Last Updated on September 25, 2023 by BFSLTeam BFSLTeam
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Understanding the NDF Market: A Closer Look
As Indian investors seek diversification in various asset classes, some turn to currency trading for potentially quick and high returns. The currency trading landscape in India has witnessed a significant surge in interest and trading volume. However, concerns exist among investors regarding the perceived complexity and regulatory burden of the Indian currency market, including extensive documentation requirements, Know-Your-Customer (KYC) procedures, and stringent rules and guidelines. This has led to misconceptions about its long-term profit potential. To address these concerns, some investors opt for trading currencies in a more flexible and less regulated environment, outside the oversight of the Reserve Bank of India. They do so by engaging in Non-Deliverable Forwards (NDF) within the non-deliverable forward market. But before delving into NDFs, it’s essential to grasp the fundamentals.
Understanding Currency Trading
Currency trading, often referred to as forex trading, involves the exchange of currencies with the aim of profiting from differences in their values. This financial market is substantial, boasting higher trading volumes than equities. In the past, currency trading was primarily the domain of large banks and corporations. However, recent technological advancements have democratised access to currency trading, enabling retail investors and individuals to explore it as an appealing investment avenue.
The fundamental principle governing currency trading is that currencies are always traded in pairs. For instance:
- Indian Rupee vs United States Dollar (USD-INR)
- Indian Rupee vs Euro (EUR-INR)
- Indian Rupee vs Great Britain Pound (GBP-INR)
- Indian Rupee vs Japan’s Yen (JPY-INR)
In these pairs, the relative values of the two currencies determine the exchange rate, providing opportunities for traders to speculate on price movements and capitalise on market fluctuations.
Also Read: Average Price
Types of Currency Markets
There are two primary types of currency markets:
1. Onshore Market: This is the local currency market of an individual’s home country, subject to strict regulations and tax obligations. For Indian citizens, the domestic forex market is considered the onshore market.
2. Offshore Market: The offshore market refers to trading conducted outside an individual’s home country. It often offers more flexibility in terms of regulations and may reduce tax obligations.
Understanding Types of Contracts
- Forward Contracts
Forward contracts are private agreements between two parties to buy or sell an underlying asset at a predetermined time and price. These contracts carry market and credit risk and only reveal their profit or loss at the contract’s settlement date. In India, forward contracts can be established for various OTC derivatives, including currencies outside the specified list by stock exchanges.
- Non-Deliverable Forwards (NDFs): NDFs are short-term, cash-settled forward contracts used to trade currencies in an offshore market. Parties agree on a settlement between the contracted NDF rate and the prevailing spot price, settling the difference in cash. Importantly, NDFs are non-deliverable, meaning the trader does not take physical delivery of the currencies.
How NDFs Operate in India
The NDF market operates by exchanging cash flows between two parties based on the NDF rate and the spot price. These contracts are typically settled in offshore currency markets, facilitating trades that involve currencies restricted from trading outside the country. NDFs convert profits and losses into freely traded currencies in both countries.
Understanding NDF Meaning Through NDF Example
Consider one party agreeing to buy Japanese Yen (selling dollars), while another party opts to buy US dollars (selling Japanese Yen) through an NDF within the non-deliverable forward market. Assume the agreed rate is 11.5 for US dollars 1 million with a two-month fixing date.
After two months, if the rate is 10.5, indicating an increase in the value of Japanese Yen, the party owing US dollars must pay. Conversely, if the rate rises to 12, indicating a stronger US dollar, the other party receives payment.
NDFs are widely used by Indian investors in high volumes, making the NDF market in India a dynamic one. If you seek quick profits through currency trading, NDFs could be an option. However, it’s advisable to consult a financial advisor, such as IIFL, to navigate tax and legal obligations effectively.
NDF Market and Its Recent Developments
The Reserve Bank of India (RBI) recently made a significant move by lifting the informal restrictions it had placed on rupee non-deliverable forward (NDF) trading for local banks in October 2022. This action was taken to manage the volatility of the Indian rupee. Now, let’s delve into what the NDF market is and its key functions.
In the quest for portfolio diversification and the pursuit of quick and high returns, currency trading emerges as a compelling asset class for Indian investors. Currency trading involves the exchange of currencies, capitalising on disparities in their values. This market operates on a global scale and is commonly known as the foreign exchange market, or simply FX or forex.
Within this expansive landscape, the NDF, or non-deliverable forward, plays a pivotal role. NDFs are derivative contracts in the foreign exchange realm that enable investors to trade non-convertible or partially convertible currencies, such as the Indian rupee, with contract settlement in a convertible currency like the US dollar. This trading occurs within offshore currency markets, situated beyond the jurisdiction of the trader’s home country. Consequently, NDF transactions take place outside the regulatory purview of the trader’s domestic market.
Operating on principles akin to forward contracts, where two parties privately agree upon an exchange rate for a specific duration, NDFs also allow for the locking in of exchange rates. However, what sets NDFs apart is that they don’t culminate in the physical delivery of the currency at the contract’s end. Instead, the discrepancy between the NDF rate and the fixing rate is settled in cash between the contracting parties.
Concluding
NDFs remain an effective tool for hedging against foreign exchange exposure involving non-convertible currencies. These non-convertible currencies encompass those like the Argentinian peso, Taiwanese dollar, and Korean won, among others. In essence, NDFs provide a means to mitigate risks associated with currency fluctuations when dealing with such currencies.
The recent decision by the RBI to lift restrictions on rupee NDF trading signifies a notable development in India’s financial landscape, impacting both investors and the broader forex market.
