User:Nehagupta01/Sandbox

Non Deliverable Forwards:Italic text

The standard FX transaction was designed to facilitate the exchange of notional currencies for the purpose of cross-border commerce. The standard FX forward transaction allows for parties to the transaction to agree a rate of exchange days, weeks, months or even years in advance of the actual transaction occurring. The use of these transactions has evolved from its original purpose. FX transactions are commonly used to hedge exposure to exchange rate risk. An example of such use would be a manufacturing company making a product in Europe and selling the product in the United States. Such an organisation would have expenditure (plant, machinery, salary etc.) in Euros and revenue (from the sales of its product) in US Dollars. If the value of the Euro against the US Dollar increases, the cost base, relative to revenues, would increase, resulting in less profit. Conversely, the company would become more profitable if the value of the US Dollar increased against the Euro. To hedge against fluctuations in the exchange rate, the company might enter into a forward FX contract to sell US Dollars against Euros at the end of its fiscal year. If the value of the Euro increased against the US Dollar, the core business of the company would be less profitable. However, the value of the FX contract would increase and the profit from this transaction would offset the reduction in profitability.

This hedging strategy works well if currency exchange between the two counties is unrestricted. However, when exchange controls are in place, the strategy becomes less effective. This is particularly true in countries where the exchange controls either forbid, or heavily penalise large cross-border cash transfers. The Non-Deliverable Forward transaction was designed to overcome some of the problems of exchange controls by eliminating the need for cross-border cash transfers without eliminating the risk profile (and hence the hedge effectiveness) of the transaction.