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Non-deliverable forwards are a type of forward contract. They effectively involve two sides making an imaginary deal, usually on foreign currency exchanges. On the date this imaginary deal would have concluded, one side will pay the other a real amount based on what the outcome of the imaginary deal would have proven to be. Using this technique means the two sides don't have to have as much cash tied up in a deal. It can also be used where carrying out the deal en its entirety would be illegal.
A forward contract in this context is effectively a wager on future price movements, such as of foreign currencies. The name "non-deliverable forwards" comes from the fact that neither side "delivers" the items at the heart of the imaginary, or "notional," deal. Instead they simply pay or receive the profits that one side would have made from the deal.
To give an example of non-deliverable forwards, an agreement might be based around a notional agreement involving the exchange rate between the US dollar and the Japanese yen. The agreement could be that one side will agree that it will buy one hundred million yen in six months, paying in dollars at a rate agreed now. In six months time, when the deal completes, the exchange rate may have changed in its favor. The firm which agreed to buy the yen may be able to immediately sell the yen and get back more dollars than it has just paid for them. Alternatively the exchange rate may have moved in the other direction, meaning the yen are now worth less than the firm paid for them.
One obvious drawback of this deal is that the two sides need to have a large amount of cash on hand to complete the deal, even though once it is completed they will likely only be up or down by a small proportion. With non-deliverable forwards, the deal is simulated to avoid this problem. Whichever side would have lost out in the deal pays an amount to the "winning" side so that the final financial outcome is the same.
In the example given, the two sides would never exchange the hundred million yen. Instead they would agree this amount, the notional principal, as the basis of the deal. They would also agree the exchange rate which they will use to settle the deal, known as the contracted NDF rate. On the day the deal concludes they will compare this rate to the genuine prevailing market rate, known as the spot rate. The difference between these two rates is then multiplied by the notional principal to work out how much the "loser" must pay to settle the deal.
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