A derivative instrument which is used for hedging the exchange rate risk associated with non-convertible currencies. By definition, a non-deliverable forward (NDF) is a synthetic foreign currency forward contract whose underlying currency is actually non-deliverable because it is thinly traded and as such can’t be easily converted into other tradable currencies. Under a non-deliverable forward, a currency that is not freely convertible, such as the Korean won, the Argentinean peso, the Turkish pound, and the Brazilian real, is measured and quoted against a freely convertible currency such as the euro (EUR), the U.S dollar (USD), the pound sterling (GBP), etc.
Basically, the forward contract is a type of non-exchange traded, non-standardized futures contract, whereby a fixed amount (of the non-convertible currency) is settled on a specific due date, and at a specific forward rate. At maturity, the daily rate (reference rate) is compared with the NDF rate. The forward contract is typically settled in the base currency of an investor who receives or pays, at maturity, the difference between the daily rate (reference rate) and the NDF rate, as the case calls for. The difference is settled in the convertible currency on the value date as no payment or account movement takes place in the non-convertible currency.
The counterparties entering a non-deliverable forward contract will also agree on the mechanism to determine the reference rate, at maturity, which might be the daily rate as defined by a financial regulator like a central bank, or an average rate published by a number of banks.
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