A Non-Deliverable Swap (NDS) is a financial derivative instrument involving the exchange of two currencies, typically where one of the currencies is restricted or non-convertible. Unlike traditional currency swaps, which involve the physical exchange of principal amounts, NDS transactions are settled in a major convertible currency such as the US Dollar (USD). This feature makes NDS an essential tool for managing currency risk in restricted currency markets.
How Non-Deliverable Swaps Work
The Mechanism of NDS
In an NDS, two parties agree to exchange cash flows based on the difference between a pre-agreed forward rate and the actual spot rate at the time of settlement. The settlement amount is calculated on a notional amount and paid in a convertible currency. Here’s a more detailed breakdown of the process:
- Contract Agreement: The two parties agree on the notional amount, forward rate, and settlement date.
- Valuation: On the settlement date, the difference between the agreed forward rate and the actual spot rate is calculated.
- Payment: The net cash flow difference is paid in a convertible currency, commonly USD.
Example of NDS
For instance, consider a U.S. company wanting to hedge its exposure to the Brazilian Real (BRL), a restricted currency. They enter into an NDS with a counterparty to exchange USD/BRL. Upon the contract’s settlement date, if the spot rate differs from the forward rate, the net difference will be paid or received in USD.
Types of Non-Deliverable Swaps
Although the general mechanism of NDS remains the same, they can be categorized based on the currencies and counterparties involved:
- Major-Minor Currency NDS: Involves a major convertible currency and a minor restricted currency.
- Interbank NDS: Agreements between banks to manage currency exposures.
- Corporate NDS: Used by multinational corporations for hedging purposes.
Special Considerations
Regulatory and Market Factors
- Regulations and Restrictions: Many emerging market currencies are subject to regulatory restrictions that prevent traditional FX transactions.
- Market Liquidity: The liquidity of NDS varies with market conditions and the currencies involved.
Risk Management
Non-Deliverable Swaps serve as a crucial tool for risk management, helping entities mitigate the risks associated with currency fluctuation in markets where direct currency exchange is not feasible.
Historical Context
Non-Deliverable Swaps have gained prominence since the early 1990s, coinciding with the rise of emerging markets and their need to participate in global trade while managing currency exposure.
Applicability and Uses
NDS are widely used by financial institutions, multinational corporations, and investors to hedge currency risks in markets with limited currency convertibility.
Comparisons to Related Instruments
- Deliverable Forwards: In contrast to NDS, deliverable forwards involve the physical delivery of currencies.
- Currency Futures: Standardized contracts traded on exchanges with physical or cash settlement.
Related Terms
- Foreign Exchange (FX) Swap: Another type of swap involving the exchange of two currencies with different settlement dates.
- Forward Rate Agreement (FRA): A derivative contract to lock in an interest rate for a future period.
FAQs
What currencies are typically involved in NDS?
Who uses NDS?
How are NDS settled?
References
- Hull, J. C. (2012). “Options, Futures, and Other Derivatives.” Pearson.
- Bank for International Settlements (BIS) – Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets.
Summary
Non-Deliverable Swaps are essential financial derivative instruments for managing currency risk in restricted and non-convertible currency markets. By settling in a convertible currency, NDS provides a practical solution for hedging and investment purposes in global financial markets.
