Non-deliverable forward (NDF)

Non-deliverable forward (NDF)

Subject: Economy

Context:

The Reserve Bank of India is asking local banks to not build additional positions in the non-deliverable forward (NDF) market to arrest the rupee’s slide

Details:

• In addition to the traditional instruments like forward and swap contracts, the Reserve Bank has facilitated increased availability of derivative instruments in the foreign exchange market.
• RBI allowed banks operating from the International Financial Services Centre Banking Units to trade in the NDF segment in June 2020 to have more control over rupee exchange rate.
  • The rupee’s decline in recent days has led to arbitrage opportunities between the onshore and offshore rates–The dollar-rupee NDF 1-month rate is 7 paisa higher than the corresponding onshore rate.
  • Eligible banks could buy spot dollars onshore and pay a 1-month premium while selling dollars in the NDF market.
  • The arbitrage increases demand for dollars onshore while providing more liquidity offshore
    • Earlier this segment was dominated by the foreign bank (over which the RBI has little influence), fuelled volatility and often led the spot rupee to drop.
• Thus, increased trading has led to a higher demand for dollars, forcing the RBI to intervene through dollar sales leading to forex decline. 

Concept:

• The Reserve Bank of India is the custodian of the country’s foreign exchange reserves and is vested with the responsibility of managing their investment.
• The market players are only banks licensed by the RBI, and the RBI. 
  • The Reserve Bank issues licences to banks and other institutions to act as Authorised Dealers in the foreign exchange market.
• Individuals and corporations cannot enter the market. They can deal only with their respective banks.
• The Reserve Bank’s exchange rate policy focuses on ensuring orderly conditions in the foreign exchange market. 
  • It closely monitors the developments in the financial markets at home and abroad. When necessary, it intervenes in the market by buying or selling foreign currencies. The market operations are undertaken either directly or through public sector banks.
• Section 40 of the RBI Act, 1934 –Transactions in foreign exchange– stipulates that the Central Government orders the “rate” at which the RBI shall buy or sell forex to banks (authorised persons).
  • This “rate”, in turn, will be governed by India’s “obligations to the International Monetary Fund .

Forex operations by Banks:

• The operations in the forex (foreign exchange) market are between the banks–The inter-bank foreign currency operations are taking place for two purposes namely: 
  • Buying and selling foreign currency on behalf of their customers as an intermediary
  • Proprietary trading (buying and selling currencies on its own account) with an intention to make money on the movement of the exchange rate.
• Most of the forex losses arise from transaction risk (exchange risk), and one of the important strategies adopted by the banks is a systematic reduction in the extent of exposure to a risk and/or the likelihood of its occurrence by limiting or restricting the operational risk on large deals.
  • Daylight limit-The highest amount of open position or exposure, the bank can expose itself at any time during the day, to meet customers’ needs or for its trading operations, is known as ‘Daylight limit’
  • Overnight limit-The highest amount of open position or exposure a bank can keep overnight when markets in its time zone are closed is known as Overnight limit.
  • This “overnight limit” and “daylight limit” is prescribed for each bank by the RBI. Even during the day, the prescribed “daylight limit” cannot be breached. The RBI enforces these limits strictly.

Non-Deliverable Forward (NDF)?

• A non-deliverable forward (NDF) is an FX exchange contract, where two parties agree to, on a date in the future, exchange currencies for the prevailing spot rate
• The difference between the NDF rate and the spot rate is the amount paid to the party who paid more of its own currency; the cash payment is most often made using U.S. dollars.
• Because NDFs are traded privately, they are part of the over-the-counter (OTC) market. The contract is drawn up and agreed upon by only the parties involved. It allows for more flexibility with terms, and because all terms must be agreed upon by both parties,
• A non-deliverable forward (NDF) is a cash-settled, and usually short-term, forward contract.

The notional amount is never exchanged, hence the name “non-deliverable.”