A primer on NDF tenor elongation

  • In mid-February 2020, the Central Bank of Nigeria (CBN) announced an extension of its supply of Naira settled OTC FX futures with the addition of forty-seven (47) new monthly OTC FX Futures contracts to the existing thirteen (13) contracts have been introduced from February 13, 2020, bringing the total number of open OTC FX Futures contracts at any point to sixty (60).
  • What are Naira settled OTC FX Futures contracts? These are non-deliverable forwards (NDF) contracts sold by the CBN to a certain class of investors (foreign direct investors, foreign portfolio investors and local corporates with FX denominated loans) which provide a means of hedging against the risk of Naira devaluation. The work like your standard FX forward/futures in that they allow you lock-in a set exchange rate today for a future delivery date only that these arrangements are Naira settled on maturity. On maturity, buyers of these OTC contracts don’t receive USD but the difference between the spot rate and the agreed rate in the contract. The NAFEX rate will serve as the benchmark rate while the futures will be marked-to-market with initial and maintenance margin requirements posted to the clearing house (FMDQ-Clear). However, it is important to note that investors still face liquidity risk as the OTC FX futures merely provide protection against currency depreciation with no guarantee on dollar liquidity at maturity. Pricing on the NDF’s are supplied by the CBN which is the sole supplier of this contract.
  • What has changed from before? Previously, investors looking to hedge only had monthly quotes for Naira settled OTC futures until February 2021, but with the elongation you now have monthly contracts to hedge FX devaluation risk from now until January 2025. The development should help ameliorate concerns from the class who need long-term capital hedging options for investment and capital budgeting purposes which should reduce the desire to front-load USD purchases during periods of uncertainty.
  • What is the pricing like? The new NDF offerings were priced at slight premiums to the spot rates with the 5-year tenor at NGN379.81/$ implying forward points of 15 to the spot USDNGN exchange rate (4% premium). Following the announcement, the 1-yr onshore forward contract appreciated to NGN391.96/$ (+2%, YTD, +2.4%) possibly reflecting the increased supply of cheaper hedging options.

Figure 1: NDF prices and premium (%)

NDF premium

Source: FMDQ

  • What is the underlying rationale? The introduction of longer NDF tenors, which follows the introduction of some FX curbs on milk imports (shortly after similar curbs were imposed on fertilizer imports)[1] likely reflects defensive measures by the CBN to dampen the pace of the declines in FX reserve. YTD, Nigeria’s external reserves have declined 6% to USD36.7billion (5months of import cover) on fundamental concerns (a current account deficit and subdued portfolio inflows).
  • Are the NDF futures appropriately priced? Reverse engineering the risk-free rates implied in the NDF futures price[2] and comparing with spot FGN bond yields, it appears that the CBN is pricing the NDF futures using much lower risk-free rates than is currently obtainable on the Naira yield curve (See Figure 2 below). For example, while the 5-yr FGN bond yield trades at 10.2%, the NDF pricing implies the CBN is saying the 5-yr FGN bond yield is 0.6%. This lends credence to the view that the real goal of the NDF elongation is likely to provide cheaper hedging options for foreign portfolio investors to rollover 1-yr OMO bill positions.

Figure 2: Implied pricing and spot FGN yields (%)

NDF implied yield

Source: FMDQ

  • What would an appropriately priced NDF look like? In finance theory, the forward price should reflect the interest rate differential between two currencies to ensure no arbitrage. For example, using the actual spot levels of FGN bonds and US Treasuries to price the NDF futures, the no-arbitrage price would place the 5-year forward price at NGN552.71/$.

Table 1: Forward price computed under uncovered interest rate parity.

No arb price

Source: FMDQ

  • Would the cheap NDF prices induce a pick-up in rollovers: Looking at the relatively cheap pricing on the elongated NDF contracts and the high yields on 1-yr OMO bills relative to the NGN yield curve (where yields are most negative in real terms), there is scope to argue that present holders of OMO bills will likely rollover their positions. Most recent CBN data on foreign OMO bill holdings places the number at USD12.5billion at the end of November. Indeed, open positions on NDF contracts have climbed from USD5billion at the end of January 2019 to USD10.9billion at the end of January 2020 implying that more foreign portfolio investors are purchasing protection against NGN depreciation in view of dwindling FX reserves and softer oil prices.

Figure 3: Open NDF contracts and Hedge ratio*

hedge ratio

Source: FMDQ *defined as the ratio of NDF open contracts to foreign OMO bill positions in Nigeria

  • That said, renewed oil price weakness due to the impact of the coronavirus on crude demand, implies that rollovers are likely to be limited. In the absence of any EM bond index inclusions and the existing high yields on OMO bills, there is limited scope for foreign appetite for FGN bonds as the negative real returns limit headroom for further duration gains from yield compression.

[1] CBN restricted all but six (6) milk importers from accessing FX citing a desire to bolster local milk production. Nigeria spends USD1.5-2billion on milk imports.

[2] Using the interest rate parity conditions that futures prices are the product of the Spot price and interest rate differentials between FGN bond yields and US treasuries of similar maturities.

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