Non Deliverable Foreign Exchange Forward Market: An Overview

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Reserve Bank of India Occasional Papers Vol. 27, No. 3, Winter 2006
Non Deliverable Foreign Exchange Forward Market: An Overview
Sangita Misra and Harendra Behera*
Recognising the growing activity in the non deliverable forward (NDF) market in the recent years, the paper attempts to present a detailed analysis of the NDF market with special focus on Indian rupee. An attempt is made to study the interlinkages among the spot, forward and NDF markets for Indian rupee. Using daily exchange rate data from Reuters database for the period November 2004 to February 2007, and applying Granger causality test and augmented GARCH formulation, the study finds that the NDF market is generally influenced by spot and forward markets and the volatility spillover effect exists from spot and forward markets to NDF market. Evidences are also observed for volatility spillover in the reverse direction, i.e., from NDF to spot market, though the extent is marginal. Furthermore, using the covered interest parity formulation, the study has found that the spread between the onshore and offshore implied yield is positive, thus, providing evidence towards appreciation pressures operating on rupee in the domestic market. Hence, the study has suggested for close monitoring of NDF market.

JEL Classification : G13, F31, G12


: Non deliverable forward, volatility, implied yield

The Indian foreign exchange market has seen a massive transformation over the past decade. From a closed and heavily controlled setting of the 1970s and 1980s, it has moved to a more open and market-oriented regime during the 1990s. Turnover has increased in both the spot and forward segments of the market. A

* Smt Sangita Misra and Shri Harendra Behera are Research Officers in the Division of International Finance, Department of Economic Analysis and Policy. The authors would like to thank Dr R.K.Pattnaik for being a constant source of encouragement and Dr Rajiv Ranjan for giving the opportunity to get introduced to the concept. The views expressed in the paper are those of the authors and not of the institution to which they belong.



recent feature has been the growing trading of the Indian rupee in the non-deliverable forward (NDF) foreign exchange market.
The NDF markets have generally evolved for currencies with foreign exchange convertibility restrictions, particularly in the emerging Asian economies, viz., Taiwan, Korea, Indonesia, India, China, Philippines, etc., With controls imposed by local financial regulators and consequently the non-existence of a natural forward market for non-domestic players, private companies and investors investing in these economies look for alternative avenues to hedge their exposure to such currencies. In this context, non deliverable forwards have become popular derivative instruments catering to the offshore investors’ demand for hedging. NDFs are types of derivatives for trading in non-convertible or restricted currencies without delivery of the underlying currency.
Trading in the NDF market generally takes place in offshore centres. In this market, no exchange takes place of the two currencies’ principal sums; the only cash flow is the movement of the difference between the NDF rate and the prevailing spot market rate and this amount is settled on the settlement date in a convertible currency, generally in US dollars, in an offshore financial centre. The other currency, usually an emerging market currency with capital controls, is non-deliverable. In this particular respect, of course, NDFs are similar to commodities futures market where commodities, like wheat or corn, are traded in organized futures markets and positions are later settled in dollars, wheat or corn being nondeliverable. The NDF prices are generally determined by the perceived probability of changes in foreign exchange regime, speculative positioning, conditions in local onshore interest rate markets, the relationship between the offshore and onshore currency forward markets and central bank policies.
Being offshore, the market has remained outside the regulatory purview of the local monetary authorities. Yet, considering the linkages that prevail between the onshore spot and forward markets and the offshore NDF market, activity in these markets has always been of interest to the regulators. However, studies on NDF markets are rather limited and in India, this aspect has remained unexplored.



Against this backdrop, the paper attempts to explore the various facets of the NDF market in the Asian region, with particular focus on the transactions in Indian rupee in the NDF markets. Section I traces the evolution of NDF markets in the Asian region. A review of the extent of activity in the Asian NDFs, at present, is attempted in Section II. Section III then, provides a detailed overview of the current NDF market structure for Indian rupee. It undertakes an assessment of the available market infrastructure in terms of market players, market regulation, settlement period, trading platform and the offshore centers for INR-USD NDFs. An assessment of the market activity in terms of market turnover, volatility and bid-offer spreads are also part of this section. Section IV tries to explore the linkages in terms of information flows between the offshore rupee NDF and the onshore markets. Empirical exercises have also been attempted to examine (1) the causality that exists between the two markets, (2) the volatility spillover that takes place between the two markets and (3) the extent of market segmentation between onshore and offshore interest rates implied by the NDFs. Section V dwells upon the policy implications of the analysis. Section VI then lists out the concluding observations along with the outlook for the future.

Section I
Evolution of NDF markets
Capital flow to emerging market economies (EMEs), particularly Asia, rose significantly during the 1980s and 1990s. During this period, however, while in some EMEs domestic forward markets were not developed, others were characterized by restrictions on non-residents’ access to domestic forward market. The objective was clear. Local monetary authorities feared that easy access to onshore local currency loans and deposits, and the ability to easily transfer local currencies to non-residents, encourages speculative financial movements, greater exchange rate volatility, and ultimately some loss of monetary control (Higgins and Humpage, 2005). Consequently, some international banks, starting from the early 1990s, began offering non-deliverable forward contracts to investors to hedge their exposures in EME currencies.



Initially, most NDF trading was in Latin American currencies. Trading volume in NDFs began to increase in 1994 after voice brokers entered the market as intermediaries facilitating interbank trading, which allowed dealers to more easily offset positions with one another that they had accumulated from their market making activities for clients. At that time, Mexican peso NDFs had the largest trading volume, reflecting market participant expectations for a devaluation of Mexican peso from its then-fixed level against the dollar. As investment flows into emerging economies grew, the NDF market increased and expanded beyond Latin American currencies to Asian and Eastern European currencies. The International Swaps and Derivatives Association (ISDA) added settlement provisions for NDF transactions to its 1997 draft FX and currency option definitions. Interest in NDF trading further increased leading up to the Asian crisis of 1997. Many emerging market countries tightened their restrictions following the financial crises of 1997 and 1998, giving a further impetus to an already developing offshore NDF market.
Today, a large and increasingly active market in NDFs exists for many Latin American, East Asian, and Eastern European currencies, with centers in Hong Kong, Singapore, South Korea, Taiwan, Japan, London (for Eastern European currencies and Asian currencies), and New York (for Latin American currencies). Experience suggests that NDF markets are likely to be most developed for countries with significant cross-border capital movements (both portfolio and/or foreign direct investment) but with some convertibility restrictions operating (Lipscomb, 2005). Conversely, NDF markets in currencies of countries that have allowed increased capital convertibility, to the point where currency hedging is fully available onshore have dissipated and/or disappeared (e.g. Australia).
Even today many emerging market economies, including China, Indonesia, South Korea, the Philippines, and Taiwan, restrict foreign access to their currency and onshore money markets, making it very difficult–if not impossible–for foreign firms or international investors to hedge in local forward exchange markets, even when such markets exist. As a part of foreign exchange control, access to onshore forward markets by non-residents is not allowed in China



and Taiwan, whereas the access is allowed, subject to underlying transactions requirement in countries like Indonesia, Korea and Philippines including India (Ma et al. 2004).
The Indonesian rupiah NDF is a very recent one that had its birth in early 2001. Before January 2001, deliverable rupiah forwards were actively traded offshore, mostly in Singapore, and non-residents enjoyed easy access to rupiah funding. To reduce speculative pressure on the rupiah, rupiah loans and transfers by banks to non-residents and related derivative transactions were prohibited or restricted by Bank Indonesia in January 2001. This effectively limited the offshore deliverability of the rupiah and dried up trading in offshore deliverable rupiah forwards. To meet the offshore hedging or speculative demand, an offshore market in rupiah NDFs gradually developed over the following months.
It is interesting to observe that the Malaysian ringgit and Thai baht are not traded actively in the NDF markets despite these countries having capital controls, because of certain policies pursued by them. In the case of Malaysia, an offshore NDF market for Malaysian ringgit could not develop after Malaysia moved to a fixed exchange rate system in September 1998. Besides, in the case of Malaysia, the absence of a reference exchange rate for the settlement of NDF contracts among market players is also another factor contributing towards lack of development of NDF market. Moreover, exchange controls in Malaysia prohibit domestic banks to undertake forward foreign exchange transactions with offshore counterparties. Thus, restricting availability of offshore institutions to hedge their exposure derived from the NDF contracts hinders the development of the market1 . Similarly in Thailand, the Bank of Thailand (BoT) actively discourages foreign banks from quoting in the NDF market. There is an implied threat that if the foreign banks quoted in the NDF market, their domestic branches would have to face the consequences. By adopting this stance, the BoT makes it difficult for banks to quote in the NDF market. However, it is felt that a more actively traded Thai baht NDF market could emerge in the future in response to the Bank of Thailand measures in the recent past to limit non-resident holdings of Thai baht bank accounts.



Annex 1 gives in detail the current restrictions that operate in the forward exchange market and on the access of onshore forward market by non-residents for select Asian countries.

Section II
Activity in Asian NDFs
Comparable and quality data on NDF turnover is generally limited. The Emerging Markets Traders Association (EMTA) Survey held in early 2003 is the latest available official source. As per the EMTA survey, Asia’s NDF turnover accounts for the majority of global NDF turnover. In particular, NDFs in the Korean won, the New Taiwan dollar, the Chinese renminbi, the Indian rupee, the Indonesian rupiah and the Philippine peso amount to more than 60 per cent of the emerging market NDF turnover globally. The major remaining NDF markets are those in Latin American currencies (mainly the Brazilian real and Chilean peso) and the Russian rouble, according to the survey. The Korean won NDF market has been the deepest in Asia as well as globally, with average daily trading volume in excess of US $ 500 million and representing nearly half of the emerging market NDF turnover (Table 1). The reason generally stated is that Korea allows domestic banks to operate in the NDF market and that is one of the reasons why the South Korean won is the most liquid NDF currency.2 Turnover in the New Taiwan dollar NDF market has been the second most active in Asia. The earlier shallow NDF markets in Asia, viz., Chinese renminbi, Indian rupee, Indonesian rupiah and Philippine peso have deepened significantly over the past few years. Also, for most of the currencies, there is limited liquidity in contracts with a maturity over one year.
NDFs form an important part of overall forward trading in regional currencies. For the six emerging Asian currencies, discussed above, the reported NDF turnover represents some 10-20 per cent of the combined trading volume of the onshore outright forwards, foreign exchange swaps and NDFs. In the case of China, domestic trading of outright forwards being a recent phenomenon and with the lack of an onshore swap market, renminbi NDFs amount to about 90 per cent



Table 1: Average daily NDF turnover in Asia

Sources of estimates


Deutche Bank


(in millions of US dollars)

Lehman Brothers

Forwards and forex



(1st quarter 2003)

(June 2001)

(April 2001)

Chinese renminbi Indian rupee Indonesian rupiah Korean won Philippine peso New Taiwan dollar Asian six total As a percentage of April 2001 forwards, Forex swaps and NDFs



1,000 100 100 500 50 500

50 20-50
50 700-1,000
20-30 300-500 1,140-1,680



150 38 65
1,350 38
250 1,890


















Source: Ma et al. 2004, BIS Quarterly Review.

of the estimated combined turnover of onshore deliverable forwards and offshore NDFs.
The investor base for the Asian NDF markets has broadened significantly over the past few years. The investor base mainly comprises multinational corporations, portfolio investors, hedge funds and proprietary foreign exchange accounts of commercial and investment banks. Both hedging demand and speculative demand are present in Asian NDF markets. In the case of the won and the New Taiwan dollar, portfolio investors and hedge funds seem to be the most important players. In contrast, in the case of renminbi, multinationals associated with large FDI into China and more recently hedge funds associated with greater speculation, play a greater role (Ma et al. 2004).
An interface with the financial institutions in conjunction with the Committee on the Global Financial System work group project on foreign direct investment in emerging market financial sectors reveal that as much as 60 to 80 percent of NDF volume is generated by speculative interest, reflecting growing participation from international hedge funds. Major financial institutions are generally



involved in NDF markets through their market-making activities. These market-making activities are a service to their customers for which the firm is compensated by a bid/ask spread as well as effective management of the firm’s NDF book. Currently, major international banks primarily offset NDF positions incurred through market-making activities with other major banks through the broker market, but also deal directly with other banks and onshore market players and exchanges (Lipscomb, 2005).

Section III
Features of Indian Rupee NDF market
Trading platform and offshore centre
NDFs are primarily over-the-counter, rather than exchangetraded products, thus making it difficult to gauge the volume of contracts traded, who trades the contracts, and where they are traded. At the international level, New York tends to dominate trading in Latin American NDFs, Singapore (and to a lesser extent Hong Kong) dominate trading in non- Japan Asian NDFs, while London spans these markets. The INR NDF is largely concentrated in Singapore and Hong Kong, with small volumes being traded in the Middle East (Dubai and Bahrain) as well.
NDF Market Regulation
At present, there are no controls on the offshore participation in INR NDF markets. The onshore financial institutions in India, however, are not allowed to transact in the NDF markets. Domestic banking entities are allowed specific open position and gap limits for their foreign exchange exposures and through these limits domestic entities could play in the NDF markets to take advantage of any arbitrage or even speculate. This itself restricts the extent to which domestic banks could participate in NDF markets. The objective has been that allowing domestic banks to participate in the NDF markets would require an enhanced level of intervention from the Reserve Bank of India (RBI) to protect Indian rupee from any speculative attack.



Market Players
NDF market players generally operate with an objective of hedging, speculating and arbitraging. While the INR NDF market has been around for over the last 10 years or so, the characteristics of this market seem to have evolved over this period in tandem with the onshore exchange controls and regulations. In the late 1990s the NDF market was provided liquidity by foreign residents who had a genuine exposure to the Indian rupee but were unable to hedge their exposure in the domestic market due to existing controls. However, with the gradual relaxation of the exchange controls, reasonable hedging facilities are available to offshore non-residents who have exposures to the rupee, especially when compared with the hedging facilities provided by some other competitor Asian countries such as China. Hence, the INR NDF market presently derives its liquidity largely from (i) Non-residents wishing to speculate on the Indian rupee without any exposure to the country, and from (ii) arbitrageurs who try to exploit the differentials in the prices in the two markets without any outlay of capital on their part by two offsetting transactions. (For the Indian rupee it is believed that arbitrage is profitable when there is difference of around 10 paise in the forwards prices. Such opportunities are not very common, but tend to occur whenever speculative actions increase).
The behaviour of NDF market players depends critically on their objective for participation. Foreign investors who participate in the NDF market to hedge their exposures generally take long positions e.g. multinational companies. Speculators, on the other hand, operate mostly in the short end of the market e.g. hedge funds, also corporates entities with an international presence who undertake speculative or arbitrage trades, jewel exporters and manufacturers that constitute another group who are active arbitraging between domestic and NDF markets.
As reported by market participants, some of the foreign banks which trade in the rupee NDFs include Deutsche Bank, UBS AG, Standard Chartered Bank, Citibank, JP Morgan Chase, ABN Amro, Barclays, ANZ Investment bank and BNP.



Settlement period
The settlement period refers to the gap between the day the NDF contract is fixed and the actual delivery date. The fixing date is the day on which the comparison between the NDF rate and the prevailing spot rate is made. The settlement date is the day whereby the difference is paid or received. Depending on the currencies dealt, there are variations whereby for some currencies, the settlement period is one day whereas for others it is two business days. Generally, the spot rate used in the NDF market is based on a reference page on Reuters or Telerate with a fallback of calling four leading dealers in the relevant market for a quote. For the Indian rupee NDF, the RBI reference rate is generally used as the fixing rate.
Market Turnover
Information on the traded volumes in the NDF market is rather difficult. Various estimates are available though they are published with a lag. As per an estimate by HSBC for mid-2003, the daily volumes for INR NDF was about US $ 100 million. The latest available information on NDF turnover indicates a substantial pick up in NDF turnover in Indian rupee in line with the pick up in domestic onshore spot and forward market turnover. The NDF market turnover, however, remains small when compared with onshore market turnover. The daily average turnover in the spot market is about 4.4 times and forward/swap market is about 4.1 times the turnover in the NDF market (Table 2). The turnover is high for 1-month and 1-year maturity. As compared with some other Asian currencies traded in the NDF market such as the Korean won, Chinese yuan and Taiwanese dollar, the turnover in the NDF market is very small for Indian rupee.
Bid Offer Spreads
Markets are generally, perceived as efficient when market prices reflect all available information, so that it is not possible for any trader to earn excess profits in a systematic manner. The efficiency/ liquidity of the foreign exchange market is often gauged in terms of bid/offer spreads. The bid-ask spread refers to the transaction costs

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Non Deliverable Foreign Exchange Forward Market: An Overview