Non-Deliverable Swaps (NDS): Definition, Function & How They Work

A non-deliverable swap (NDS) is an exchange of different currencies, between a major currency and a minor currency, which is restricted.

With most swaps, currency flows physically change. With an NDS, it is not the case because the currencies are not convertible. The two currencies that are involved in the swap can’t be delivered; hence it is a non-deliverable swap.

There is a way to periodically settle an NDS. It is done through cash, most often using the U.S. dollar. When making a settlement between the two currencies involved, value is based on the spot rate and the exchange rate listed in the swap contractCurrency Swap ContractA currency swap contract (also known as a cross-currency swap contract) is a derivative contract between two parties that involves the. In order to bring the NDS to a settlement, one of the parties involved needs to pay the other the difference in the rates between the time of the contract’s origination and its settlement.

Summary:

•  A non-deliverable swap (NDS) involves the exchange of a major currency and a minor currency, which is restricted.
• An NDS differs from a non-deliverable forward (NDF) in two primary ways: NDFs don’t usually involve major currencies, and the difference between the contract and spot rates is an agreed upon, notional amount.
• The U.S. dollar is the most universally used settler for non-deliverable swaps.

Non-Deliverable Swap vs. Non-Deliverable Forward

One major difference between an NDS and a non-deliverable forward (NDF) is the use of a major currency as a conduit for settling the swap. An NDS is used when an exchange needs to be made between a restricted currency and a major one. The U.S. dollar is an almost universally used settler for NDS.

An NDF doesn’t typically involve a major currency in the exchange. In addition, when two parties participate in an NDF, the difference between the contract’s rate and the spot priceSpot PriceThe spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now. is settled when both parties agree to a notional amount, which is a face value that can be used to facilitate the exchange.

Example of an NDS

To best understand how an NDS works, let’s look at the following example:

Two major companies enter into a swap. The exchange is taking place between the U.S. dollar and won, South Korea’s currency.

In the swap, the contract comes with a fixed rate that’s been taken directly from the spot rate. For our example, let’s say that the rate is 800 won/dollar. The U.S.-based company is set to pay $150,000; the South Korean company is set to pay $90,000 won.

Using the fixed rate established in the contract, it means, then, that the South Korean company must pay $112,500 US dollars ($90,000 / 800) in order to keep in line with the company from the U.S. Because the South Korean company is now paying more, it’s the U.S. company’s responsibility to pay its Korean counterpart the difference.

The swap is settled when the company from the U.S. pays the South Korean company $22,500 dollars ($112,500 – $90,000) to make up the difference.

Related Readings

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