In a bid to control the pressure on the Nigerian naira, the Central Bank of Nigeria (CBN) recently introduced what it calls the Non-Deliverable Forwards contracts for dollars. So how does this work for the average firm that wants dollars.
1. A firm may need a certain amount of dollars say in three months time. For example, a firm may need $1 million in December 2016. Exchange rate today is at N318, but the Chief Financial Officer of the firm is afraid that the exchange rate may drop to N400 by December. If the firm pays for the dollar today, it will cost N318 million but if it waits till December, it will pay N400 million which is N82 million more. This could wipe off a significant part of the firm’s profit.
2. The firm has a choice of buying the $1 million today and holding unto it until it needs it in December. But this has a disadvantage as the firm will unnecessarily tie down money that could have been used for other business. On a macro level, this decision could also increase unnecessary demand for the dollar, which is spurred by fear rather than immediate need.
3. So this is why the Central Bank of Nigeria introduced the Non-Deliverable Forward Contracts, where a firm faced with this dilemma can guide against the risk of having to pay N82 million than it could pay today for $1 million by buying a Non Deliverable Forward (NDF) contract.
4. The CBN will sell a NDF contract to the firm at say today’s exchange rate of N318 to the US$ without giving the firm dollars immediately and also without the firm having to pay the N318 million immediately. It must be noted that this transaction does not include dollar delivery on the settlement date and the customer is expected to source dollars from the spot market on or before that settlement date.
5. If in December, as the firm feared, the official exchange rate of the Naira has actually dropped to N400, then the CBN will pay the firm the difference between the NDF contract rate of N318 and the new (spot) exchange rate of N400, which in this case is N82 per dollar or N82 million for the $1 million to enable the firm buy the $1 million it requires.
6. So a firm faced with the fear of a weakening naira, can take an NDF contract to guide against the risk of having to pay higher for future dollar requirements.
7. The CBN essentially introduced the NDF to help firms manage the risk of a weakening naira and also reduce the demand pressure on the naira in the spot market. If more firms push their demand to the futures market, it makes the naira stronger in the long run as demand in the spot market reduces.
Another reason why the CBN introduced the NDF product is to encourage foreign investors who are concerned that if they bring in their dollars for conversion and investment in the Nigerian market space, they face the risk of income and capital erosion when they eventually need to convert their naira back to dollars at the end of their investment cycle.
The NDF product helps these investors lock in their future price of dollars (price assurance) and helps their cash flow planning.