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Definition: Non-Deliverable Swaps
A certain kind of currency swap between major and minor currencies where conversion is restricted or not allowed is known as Non –Deliverable Swaps (NDS). In a normal currency swap there is physical exchange of money / currency taking place. But in such a NDS case there is no delivery mechanism of currency. The settlement clearance of NDS takes place in a periodic basis on US Dollars denomination. Generally the numerical value is derived from the difference in the exchange rate mentioned in the swap and the current spot rate.
The important features in a NDS are the amount of money mentioned in the swap. The two currencies that are mentioned in the NDS. The settlement dates, the contract rates for the swap the fixing rates and the dates are all significant part of a NDS. NDS is generally used a hedging tool against currency risks like devaluation, depreciation and liquidity risks where the cost of exchanging currencies in the local market is prohibitive. Generally financial institutions in countries with restriction in foreign exchange uses NDS to hedge their foreign currency loan exposure.
For eg XYZ Co. based in Argentina has taken a loan of USD 10 million for a period of 5 years from a US lender at a fixed 5 % per annum semi annually. Lets say that XYZ has converted the USD into pesos at exchange rate of say 6 for business. There are fears that depreciation of peso will take place and so interest payments and principle repayment in USD will be costlier.
So to counter this NDS is considered with following features:
• Notional amount USD 500,000 for interest and principle of USD 10 million.
• Currencies : Argentine peso and USD
• Settlement dates : 10 (5 years semi annually) with the final one coinciding with principle repayment.
• Contract rate for swaps: let us assume contract rate of 7 pesos per dollar and 8 for principle repayment
• Fixing rate and date: 2 days before the final settlement date
So on the 1st fixing date that is 2 days before the 1st interest payment day let the spot exchange rate be 6.3 pesos to USD. XYZ will buy dollars at the rate of 7 thus the settlement amount then comes out to be USD 58,333 [(7-6.3)*500,00/6].
On 2nd settlement date say the spot rate has increased to 7.2 then the interest amount will be USD 16,666 [(7.2-7)*500,000/6]