pricing deliverable vs non-deliverable fx forwards

Question

I am trying to link these two questions together

Pricing a regular FX forward This is a contract (say USD vs JPY) where you exchange 2 currencies at maturity at a pre-determined rate, while no exchange happens today.

Pricing an Non- Deliverable FX forward This is a contract (Say USD vs TRY) where you exchange the net payment in a deliverable currency (USD) generally, instead of exchanging 2 currencies.

For a deliverable currency( say USDJPY case), the price of the contract should not change even if the contract calls for settling the net payment in USD instead of exchanging USD vs JPY.

But from second link, it seems that price of a non-deliverable FX forward is equal to a regular FX forward multiplied by some adjustment term.

Is there a reason why settling net payment in USD vs exchanging both currencies would lead to different prices?

Answer 1

First let us look more closely ay physical-delivery forward contract, so we can contrast it to non-delivery one. On the maturity date, one party pays notional N first currency (such as USD or EUR) and recives notional strike * N second currency (such as JPY). The other party receives USD, pays JPY.

The strike is typically calculated from the spot exchange rate and the interest rates of both currency so the mark to market would be zero at inception. The mark to market on the following days, until maturity, depends on the spot rate and the interest rates.

In contrast, in a non-delivery contract, there is one more date called determination date or observation date. It is typically 2 business days before maturity, using both currencies' calendars. On that date, the spot rate is observed (typically, most countries' central banks publish some official rate of their currency v USD). After that, the foreign currency leg is worth exactly USD F = strike * N / observed_rate. On maturity date, the side that had sold USD and bought foreign currency, either pays USD N - F if strike is less than observed_rate, or receives F - N if strike is greater than observed_rate (unless the foreign currency is quoted cable). The mark to market stops being sensitive to the spot rate once observed_rate is observed.

You would not need this if you did not have this 2-day observation delay, i.e. if maturity date were the same as the determination date somehow, but this is how the contract always trades.