[Song Seungseop's Financial Light] How Did NDF Shake the Korean Foreign Exchange Market?

NDF is a Foreign Exchange Transaction Without Money Exchange
Due to Domestic Foreign Exchange Regulations, Won-Dollar NDFs Flourish
NDFs Reverse Impact on Korean Exchange Rate
"Opening Foreign Exchange Market Can Absorb NDFs"

Editor's NoteFinance is difficult. Confusing terms and complex backstories are all tangled together. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, basic financial knowledge must be grounded. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these 'light' stories that turn on the bright 'light' of finance for you.

A staff member organizing US dollars at the Hana Bank Counterfeit Response Center in Euljiro, Seoul. Photo by Mun Ho-nam munonam@

[Asia Economy Reporter Song Seung-seop] The government has decided to allow foreign financial firms to participate in the domestic foreign exchange market. There are several reasons, and the Non-Deliverable Forward (NDF) is one of them. Kim Sung-wook, Director General of International Economic Affairs at the Ministry of Strategy and Finance, once said, “Speculative trading in the offshore NDF market is driving exchange rate movements, causing the Korean won to be perceived as a risky currency in the global market.” Although NDF is an unfamiliar concept and seems difficult, if you carefully examine it, you can understand why the government has such thoughts.

NDF stands for Non-Deliverable Forward. Literally translated into Korean, it means ‘a forward exchange transaction that is not delivered’ or ‘a forward exchange transaction without actual delivery.’ It is a foreign exchange transaction, but it means that money is not actually exchanged. To fully understand NDF, you first need to understand spot exchange transactions and forward exchange transactions.

NDF: Earning Profit from Exchange Rate Fluctuations Without Actual Foreign Exchange Transactions

Spot exchange refers to foreign exchange transactions that occur immediately. Let's assume that 1,000 Korean won equals 1 US dollar. Person A, who has 1,000 won, exchanges it for 1 dollar at Bank B. This is a spot exchange transaction, where currencies of different countries are exchanged based on current value. Although expressed in technical terms, exchanging money at a bank at the current exchange rate for travel is a spot exchange transaction. In the foreign exchange market, exchanging money within two business days is generally considered a spot exchange transaction.

On the other hand, forward exchange transactions do not occur immediately. The exchange rate and the exchange date are predetermined. Let's think about Person A exchanging 1 dollar at Bank B again. However, this time, A and Bank B agree to exchange 1 dollar for 1,500 won six months later. A and Bank B wait for six months. Regardless of the exchange rate after six months, A pays Bank B 1,500 won and receives 1 dollar. This is called a forward exchange transaction, where the exchange rate, currency type, and period are predetermined. The period is usually set between one week and six months.

Did you notice a very important characteristic that arises in forward exchange transactions, unlike spot exchange? Depending on how the contract is made, someone incurs a loss. A paid 1,500 won to receive 1 dollar after six months. But what if the exchange rate rises to 2,000 won per dollar? A effectively exchanged dollars 500 won cheaper. Bank B could have received 2,000 won but only got 1,500 won due to the prior contract. Conversely, if the exchange rate dropped to 500 won per dollar, A suffers a loss, and Bank B gains.

In other words, if you use forward exchange transactions well, you can avoid risks from exchange rate fluctuations. Because the contract is made in advance, you won't suffer large losses from soaring or plummeting exchange rates. This investment technique is called ‘currency hedging.’ If you actively use forward exchange transactions, you can also make significant profits. If you predict the exchange rate will rise or fall well, you can set a favorable price in the forward contract. In fact, in the foreign exchange market, there is a lot of ‘currency speculation’ capital trying to make money using this.

Since NDF is a type of forward exchange transaction, it also involves funds for currency hedging and speculation. However, unlike forward contracts, NDF does not involve actual currency exchange. Instead, on the contract date, only the difference between the predetermined exchange rate and the actual exchange rate is exchanged. For example, A agreed with Bank B to pay 1,000 won and receive 1 dollar six months later. But after six months, the exchange rate rose to 1,500 won per dollar. Then A gains 500 won. A bought a dollar worth 1,500 won for 1,000 won. In this case, if an NDF contract was made, A does not actually exchange currency but only receives the profit difference (500 won).

NDF Exchange Rate Actually Influences Korea’s Real Exchange Rate

The scale of foreign exchange derivative transactions by foreign exchange banks last year. In 2022, the average daily forward exchange transaction volume was 12 billion dollars, an increase of 770 million dollars (6.8%) compared to the previous year. Data=Bank of Korea

If you want to speculate for exchange rate gains, NDF would be advantageous. Forward contracts require actual money exchange, which is cumbersome. You have to settle the entire contract amount. But with NDF, only the difference is traded, so additional costs are much lower. In fact, NDF is used more for currency speculation than for hedging. Up to 80% of NDF transactions are known to be speculative.

Interestingly, the most actively traded currency pair in the global NDF market is the won-dollar pair. While the spot exchange market is outside the top 10, the NDF market ranks first. This is due to Korea’s foreign exchange regulations. Under current law, foreigners cannot trade won domestically. Since they cannot trade directly, foreign investors who want to hedge or speculate must turn to the NDF market. Because NDF does not involve actual money exchange, foreign banks can freely participate.

You might wonder what the problem is, but as NDF trading grows, the foreign exchange market becomes distorted. Foreign investors have started to refer to the NDF exchange rate when predicting the won-dollar exchange rate. Seeing an NDF contract to exchange 1 dollar for 1,000 won in six months means they predict the actual exchange rate will be 1,000 won per dollar in six months. Speculators’ expectations actually make the won-dollar exchange rate in Korea become 1,000 won per dollar in six months. The NDF market, a forward contract and derivative product, ironically influences the spot exchange market in Seoul, creating a so-called ‘tail wagging the dog’ structure.

The government predicts that allowing foreign institutions to directly buy and sell won domestically will reduce these side effects. Since the narrow channel of Korea’s foreign exchange market caused this issue, widening the channel will reduce exchange rate volatility. The Bank of Korea explained, “Since the global regulatory tightening after the financial crisis increased NDF transaction costs, overseas investors prefer to trade directly in the domestic market rather than the NDF market,” and added, “The domestic market can sufficiently absorb NDF transactions.”

This content was produced with the assistance of AI translation services.