Currency Question about Yuan

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 2,030,500 Chinese Yuan (CNY). Forward rate = 7.5 Chinese yuan per US dollar. Contract entered into on 1/1/2012. The contract will mature 6 months from today (6/30/2012).
Assume they are able to buy their Chinese yuan in the spot market at the rate of 8.122 chinese yuan per US dollar on 6/30/2012.
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

Start with what the contract is doing. ABC is concerned that the yuan might strengthen (fewer CNY per USD), which would increase its import costs in dollar terms. To hedge that risk, it enters into a non-deliverable forward (NDF) locking in 7.5 CNY/USD on a notional amount of 2,030,500 CNY.

At maturity (6/30/2012), the spot rate is 8.122 CNY/USD. That means the yuan actually weakened (more CNY per USD), so the hedge ends up generating a loss—but it still locks in an effective cost near the forward rate.

First, compute the NDF settlement. NDFs are cash-settled in USD based on the difference between the forward rate and the spot rate:

Settlement (USD) = Notional in CNY × (1 / Forward rate − 1 / Spot rate)

Settlement = 2,030,500 × (1/7.5 − 1/8.122)

1/7.5 ≈ 0.133333

1/8.122 ≈ 0.12312

Difference ≈ 0.010213

Settlement ≈ 2,030,500 × 0.010213 ≈ 20,740 USD

Because the forward rate (7.5) is lower than the spot rate (8.122), ABC pays about $20,740 to the counterparty.

Next, ABC still needs to obtain the yuan in the spot market to pay its supplier:

USD needed = Notional in CNY / Spot rate

USD needed = 2,030,500 / 8.122 ≈ 249,995 USD

Now combine the two cash flows to get the total effective cost:

Total cost = Spot purchase + NDF settlement

Total cost ≈ 249,995 + 20,740 ≈ 270,735 USD

As a check, compare this to what ABC effectively locked in via the forward rate:

Cost at forward = Notional in CNY / Forward rate

Cost = 2,030,500 / 7.5 ≈ 270,733 USD

The results are essentially identical, confirming that the hedge worked as intended: ABC’s effective exchange rate is about 7.5 CNY/USD regardless of what happened in the market.

In contrast, a standard (deliverable) forward would involve actual exchange of currencies at maturity—ABC would pay USD at the agreed rate and directly receive 2,030,500 CNY. There would be no separate spot transaction and no cash settlement difference. With an NDF, there is no physical delivery; only a net USD payment is made, and the firm must still transact in the spot market.

NDFs are typically used when the underlying currency is restricted or not freely convertible. In 2012, the Chinese yuan had capital controls that limited offshore deliverability. The NDF structure allows firms like ABC to hedge exchange rate risk without needing to physically exchange currencies, settling instead in USD while still achieving the same economic outcome as a forward.