Non-deliverable forwards are used to hedge or speculate against currencies when exchange controls make it difficult for foreigners to trade in the spot market directly.
The idea is the same as a regular foreign exchange forward - an investor or company wants to lock in an exchange rate for a certain period in the future.
The contracts are called "non-deliverable" though, since no exchange of the underlying currency takes place. Instead the whole deal is settled in a widely traded currency, normally U.S. dollars.
WHO USES THEM
- Investors who buy assets in emerging markets use them to hedge the currency risks posed by their investments.
- Multinational companies operating in markets with exchange controls to mitigate the risk of swings in the currency rate hitting their bottom line.
- Banks and hedge funds to take speculative positions.
WHY THE FIXING MATTERS
Whether someone makes or loses money on an NDF trade hinges on the fixing.
NDFs in some currencies, most notably the Chinese yuan, are fixed against a daily rate published by the relevent central bank.
In Southeast Asia however, NDFs in the Malaysian ringgit, Indonesian rupiah and Vietnamese dong are fixed against rates published by the Association of Banks in Singapore (ABS).
The ABS, via its agent Thomson Reuters, polls a panel of banks on their estimate of the exchange rate for each currency every day at 11 a.m. The top and bottom quarter of estimates are taken out, and then the fixing is the average of the remaining estimates.
Removing the top and bottom set of estimates is meant to guard against banks submitting rates that benefit their trading books. The concern of regulators however, is that if traders collude with each other, they can try to move the fixing in their favour to benefit their trading book and away from an accurate market rate.
Copyright @ Thomson Reuters 2013
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