As rupee roils, a look at the secretive NDF trades

Non-deliverable forwards (NDFs) have been in the news of late with the rupee skating downhill.

NDF is an over-the-counter, or OTC, derivative market for currencies based offshore.
Trading for the $/rupee pair takes place in Singapore, which is the hub for NDF markets.

A trade does not require physical delivery of the currency and is more like the futures market on a stock exchange.

Here’s an FAQ to help you understand it better:

NDF – How is it traded?
Trading takes place through telephones and private electronic channels. Traders quote bid-ask (buy-sell) spreads on currency pairs such as the dollar-rupee, dollar/yuan, dollar/Thai baht, dollar/Indonesian rupiah, dollar/Phillipines peso, dollar/Korean won and dollar/Malaysian ringitt and hedge funds, banks and FIIs hit the quotes to buy or sell a currency pair.

Example of an NDF quote
A trader quoting on a 1 month dollar/rupee NDF will quote Rs 58.90/ Rs 59.10 for a $5 million notional against a spot price of Rs 58.50. A hedge fund wanting to go long the pair — i.e., shorting the rupee, will buy the pair at Rs 59.10. The hedge fund is long the dollar/rupee pair at Rs 59.10 for a notional amount of $5 million.

Are there any margin payments involved in the transaction?
Margin payments depend on the counterparty risk limits the trader has with the hedge fund. Trades between two banks would not usually involve margin payments but again this depends on the banks involved. 

Price movements on the NDF
The hedge fund is long the dollar-rupee pair for $5 million notional at Rs 59.10. The rupee depreciates against the dollar in the next one week and the quote for one month NDF by the trader for $5 million notional is now Rs 59.30/Rs 59.50. The hedge fund believes that it is the right time to take profits and goes and sells the pair at Rs 59.30.  The hedge fund has effectively made a profit of $16,863 on the trade in a week and receives the profit from the trader. ((59.30-59.10)*50000000)/59.30) Cash settlement  NDF trades are cash settled with only the difference between buy-sell rate being exchanged between counterparties.
Limits on transactions

The NDF market is not regulated and a country’s currency controls (if any) are not applicable.

How does the NDF market affect a domestic market?

The NDF market affects a domestic market largely on sentiment. For example, if the dollar/rupee one-month forwards rise in the NDF market, it will affect both the spot and the forward market in India as there will be worries on FIIs pulling money out. Equities and bonds will see weak sentiment.

The reason why rising NDF markets suggest FII pull out is that hedge funds and FIIs selling the rupee indicates risk aversion leading to selling in all other asset classes.

Parthasarathy is the editor of  www.investorsareidiots.com, a website for investors.