What are non-deliverable forwards?

Non-deliverable forwards (NDFs) are foreign exchange derivative contracts that are economically equivalent to regular currency forwards but are settled in a convertible currency (almost always US dollars) rather than in the restricted local currency. They exist because some countries impose capital controls that prevent the free conversion and transfer of their currencies, making standard deliverable forwards impractical or impossible for offshore investors.

The NDF market is substantial, with daily turnover estimated at over $250 billion. The most actively traded NDF currencies include the Chinese yuan (CNY), Indian rupee (INR), Korean won (KRW), Brazilian real (BRL), and Taiwan dollar (TWD). In an NDF contract, two parties agree on an exchange rate for a future date. At settlement, no actual currency is delivered; instead, the difference between the contracted rate and the prevailing spot rate is calculated, and one party pays the other the net difference in US dollars.

NDF rates often diverge from onshore forward rates because the two markets have different participant bases and face different regulatory constraints. The NDF rate reflects offshore investor expectations and sentiment, which can be more negative or positive than onshore views. A widening gap between the offshore NDF rate and the onshore forward rate signals stress, capital flow pressures, or expected policy changes. During the 2015 China devaluation episode, the offshore yuan NDF market priced in significantly more weakness than onshore markets, reflecting foreign investor pessimism about China's economic outlook.

For investors and corporations with exposure to emerging market currencies, NDFs provide essential hedging tools. A US company with revenues in Indian rupees cannot easily access onshore rupee forward markets due to capital controls. But it can hedge its rupee exposure using NDFs traded in London or New York, settling the profit or loss in dollars. Similarly, macro hedge funds use NDFs to express views on EM currencies without navigating local regulations. Understanding the NDF market is essential for anyone operating in or investing in economies with managed exchange rates and capital controls.