Pricing and valuation

An investor enters into a forward agreement to purchase a notional amount, N, of the base currency at the contracted forward rate, F, and would pay NF units of the quoted currency. On the fixing date, that investor would theoretically be able to sell the notional amount, N, of the base currency at the prevailing spot rate, S, earning NS units of the quoted currency. Therefore, the profit, ?, on this trade in terms of the base currency, is given by:

Uses

Synthetic foreign currency loans

NDFs can be used to create a foreign currency loan in a currency which may not be of interest to the lender. In this structure, the borrower receives (for example) a dollar sum, but repayments are fixed to a foreign currency schedule. Settlement between the borrower and the lender takes place in dollars, but fixed to the exchange rate at time of repayment. At the same time as disbursing the dollar sums to the borrower, the lender enters into a non-deliverable forward agreement with a counterparty (for example, on the Chicago market) that matches the cash flows of the synthetic foreign currency repayment schedule. Effectively, the borrower has a synthetic foreign currency loan; the lender has a (synthetic) dollar loan; and the counterparty has an NDF contract with the lender. Under certain circumstances, the rates achievable using synthetic foreign currency lending may be lower than borrowing in the foreign currency directly, implying that there is a possibility for arbitrage.

Although this is theoretically identical to a foreign currency loan (with settlement in dollars), the borrower may face basis risk: the possibility that a difference arises between the swap market's exchange rate and the exchange rate on the home market. The lender also bears counterparty risk.

The borrower could, in theory, enter into NDF contracts directly and borrow in dollars separately and achieve the same result. NDF counterparties, however, may prefer to work with a limited range of entities (such as those with a minimum credit rating).


Speculation

It is estimated that between 60 to 80 per cent of NDF trading is speculative. The main difference between the outright forward deals and the non-deliverable forwards is that the settlement is made in dollars since the dealer does not trust the alternative currency of the deal.


Source: Wikipedia - General Public Licence