A forward contract is an agreement to buy or sell a product or asset for an agreed-upon price at a later time in the future.
In the event that the cash is not fully exchanged for the commodity or the asset, only the gain or loss is exchanged and this is called non-deliverable.
For example, if you buy a barrel of oil at $100 for delivery after a month and when the price of oil is $150, all that will happen is that you will receive $50 from the seller and buy from the market yourself.
A simplified example of the domestic NDF:
A foreign investor wants to buy shares in Egypt with a value of $100. On December 31, 2022.
The investor converts $100 into Egyptian pounds using the official exchange rate, which is EGP 20 to the dollar.
$100 x 20= EGP 2,000
If the stock price does not move for a year but the exchange rate drops to 25 pounds to the dollar, the investor will lose 20%.
EGP2,000/25 = $80
Forward contracts that are settled in Egyptian pounds insure the investor against the risk of depreciation in the exchange rate under a certain limit as follows:
1. At the beginning of the investment period, the foreign investor agrees with a local bank to sell the EGP 2000 after a year and buy the dollar at an agreed exchange rate from now on, let it be EGP 22 to the dollar.
2. The forward exchange rate (the EGP 22) is determined based on the interest rate differential between Egypt and America.
3. After a year, the official dollar exchange rate is already EGP 25, which is lower than the agreed exchange rate, which means that the investor has made a profit as a result of the hedging.
4. So, the client’s gain as a result of hedging = 2000/22 – 2000/25 = $11.
5. Finally, the $11 is paid to the customer’s account in Egyptian pounds in Egypt at the current exchange rate = 11 x 25 = 275 pounds.
This mechanism has been used in some emerging countries, such as Indonesia in 2018, during periods of pressure on the local currency exchange rate and the country’s desire to provide an insurance tool for foreign companies and investors.