Non-Deliverable Swaps and Options (NDS, NDO)

Corporate treasurers who hedge rupee borrowing or investment, and the people who settle those trades, meet two instruments besides the NDF: a swap that pays many times during its term, and an option that protects one side of the move for a fee.

How an NDS works, and the NDIRS

A non-deliverable swap (NDS) converts the interest and principal of a swap into a settlement currency such as the US dollar, at the exchange rate on a determination date set for each currency, and pays or receives them in that currency. An NDS takes one of two forms: the non-deliverable interest rate swap (NDIRS), in the form of an interest rate swap, or the non-deliverable cross-currency swap (NDCCS), in the form of a currency swap¹.

An NDIRS is an interest rate swap that exchanges fixed and floating interest on the same notional amount, and the difference is paid in dollars². The notional amount and the rates are set in a currency such as the rupee, but no rupees change hands, so you can trade rupee interest rates without holding rupees. Paying only a difference in one currency is the same as an NDF. The basics of a trade that pays one difference are covered on the Non-Deliverable Forwards (NDF) page.

Consider a hypothetical example in which Company J and Bank I enter a one-year NDIRS with a notional amount of INR 840 million. Company J pays a fixed rate of 6.50% per year and receives a floating rupee rate. Take one of the semiannual payments, in which the floating rate for the period is 6.00% per year³.

The date that sets the conversion rate (the determination date) depends on the rules for each currency. The INR 2.1 million is converted into dollars at the fixing (the rate used for conversion) and paid. Company J's payment at each fixing is as follows⁴.

The rupee difference is the same at every fixing, and the weaker the rupee (the higher the fixing), the smaller the dollar payment. If the floating rate were 7.00% per year, Company J would receive INR 2.1 million, converted into dollars at the same fixings. Both interest rate moves and exchange rate moves decide the amounts paid and received.

Currency swap with converted principal (NDCCS)

An NDCCS converts the interest and principal on the rupee side into dollars at the fixing and pays or receives them⁵. The basics of a currency swap that actually exchanges principal are covered on the Cross-Currency Swaps page. In an NDCCS, the rupee principal is paid or received in dollars, at its converted value on the final date.

Consider a hypothetical example in which Company J and Bank I enter a three-year NDCCS, with a rupee notional amount of INR 840 million and a dollar notional amount of USD 10 million. Company J is a dollar-based company with rupee debt, and the rupees it receives are meant to cover payments on that debt. Company J receives a fixed rupee rate of 7.00% per year and pays a floating dollar rate. Interest is paid once a year, principal is paid or received only on the final date, and everything is settled in dollars. The rate at the start of the trade is INR 84.00 per dollar. The rupee amounts are converted into dollars by dividing by the fixing in rupees per dollar⁴.

Figure description

The rupee-side amounts are set by the fixing on each date, so they are not known when the trade is made. The dollar interest also depends on a floating rate. The arrow length is a rough guide to the size of each amount, and Bank I's payments are in the opposite direction from Company J's at every date.

The interest payments after one year are as follows, assuming the floating dollar rate for the period is 4.00% per year.

On the final date, Company J receives the INR 840 million of rupee principal divided by the fixing, in dollars, and pays the USD 10 million of dollar principal⁶. At a fixing of INR 87.50, it receives USD 9.6 million and pays USD 10 million. At INR 80.00, it receives USD 10.5 million and pays USD 10 million. The difference between the two flows equals the settlement of an NDF on the side that buys rupees.

Option that pays a difference (NDO)

A non-deliverable option (NDO) is a currency option that does not deliver currency. When the right has value, it pays only the difference, in a settlement currency such as the dollar. In the template of the industry association EMTA, the right can be exercised only at expiry, so it is a European option, and the template has fields for the premium, the premium payment date, and the buyer and seller⁷. The exercise deadline is the time the fixing is set, and the settlement date is no later than 2 business days after the day the fixing is set.

Consider a hypothetical example in which Company M expects to receive INR 840 million in three months, and buys from Bank I the right to sell rupees and buy dollars. The notional amount is USD 10 million, the strike price is INR 84.00 per dollar, and the premium is USD 150,000. The payout is calculated as follows⁸. When the fixing at expiry is above INR 84.00, Company M multiplies the notional amount by the difference between the fixing and the strike to get the rupee difference, and receives that amount converted into dollars at the fixing.

$$\text{Company M's payout (USD)} = N \times \frac{\max(S - K, 0)}{S}$$

$N$ is the notional amount (in dollars), $K$ is the strike, and $S$ is the fixing (both in rupees per dollar). In this formula, the payout is 0 when the fixing is at or below the strike, and Company M loses only the premium. Assuming the proceeds from selling the rupees can be converted into dollars at the same rate as the fixing, the dollars from the rupees and the NDO result combine as follows.

Even if the rupee weakens, Company M's total does not fall below USD 9.85 million. If the rupee strengthens, Company M keeps the increase in the dollars from the rupees, after deducting the USD 150,000 premium it bears as the option buyer. With an NDF, Company M would give up that increase but would not pay a premium.

Figure description

The chart shows the profit or loss of Company M, the NDO buyer, including the USD 150,000 premium, for each fixing at expiry. On the left, where the fixing is at or below the INR 84.00 strike, the loss stays constant at the USD 150,000 premium. Above the strike, the profit rises toward the right. The line flattens as it moves right, because the rupee difference is divided by the fixing to convert it into dollars. The profit or loss is 0 at a fixing of about INR 85.28.

How the fixing and settlement currency are set

The fixing used for NDS conversion and NDO exercise is set by the template or standard terms for each currency. The swap execution facility tpSEF presented contract terms in 2017 that divide currencies into two groups. One group is currencies whose fixing uses the NDF template (such as the Brazilian real). The other follows the ISDA standard terms for NDS (Asian terms): the Indian rupee, the Malaysian ringgit, and the Thai baht. For the Brazilian real and similar currencies, the determination date is 2 business days before the payment date⁹.

In the template for the Indian rupee NDO (effective July 10, 2018), the fixing is INR FBIL (INR01), which is published at about 1:30 p.m. Mumbai time. The NDF template uses the same INR FBIL (INR01)⁷¹⁰.

If the valuation date is not a business day, it moves to the preceding business day, and if an unscheduled holiday is declared, it moves to the next business day. The cities that define business days are Mumbai for the valuation date and New York for the settlement date⁷. If the fixing is not published, fallbacks apply in this order: postponement of the valuation, a rate from an industry poll, and a determination by the calculation agent (the party the trade designates to set the rate)⁷.

The settlement currency is the dollar in the INR NDO template, in the tpSEF contract terms, and in the cleared NDIRS⁷¹².

When the settlement currency is not the dollar, the 2011 EMTA guide shows how to build the settlement rate from the rate of the non-deliverable currency, such as the rupee, against the dollar and the rate of the settlement currency against the dollar. It also includes a trade-terms template, using the Brazilian real and euro pair as an example¹¹.

Clearing practice

The clearing house LCH clears NDIRS through SwapClear. In its 2023 factsheet, eight currencies are eligible: the Brazilian real, Chilean peso, Chinese yuan, Colombian peso, Indian rupee, Korean won, Thai baht, and Taiwan dollar¹². For a cleared NDIRS, all payments, including variation margin, interest, and upfront fees, are instructed in dollars¹².

Differences from the NDF

An NDF pays one difference on the settlement date. An NDS pays an amount converted at the fixing on each payment date of the swap, and an NDO pays at expiry.

An NDF fixes only a single conversion, on the settlement date. A trade that pays rupee interest many times, such as an NDS, converts the rupee amount into dollars on each payment date. An NDO protects only against the loss from a weaker rupee and keeps the gain from a stronger rupee, in exchange for the premium the buyer bears.

Notes

1. tpSEF Inc., "Regulation 40.2 Certification of Non-Deliverable Swaps – INR-MITOR-OIS-COMPOUND" (external site) (October 26, 2017), Exhibit B, Summary and Settlement Currency (pages 4 and 5). ↩ ↩²

2. LCH Limited, "Self Certification: Rule Changes on the addition of Non-Deliverable Swaps as eligible SwapClear products" (external site) (April 13, 2018), Part I (page 1), and Procedures 1.7.6 and 1.8.15 (pages 25 and 29). ↩ ↩²

3. Half a year is taken as 0.5 to simplify the day count. ↩

4. The same terms (external site), Fixed Amount and Floating Amount (pages 6 and 7) and Applicability of Asian Terms (page 10). The Indian rupee is calculated under Asian Terms, and the terms contain no formula for it. The conversion in the text applies the form used for currencies outside Asian Terms, as an example. ↩ ↩²

5. The same terms (external site), Currency Amount, Fixed Amount, and Floating Amount (pages 6 and 7). The rupee side is the Index Currency and the dollar side is the Settlement Currency. ↩

6. The same terms (external site), Final Exchange (pages 8 and 9). This formula covers currencies outside Asian Terms, and the Indian rupee follows Asian Terms (page 10). The conversion in the text applies the formula with the FX Rate taken as rupees per dollar and used as a divisor, as an example. ↩

7. EMTA, Inc., "EMTA Template Terms for INR / USD Non-Deliverable Currency Option Transactions" (external site) (effective July 10, 2018), General Terms, Other Terms, and endnote 2. ↩ ↩² ↩³ ↩⁴ ↩⁵

8. EMTA, Inc., "User's Guide to Documenting Non-Deliverable Cross Currency FX and Currency Option Transactions" (external site) (May 31, 2011), Appendix A (page A-2), In-the-Money Amount. The formula in the text applies it to dollar settlement, as an example. ↩

9. The same terms (external site), FX Rate (page 6) and the table of Applicability of Asian Terms (page 10). ↩

10. EMTA, Inc., "SFEMC & EMTA Template Terms for INR / USD Non-Deliverable FX Forward Transactions" (external site) (effective July 10, 2018), Settlement Rate Option. ↩

11. EMTA, Inc., "User's Guide to Documenting Non-Deliverable Cross Currency FX and Currency Option Transactions" (external site) (May 31, 2011), Section I (pages 2 and 3) and Market Practice No. 58 (page 4). ↩

12. LCH Limited, "Non-deliverable interest rate swaps" (external site) (2023), pages 1 and 2. ↩ ↩²