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As part of our commitment to bring interesting and innovative opportunities to our clients Finalto offers NDF assets within our trading ecosystems. To understand how this exciting asset class fits into your strategy, Finalto sat down with its Head of Liquidity, Antony Parsons. In this interview we explore what NDFs are and why they and how they solve liquidity issues for less accessible currency pairs.
What is an NDF?
NDF stands for, ‘non-deliverable forward’. They are a type of forward contract used in foreign exchange markets. When trading an NDF, counterparties agree to settle the difference between the contracted NDF rate and the prevailing spot exchange rate on a specified future date. The key characteristic behind an NDF contract is that they are settled in cash rather than physical delivery of the underlying currency.
Why is it significant that NDFs are settled in cash?
Certain assets are more difficult to deliver than others. For example, EUR/USD is a very deliverable asset because it is easy to find liquidity in both the Euro and US Dollars. However, something like USD/BRL isn't as deliverable as it is harder to find liquidity for the Real. By using a cash deliverable contract this makes these otherwise inaccessible forex pairs much more viable additions to a portfolio. This same principle can be applied for lots of places that have currency controls, and NDFs can be used as a way of acting on or hedging any interesting but less liquid opportunities.
Is there an increasing demand for NDFs in the market right now? Where is that coming from?
In a broad sense, yes. More people are becoming interested in NDFs, but there is a caveat as in a lot of cases the demand can be increasingly made up of people hedging rather than looking to speculate on the currency. A big advantage for companies with foreign offices is that NDFs make it possible to hedge the exchange rate risk of an expansion. However, there will still be a good amount of demand for NDFs from those looking to speculate. Especially for NDFs, there can be quite a lot of volatility in these types of pairs so it can be an interesting addition to a well risk managed portfolio.
Is hedging the main use for NDFs? How would someone use NDFs to hedge against risk?
Hedging or speculation, it'd be one of the two.
For hedging, we can use the Brazilian Real as an example again. If there's a firm who has a Brazilian office, that firm will have to pay salaries in Brazilian to its local employees. Therefore, they are at least partly tied to the value of Brazilian currency in their operating cycle; to manage their exposure that more volatile currency, they can hedge the difference between another currency and Brazilian. Because an NDF is essentially a forward contract, it makes it much easier to hedge against the less available currency.
The same principle applies to speculation. You can go to Brazil and get Brazilian Real but outside of that economy it is much harder trying to access and trade that currency, because there's limited liquidity. That's where an NDF comes in and allows brokers and traders to speculate on these instruments without the need for a deliverable currency.
