Non-Deliverable Swap (NDS)

What Is a Non-Deliverable Swap (NDS)?

A non-deliverable swap (NDS) is a variation on a currency swap between major and minor currencies that is restricted or not 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, periodic settlement of a NDS is done on a cash basis, generally in U.S. 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 other the difference. A non-deliverable swap can be viewed as a series of non-deliverable forwards bundled together.

Understanding Non-Deliverable Swaps (NDS)

Non-deliverable swaps are used by multi-national corporations to mitigate the risk that they may not be allowed to repatriate profits because of currency controls. They also use NDSs to hedge the risk of abrupt devaluation or depreciation in a restricted currency with little liquidity, and to avoid the prohibitive cost of exchanging currencies in the local market. Financial institutions in nations with exchange restrictions use NDSs to hedge their foreign currency loan exposure.

The key variables in a NDS are:

NDS Example

Consider a financial institution – let’s call it LendEx – based in Argentina, that has taken a five-year US$10 million loan from a U.S. lender at a fixed interest rate of 4% per annum payable semi-annually. LendEx has converted the U.S. dollar into Argentine pesos at the current exchange rate of 5.4, for lending to local businesses. However, it is concerned about the future depreciation of the peso, which will make it more expensive to make the interest payments and principal repayment in U.S. dollars. It therefore enters into a currency swap with an overseas counterparty on the following terms:

The methodology for determining the NDS follows the following equation:

Profit = (NS – NF) / S = N (1 – F/S)

Here’s how the NDS works out in this example. On the first fixing date – which is two days before the first interest payment / settlement date – assume the spot exchange rate is 5.7 pesos to the U.S. dollar. Since LendEx has contracted to buy dollars at a rate of 6, it would have to pay the difference between this contract rate and the spot rate times the notional interest amount to the counterparty. This net settlement amount would be in U.S. dollars and works out to -$20,000 [i.e. (5.7 - 6.0) x 400,000 = -120,000 / 6 = -$20,000].

On the second fixing date, assume the spot exchange rate is 6.5 to the U.S. 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 because this is a non-deliverable swap, settlements between the counterparties are made in U.S. dollars, and not in Argentine pesos.