Non-Deliverable Forwards

Not quite. The forward contract was set up to cover currency risk over the entire six-month period.

In December of 2015, Argentina finally let go and decided to end capital controls that forced citizens to hold their domestic currency. It was a welcomed relief for the citizens of Argentina, who had an extremely difficult time sourcing and buying USD. It was just as frustrating for investors with exposure to the Argentinian peso (ARS) because trying to hedge that exposure through common tools was practically impossible. Take a forward contract for example. What must occur if you can't deliver the ARS necessary?

No. That's not going to give you the actual cash payment based on the contract's status.

Yes! The forward contract will be cash settled, which means that it will be settled in the non-controlled currency, usually USD. It's called a __non-deliverable forward (NDF) contract__ because the controlled currency isn't available for settlement—not deliverable—and so the contract must be cash settled.

No. That's not going to hedge your exposure because it has only one exposure.

That's not it. There are ways around capital controls that still allow currency hedging.

For example, you could enter into a six-month non-deliverable forward on ARS/USD that's cash settled. At initiation the ARS/USD was 18.87, and suppose that six months later it was 19.05. Typically, if USD appreciated like this versus ARS, you'd need to settle in ARS, but you can't because of capital controls. So to calculate the actual cash-settled payment, you first find the appreciation of USD versus ARS for the notional value, and then convert that ARS amount back into USD. But what exchange rate would you use to convert the ARS amount back to USD?

Exactly! The payment will need to be based on the current value of the forward contract, so you'll need to use the current exchange rate. But that's only if payment is required in USD. There's an extra step in the process that will convert ARS back to USD if needed for settlement. And these non-deliverable forward contracts also have another unique feature in regards to risk, specifically credit risk. Why would credit risk be lower in a non-deliverable forward than in a regular forward contract?

That's not it. There's still some exchange rate risk in the contract.

No. The exchange rate at initiation factors into the exchange rate risk.

Right! Since one of the currencies is controlled, the notional value of the non-deliverable forward contract doesn't change. It's always in the non-controlled currency, and this reduces credit risk because both parties can access the same safe-haven currency. But while credit risk is lower, government intervention in currency markets typically leads to sharp movements in spot rates, which increases tail risk for non-deliverable forward contracts.

This tail risk is a result of the fact that capital controls constrict the cross-border flow of capital. Since the flow of capital is constricted, capital controls also change the ability of arbitrage to enforce interest rate parity. Essentially, that means that interest rate parity and the onshore currency market of the controlled currency don't impact the pricing of the non-deliverable forward. So what do you think actually does impact the price of the non-deliverable forward?

That's it! The pricing for a non-deliverable forward is based on the offshore market and its supply-and-demand conditions. That's because the capital controls force the non-deliverable forward to price based on the available source of the controlled currency. But this pricing structure can be abused, because there are mostly speculators placing directional trades in non-deliverable forward contracts. And since capital controls can vary between countries, you'll need to make sure that you know local regulations in order to invest and price non-deliverable forwards.

No. Even though the non-controlled currency market influences pricing, you still need access to the controlled currency.

Not really. The controlled currency will still need to be sourced, so the interest rates of the non-controlled currency aren't the primary factor.

To sum it up: [[summary]]

It must be cash settled

You must deliver more ARS

You'll default on the contract

The exchange rate at initiation

The exchange rate six months after the contract was initiated

The average exchange rate between the initiation point and the closing of the contract

The exchange rates are all set at initiation

The exchange rates are all set at contract settlement

The notional value of the non-deliverable forward doesn't change

The offshore controlled currency market

Only the non-controlled currency market

The interest rates of the non-controlled currency

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