Non Deliverable Forwards

Indian Rupee is once again on a downward spiral; while oil importers' dollar demand is one key factor, what has been adding to rupee volatility is the offshore rupee market.  Popularly known as NDF (non deliverable forward) market , has been gaining volume and momentum over the last few years and a major price determinant of USD / INR.  This week's market talk is an attempt  at  exploring the how, why and what of NDF market.

NDF is an instrument to hedge foreign currencies which are not traded internationally and which do not have forward markets outside their countries.  This instrument only trades outside the country of the currency. NDF is typically a short term, cash settled, currency forwards between two counterparties. On the contracted settlement date, the profit or loss is settled  between the two, based on the difference between the contracted rate and a fixing (benchmark) rate. Fixing rate for rupee is RBI reference rate.  As the name suggests, there is no physical delivery of currencies and profit / loss is cash settled. NDFs are quoted from one month to one year.

NDF evolved as a result of restrictions in local forward markets.  It was mainly used to hedge currencies which could not be delivered offshore or unhedgeable in the corresponding countries.  Rupee is not fully convertible, there are capital restrictions and NDF market helps circumvent the issue.

Some of the Asian currencies which have active NDF markets are: Chinese Renminbi, Indian Rupee, South Korean Won, Malaysian Ringgit and Indonesian Rupiah. The main trading locations for NDFs are Singapore, Hongkong, Korea, Taiwan, New York, London and Tokyo.  

Offshore forward market now serves more as a platform to speculate and take advantage of arbitrage that exists between onshore and offshore currency forwards.  Offshore INR market is trading 24 * 7 moving from one financial center to another and reflects the views of international investors / speculators. Also as Indian market is not fully evolved  (due to capital restrictions), there are interest arbitrage and currency arbitrage that exists from time to time.  For instance, an Indian company which borrows in US Dollar (USD) and hedges forward may have an all-in borrowing cost that is lower than if it borrowed in rupees as rupee forwards is not function of interest differential between USD and  INR. 

This arbitrage opportunities exist between offshore (NDF) and onshore rupee forwards.  Many Indian companies with operations overseas, take advantage of this arbitrage by simultaneously entering in forward contracts onshore and offshore.  For instance if one month forward rate is 51.10 in India and the same is 51.20 in offshore NDF market, the offshore arm of the Indian company simply sells and the onshore (India) parent contracts to buy, making a neat 10 paise risk free profit.  On the settlement date, wherever the fixing rate is, this 10 paise (per dollar) profit is assured.  The more number of time this deal is churned, the more profitable it gets.  This has pushed up the volume of NDFs considerably.   

While the arbitragers come in only when there is a window of opportunity, speculators take more risk based on their view.  If global investors have a weak outlook of rupee, they sell the currency in the offshore market , arbitragers close the difference between offshore and onshore rupee exchange rate; this moves the rupee onshore (India) to reflect the view of global investors.  This in itself is not bad.  However an Indian entity with an actual exposure to currency risk, can do nothing about overnight rupee swings offshore and in a trending market it could prove detrimental as the currency may open with a huge gap the next morning in India.  

So NDF market has largely been determining the direction of rupee and rupee is now globally traded currency albeit non deliverable.  Why not open up the market and make it more efficient?