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News: The Reserve Bank of India barred banks from NDD contracts in rupee to curb misuse, stabilize currency, and improve transparency.
About Non-Deliverable Derivative (NDD) Market
- An NDD is a derivative contract where parties agree on a future rupee exchange rate but settle differences in cash, usually in US dollars.
- Mechanism
- Agreement on Exchange Rate: Two parties enter into a contract and agree on a future exchange rate for the rupee.
- No Physical Delivery: Due to capital controls, offshore investors cannot trade the rupee physically, so the contract does not involve actual currency delivery.
- Calculation of Difference: On the settlement date, the difference between the agreed exchange rate and the prevailing market rate is calculated.
- Cash Settlement: The calculated difference is settled in cash, usually in US dollars, instead of exchanging the rupee.
- Purpose of Structure: This mechanism allows participants to take positions on the rupee’s movement without handling the currency itself.
- Offshore Nature: NDD trades occur outside India in financial hubs and remain outside RBI control.
- Eligibility: It is mainly used by foreign investors, hedge funds, and global banks who cannot freely access the rupee market.
- Role in Price Discovery: NDD markets influence rupee expectations and often act as a price discovery mechanism before Indian markets open.
- Limitations: NDD markets distort price discovery and are misused for speculative activities through repeated contract entry and exit.
- Significance for India: The RBI move reduces speculative activity, limits misuse, stabilises rupee volatility, and strengthens the onshore market.
