Derivative and Currency

Question 1

Non-Deliverable Forwards (NDFs)

Answer 1

• NDFs are cash-settled in the non-controlled currency of the currency pair. Non-deliverable forwards exist in situations involving capital controls on one of the currencies. The controlled currency cannot be physically settled (i.e., not delivered or received), but instead it is cash-settled in the non-controlled currency.
• The credit risk underlying an NDF is lower than an outright forward contract since the notional size of the contract is not exchanged at settlement, but only the non-controlled currency amount by which the notional size of the controlled currency has changed over the life of the contract—that is, the change in the controlled currency times the notional size converted to the non-controlled currency at the spot rate on the settlement date.
• The pricing of NDFs may differ from what is expected on the basis of arbitrage conditions. When capital controls exist, the free cross-border flow of capital that ensures the arbitrage condition underlying covered interest rate parity does not function consistently, and so the pricing of NDFs may differ from what is expected under arbitrage conditions.

Question 3

Three Principles for Market Technicians

Answer 3

In forming a market view on such turning points in future exchange rate movements (e.g., peaking in the US dollar) or timing-related position entry and exit points, market technicians follow three principles:

(1) Historical price data can be helpful in projecting future movements,
(2) historical price patterns have a tendency to repeat and identify profitable trade opportunities, and
(3) technical analysis attempts to determine not where market prices should trade but where they will trade.