Forex Investment and Currency Trading

Questions:

• How can I take advantage of an expected currency move without having to bother about exchange controls?
• How can I hedge my risk without having to take delivery of currency?

Answer:

• Non-delivery forwards or options

A theoretical example:

• You think the Korean won will appreciate – current spot 1506.50 bid, 1513.50 offer
• You buy KRW 1000 million one-year forward – forward points –40 / -20 = forward outright 1466.5 – 1493.5 – cost = USD 681,895.67
• At maturity, spot is 1300-1310
• You sell the won spot for dollars and receive USD 763,358.88
• Net gain = USD 81,463.11 = net settlement

Since I don’t want to take delivery of the Korean Won, and I don’t want to deal with exchange controls, can I do a deal where I just receive or pay the net settlement amount?

• This is a non-delivery forward, i.e. no delivery of currency, but net settlement at maturity of the difference between the forward rate and the spot rate at maturity
• No exchange controls to bother with
• No documentation to be provided to foreign central bank
• Non-delivery forwards emerge where there are exchange controls, or concerns about counterparty risk in the foreign country, or limited liquidity in the foreign market
• NDFs in Chinese renminbi, Indian rupee, Korean won, Brazilian real, Chilean peso, Colombian peso, etc.

Example:
In 1990: A computer company produced computers in Taiwan and wanted to hedge its New Taiwan dollar risk. But Taiwan had very tight exchange controls and domestic forward contracts did not exist. A New York money manager wanted to take Taiwan risk but did not want to convert cash into New Taiwan dollars for feat it could not be converted back.

Money manager bought TWD forward on a non-delivery basis -> FX Brokers -> Computer company sold TWD forward on a non-delivery basis

May 15:

• Spot = 26.43
• NDF = 26.83

If at maturity, the New Taiwan dollar was weaker than 26.83, then the computer company would gain an amount equal to the difference between the fixing rate and the forward rate AND the money manager would pay the amount equal to the difference between the fixing rate and the forward rate and of course, vice versa if the New Taiwan dollar was stronger than 26.83.

August 15: fixing rate = 27.28

Three months later,

• computer company received an amount equal to (27.28-26.83) x principal amount
• Computer company was correct in its judgment to hedge the risk
• The hedge fund’s investment did not work out

Note: risk was hedged but there was no exchange of currency

Some important points:

1. It is important to agree before maturity on the exchange rate to be used to settle the contract – an “unbiased rate” – and what to do if that rate is not available. There are now standardized rules for most fixings, with an increasing use of the EMTA as the arbiter. Typically, fixing rates are rates posted by the central bank or an average of rates posted by three other banks at a specified time.
2. Non-delivery forwards may not be priced off interest rate differentiates – the forwards may instead reflect exchange rate expectations. If there are exchange controls and the local market cannot be accessed, then you cannot create a money market hedge equivalent. If NDF prices reflect exchange rte expectations, then the pricing can change very quickly.
3. NDF prices may not always be available. Where tight exchange controls exist, they will depend on the existence of counterparties. Everybody may be on the same side of the market.
4. Nothing to do with NDFs: If you place an order at a weaker level than the market, you will be filled at the next available price NOT the order level if the market gaps. In the case of Taiwan, this meant receiving the absolute worst rate.

Delivery forwards entail sovereign & credit risk

• Can the local bank fulfill the contract?
• Will the local regulations allow conversion of the funds into U.S. dollars?
• Can the funds be transferred to the United States?

NDFs avoid these risks

• Contracts are offshore
• Not subject to local exchange controls
• No issue with whether funds can be transferred, but at the cost of different pricing
• Pricing difference between onshore delivery forwards and offshore NDFs will reflect a premium to avoid sovereign risk