What is an Undeliverable Exchange (NDS)?
A non-deliverable swap (NDS) is a variation of a currency swap between major and minor currencies that is restricted or non-convertible. This means that there is no actual delivery of the two currencies involved in the swap, unlike a typical currency swap where there is physical exchange of currency flows. Instead, the periodic settlement of an NDS is made in cash, usually in US dollars.
The settlement value is based on the difference between the exchange rate specified in the swap contract and the spot rate, with one party paying the difference to the other. An undeliverable swap can be viewed as a series of pooled undeliverable futures.
Key points to remember
- An undeliverable swap (NDS) is a type of currency swap that is paid and settled in US dollar equivalents rather than the two currencies involved in the swap itself.
- Consequently, the swap is considered to be non-convertible (restricted) since there is no physical delivery of the underlying currencies.
- NDS is generally used when the underlying currencies are difficult to obtain, illiquid or volatile – for example, for the currencies of developing countries or restricted currencies like Cuba or North Korea.
Understanding undeliverable exchanges (NDS)
Undeliverable swaps are used by multinational companies to mitigate the risk that they will not be allowed to repatriate profits due to currency controls. They also use NDS to cover the risk of devaluation or sudden depreciation in a tight currency with little liquidity and to avoid the prohibitive cost of exchanging currencies on the local market. Financial institutions in countries with exchange restrictions use NDS to hedge their exposure to foreign currency loans.
The key variables of an NDS are:
- notional amounts (i.e. transaction amounts)
- the two currencies concerned (the non-deliverable currency and the settlement currency)
- settlement dates
- the contractual swap rates, and
- fixing rates and dates – the specific dates on which the spot rates will come from reliable and independent market sources.
Consider a financial institution – let’s call it LendEx – based in Argentina, which contracted a loan of 10 million US dollars over five years with a American lender at a fixed interest rate of 4% per year, payable semi-annually. LendEx has converted the US dollar into Argentine pesos at the current exchange rate of 5.4 for loans to local businesses. However, it is concerned about the future depreciation of the peso, which will make it more expensive to pay interest and repay the principal in US dollars. It therefore enters into a currency swap with a foreign counterparty under the following conditions:
- Notional amounts (N) – US $ 400,000 for interest payments and US $ 10 million for the repayment of capital.
- Currencies affected – Argentine peso and US dollar.
- Payment dates – 10 in all, the first coinciding with the first interest payment and the 10th and final coinciding with the final interest payment plus the repayment of the principal.
- Contractual swap rates (F) – For the sake of simplicity, let’s say a contractual rate of 6 (pesos per dollar) for interest payments and 7 for repayment of the principal.
- Fixing of prices and dates (S) – Two days before the settlement date, from 12 noon EST of Reuters.
The PDN methodology follows the following equation:
Profit = (NS – NF) / S = N (1 – F / S)
Here’s how NDS works in this example. On the first fixing date – that is, two days before the first payment / interest payment date – assume that the spot exchange rate is 5.7 pesos for the US dollar. Since LendEx is committed to buying dollars at the rate of 6, it should pay the difference between this contractual rate and the spot rate multiplied by the amount of notional interest to the counterparty. This net settlement amount would be in US dollars and corresponds to – $ 20,000 [i.e. (5.7 – 6.0) x 400,000 = -120,000 / 6 = -$20,000].
On the second fixing date, assume that the spot exchange rate is 6.5 for the US dollar. In this case, because the spot exchange rate is worse than the contracted rate, LendEx will receive a net payment of $ 33,333 [calculated as (6.5 – 6.0) x 400,000 = 200,000 / 6 = $33,333].
This process continues until the final repayment date. A key point to note here is that, since this is an undeliverable swap, payments between counterparties are made in US dollars and not in Argentine pesos.