What Is a Non-Deliverable Swap (NDS)?
Let me explain what a non-deliverable swap, or NDS, really is. It's a variation on a currency swap that involves major and minor currencies which are restricted or not convertible. You won't see any physical delivery of the two currencies here, unlike in a standard currency swap where actual currency flows are exchanged. Instead, periodic settlements happen on a cash basis, typically in U.S. dollars. The value for settlement comes from the difference between the exchange rate set in the swap contract and the current spot rate, with one party paying the other that difference.
Key Takeaways
Here's what you need to remember about non-deliverable swaps. They are a form of currency swap paid and settled in U.S. dollar equivalents, not the actual currencies involved. This makes the swap non-convertible and restricted because there's no physical delivery of the underlying currencies. You typically use NDSs when the currencies are hard to get, illiquid, or volatile, such as those from developing countries or restricted ones like Cuba or North Korea.
Understanding Non-Deliverable Swaps (NDSs)
Now, let's dive into how non-deliverable swaps work. Multinational corporations use them to reduce the risk of not being able to bring profits back home due to currency controls. They also hedge against sudden devaluation or depreciation in a restricted currency that's not very liquid, and to steer clear of the high costs of exchanging currencies locally. Financial institutions in countries with exchange limits rely on NDSs to hedge their exposure to foreign currency loans.
The main variables in an NDS include the notional amounts, which are the transaction sizes; the two currencies, one non-deliverable and the other for settlement; the settlement dates; the contract rates for the swap; and the fixing rates and dates, pulled from reliable independent sources on specific days.
Fast Fact
You can think of a non-deliverable swap as essentially a bundle of non-deliverable forwards put together.
Example of Non-Deliverable Swap (NDS)
Consider this scenario with a financial institution I'll call LendEx, based in Argentina. It has a five-year US$10 million loan from a U.S. lender at 4% interest per year, paid semi-annually. LendEx converted those dollars to Argentine pesos at an exchange rate of 5.4 to lend locally. But it's worried about the peso depreciating, making dollar repayments more expensive. So, it sets up a currency swap with an overseas counterparty.
The terms are: notional amounts of US$400,000 for interest and US$10 million for principal; currencies are Argentine peso and U.S. dollar; 10 settlement dates matching payments; contract rates of 6 pesos per dollar for interest and 7 for principal; fixing rates two days before settlement from Reuters at noon ET.
The profit calculation for the NDS uses this equation: Profit = (NS – NF) ÷ S = N (1 – F ÷ S).
In practice, on the first fixing date with a spot rate of 5.7 pesos to the dollar, LendEx pays the counterparty $20,000, calculated as (5.7 - 6.0) x 400,000 ÷ 6 = -$20,000. On the second date with a spot of 6.5, it receives $33,333, from (6.5 – 6.0) x 400,000 ÷ 6 = $33,333. This goes on until the end, and remember, all settlements are in U.S. dollars, not pesos, since it's non-deliverable.
What Is a Swap?
A swap is a financial contract where two parties exchange cash flows or liabilities from different financial instruments. Most involve cash flows based on a notional principal from a loan or bond, though the security can be various things. Keep in mind, the principal usually doesn't change hands.
Who Uses Swaps?
Swaps are traded by experienced investors, especially institutional ones like banks, financial institutions, and governments. They use them to manage risks such as currency, interest rate, and price risks.
Are Swaps Regulated?
Yes, the swap market is regulated by the Commodity Futures Trading Commission (CFTC), which got its authority from the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The Bottom Line
Non-deliverable swaps are financial contracts for experienced investors trading in non-convertible currencies. There's no physical exchange; everything settles in cash. Due to their complexity, if you're a novice investor, you probably shouldn't get involved with NDSs.
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