At the time of expiry of a non-deliverable forward (NDF) forex contract, the parties involved in the agreement settle the difference between the agreed-upon NDF rate and the prevailing spot rate at the time of expiry. This settlement is made in the currency of the NDF contract.
NDF contracts are commonly used by companies and investors to hedge against currency risks in emerging markets. They are similar to forward contracts, but instead of delivering the currency at the end of the contract, the settlement is made in the form of a cash payment. This makes NDFs particularly useful in countries with strict currency controls or where it is difficult to obtain the local currency.
The settlement of an NDF contract at expiry can take one of two forms: physical settlement or cash settlement. In physical settlement, the buyer of the NDF contract delivers the agreed-upon amount of the foreign currency to the seller at the NDF rate. In cash settlement, the difference between the NDF rate and the prevailing spot rate is calculated, and the party with the net loss pays the other party in the currency of the NDF contract.
For example, if a company enters into an NDF contract to buy 10 million Indian rupees in six months at an NDF rate of 75 rupees to the US dollar, and the prevailing spot rate at expiry is 73 rupees to the US dollar, the company would receive a cash payment from the seller of the NDF contract equal to the difference between the NDF rate and the spot rate (2 rupees per US dollar in this case) multiplied by the 10 million rupees contracted. If, on the other hand, the prevailing spot rate is 77 rupees to the US dollar, the company would be required to make a payment to the seller of the NDF contract.
The settlement of an NDF contract at expiry can have important implications for the parties involved. For buyers of NDF contracts, a cash settlement at expiry can result in a loss if the prevailing spot rate is unfavorable. This loss can be offset by gains made in the underlying business operations that the NDF contract was intended to hedge against. For sellers of NDF contracts, a cash settlement at expiry can result in a gain if the prevailing spot rate is favorable, but this gain may be offset by losses in the underlying business operations.
In addition to the settlement of NDF contracts at expiry, there are other factors that can affect the value of these contracts. These include changes in interest rates, political developments, and economic indicators in the countries covered by the NDF contract. It is important for investors and companies to closely monitor these factors and adjust their hedging strategies accordingly.
In conclusion, the settlement of NDF contracts at expiry involves the calculation of the difference between the agreed-upon NDF rate and the prevailing spot rate, and the payment of this difference in the currency of the NDF contract. This settlement can take the form of physical or cash settlement, and can have important implications for the parties involved. NDF contracts remain an important tool for managing currency risks in emerging markets, but their value can be affected by a variety of external factors.
