------------------------------------------------------4

Dhir, Rajiv, reviewed by Scott, Gordon, Understand Forward Contracts: Types of Forward
Contracts, (2021) accessed at: https://www.investopedia.com/terms/f/forwardcontract.asp 5

Ganti, Akhilesh, reviewed by Boyle, Michael J., Understanding Non Deliverable Forward
Contracts (2021), accessed at: https://www.investopedia.com/terms/n/ndf.asp---------------7

BOOKS AND JOURNALS

Ma, Guonan; Ho Corrinne; McCauley, Robert N., The Markets for Non-Deliverable
Forwards in Asian Currencies, BIS Quarterly Review (2004).---------------------------------3

Misra, Sangita; Behera, Harendra, Non Deliverable Foreign Exchange Forward Market: An
Overview, 27 (3) Reserve Bank of India Occasional Papers (2006).---------------------------8

Shaik, Khader, Managing Derivatives Contracts: A Guide to Derivatives Market Structure,

Contract Life Cycle, Operations, and Systems, pp 48-, Apress (2014)-------------------------6