Question

Company ABC imports product from China and is worried about the impact a potential upward revaluation of the Chinese yuan may have on its import costs. As a result ABC enters into a non deliverable forward contract with the following terms: Amount of contract 2,000,000 Chinese Yuan (CNY). Forward rate = 7.25 Chinese yuan per US dollar. Contract entered into on 1/1/2017. The contract will mature 6 months from 1/1/2017 (6/30/2017).  

Assume they are able to buy their Chinese yuan in the spot market at the rate of 8.000 chinese yuan per US dollar on 6/30/2017.

How is this transaction settled, in detail(include calculation showing amount contract settles for, amount paid for buying Chinese yuan in spot market, and the overall settlement amount)? How is it different from a forward contract? Why is a NDF done instead of a forward contract?

Answer 1

The transaction would be settled in cash at spot rate instead of the forward rate on 6/30/2017. The profit obtained per US Dollar would be: (8.000 - 7.25) Chinese yuan, i.e., 0.75 Chinese yuan.

The contract would be settled for $ 250,000, i.e., 200,000/8.

It is different from forward contract because in it settlement takes place at the spot rate instead of the forward rate.

NDF is done instead of a forward contract because it is found out to be more profitable.