An Overview of Non-Deliverable Foreign Exchange Forward Markets

Laura Lipscomb
Federal Reserve Bank of New York
May 2005

In conjunction with the Committee on the Global Financial System work group project on foreign
direct investment in emerging market financial sectors, staff of the Federal Reserve Bank of
New York examined markets for different products used to hedge risks associated with
emerging markets, including credit default swaps, political risk insurance, as well as nondeliverable
forward foreign exchange contracts (NDFs). This note has also been substantially
informed by the author’s discussions with NDF market participants in the context of the ongoing
global market monitoring efforts of the Federal Reserve Bank of New York’s Foreign Exchange
and Investments Desk. This note outlines the development and characteristics of the NDF
market highlighting findings from discussions with U.S. commercial and investment banks as
well as brokers active in the market.1
Of the firms interviewed for the CFGS project, most noted limited interest in using NDF
contracts to hedge the underlying exposure associated with the firms’ own foreign direct
investment in emerging markets. Major international banks indicated that they are primarily
involved in NDF markets through their role as market makers for their customers. In addition,
many bank trading desks take positions in NDF currencies based on their views of the likely
path of the underlying currency markets.
From a broader perspective, markets for non-deliverable currency forwards (NDFs) are of
interest to policy makers because they are a product generally used to hedge exposure or
speculate on a move in a currency where local market authorities limit such activity. NDF prices
can be a useful tool for market monitoring in that these prices reflect market expectations and
supply and demand factors that cannot be fully manifested in onshore currency product prices in
a country with capital controls. The difference between onshore currency forward prices, where
they are available, and NDFs can increase in periods of heightened investor caution or concern
over potential change in the exchange rate regime or a perceived increase in onshore country
risk. Prices in the NDF market can be a useful informational tool for authorities and investors to
gauge market expectations of potential pressures on an exchange rate regime going forward.

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