Definition
A Non-Deliverable Swap (NDS) is a type of financial derivative contract in which two parties agree to exchange (or swap) cash flows based on the difference between an agreed contract rate and the spot rate of a specified non-convertible foreign currency. It is typically used when there are restrictions on foreign exchange transactions or barriers to capital mobility. Unlike a traditional swap, NDS does not require delivery of the non-convertible currency, hence it is termed “non-deliverable”.
Phonetic
Non-Deliverable Swap (NDS) phonetics: Non: nɒn Deliverable: dɪˈlɪvərəbəl Swap: swɒp So, it’s pronounced as “non-deliverable swap”.
Key Takeaways
1. Non-Deliverable Swap (NDS) Definition: An NDS is a currency derivative product that allows parties to swap interest rate differential payments without actually exchanging principal amounts. Essentially, they are a risk management tool for investors looking to hedge against potential foreign exchange rate changes.
2. Functioning of NDS: An NDS is cash-settled in a reference currency, usually USD. The contracts specify an interest rate, a notional amount, and a period until maturity. On the settlement date, the difference between agreed-upon exchange rate and the market exchange rate is calculated and settled in the reference currency. This non-delivery feature makes NDS an ideal tool for countries with capital control rules and regulations.
3. Application and Risks: NDS is predominantly used in emerging markets, where it is often illegal or difficult to deliver a physical asset. NDS can be used to protect against currency risk, but they also carry risks such as counterparty risk, interest rate risk, and country risk. If the exchange rate moves unfavorably, parties can incur substantial losses. Therefore, careful management and knowledge are essential when trading this financial instrument.
Importance
Non-Deliverable Swap (NDS) is a crucial concept in business/finance as it is a cash-settled, offshore currency swap. In markets where there are restrictions on currency conversions, NDS provides an important platform that allows participants to hedge their foreign exchange risks. Using the NDS, counterparties agree on an exchange rate at the initiation of the contract, but unlike a regular currency swap where principal amounts would be physically exchanged at maturity, in an NDS the difference is settled in a globally convertible currency, typically USD. It’s particularly significant in derivative markets and helps investors manage risks in emerging markets where direct trading can sometimes be difficult due to regulatory restrictions.
Explanation
A Non-Deliverable Swap (NDS) is an essential financial instrument used predominantly in the foreign exchange markets. Its primary purpose is to manage or hedge exposure to foreign currencies by removing the risk associated with exchange rate fluctuations. Non-deliverable swaps are extensively used by organizations to secure a predictable exchange rate in countries where direct trading of the local currency is not allowed due to capital control practices. This allows organizations to conduct business predictably and securely.An NDS agreement involves an arrangement between two parties to exchange predetermined amounts of money on specific future dates. Here, the notional amounts are in two different currencies, but the cash flows are settled in one currency only, typically in USD. Simply put, the NDS works in such a way that the difference in the agreed swap rate and the prevailing spot rate is settled in cash on the swap maturity date. This eliminates the physical delivery or transfer of the underlying asset, hence the term ‘non-deliverable’. This particular feature makes NDS an attractive tool for foreign investors working in a nation with strict currency controls.
Examples
Non-Deliverable Swap (NDS) is a currency derivative instrument against liquidity and default risks that companies use when dealing with countries with foreign exchange restrictions. Here are three examples of NDS in a real-world context:1. Brazilian Market: A global manufacturing company with operations in Brazil could enter into a NDS to hedge against Brazilian Real (BRL). Due to Brazilian regulations, not every derivative against BRL can be physically delivered or converted. So, the company can enter into a NDS with a bank, where at the end of each contract period, only the net amount resulting from the fluctuation of BRL against USD is paid in a deliverable currency, usually USD.2. Chinese Market: A multinational US corporation who generates revenue in RMB, but needs to satisfy expenses in USD, may engage in a NDS to protect themselves against currency fluctuations in the RMB/USD exchange rate. Since China’s currency is not fully convertible, the NDS will allow the company to swap RMB for USD, usually settled in cash based on an agreed upon currency rate.3. Argentine Market: Suppose a European company has an investment in Argentina, subjected to the risks of Argentine Peso (ARS) depreciation against Euro. Due to foreign exchange control in Argentina, it is not easy for the company to exchange a large amount of ARS into Euro. The company can make a NDS contract with a bank, where they pay ARS and receive Euro in a non-deliverable way. If ARS depreciates against Euro, the company will receive more Euro, offsetting their loss from the investment.
Frequently Asked Questions(FAQ)
What is a Non-Deliverable Swap (NDS)?
A Non-Deliverable Swap (NDS) is a type of foreign exchange derivative where two parties agree to swap certain cash flows at specified intervals for a period of time. Unlike regular swaps, in an NDS, the principal does not change hands.
How does an NDS work?
In an NDS, the parties agree upon an amount and a currency pair. The net settlement is made depending upon the difference between agreed rate and the spot rate at the time of settlement. The settlement is always made in cash, hence it is non-deliverable.
How is the settlement amount of an NDS determined?
It is determined based on the difference between the agreed-upon exchange rate and the spot exchange rate at the time of settlement. The party that benefits from this rate difference will receive the difference from the counterparty.
What is the benefit of using an NDS?
One key benefit of NDS is that it allows businesses to manage the risks associated with foreign exchange rate fluctuations. This is particularly beneficial when dealing with currencies that have trading restrictions.
How risky is an NDS?
Like all financial instruments, NDSs do carry a certain level of risk. The primary risk is the credit risk or the risk that a counterparty will not fulfill their financial obligation.
Can individual investors use NDS?
NDS are typically used by large corporations, banks, and financial institutions. However, individual investors who have the understanding and means to manage the risk can also utilize NDS.
Can an NDS be bought or sold in a secondary market?
NDS contracts are usually over-the-counter (OTC) derivatives, meaning they are traded directly between two parties and are not listed on exchanges. Therefore, they typically do not have a secondary market and are less liquid compared to other financial instruments.
In which currencies can an NDS be agreed upon?
NDS can be agreed upon in any currency pairs, however, they are commonly used in pairs where one or both are not freely tradable or have trading restrictions.
Related Finance Terms
- Swap Agreement
- Forwards Contract
- Currency Swap
- Counterparty Risk
- Interest Rate Swap
Sources for More Information
