I was so intrigued by implied forward rates that I asked Noet Ravalo for more explanations. Here is his first
guest post on MoneySmarts:
Let me put my teacher cap on. Example na lang. Mas madaling intindihin. What if investor has P1 million to invest. Choices are a peso one-year Treasury at 6% versus a one-year US Treasury at 4%. What will investor do? Answer = he needs to read Salve's blog to find out what implied forward rates will do.
Let the peso-dollar rate be P50 to one so that the P1 million is $20,000. For as long as peso returns are higher, the investment decision is obvious (go with peso treasury). But what comprises the return are (a) the outright interest and (b) the value of the currency upon maturity. So, "return" is interest rate LESS depreciation.
Implied forward rates will calculate the "break-even" exchange rate to make the investor neutral between peso or USD investment. Since the peso has higher interest, we know that the peso can afford to weaken versus the dollar before the advantage of the interest rate (6% - 4%) is totally eliminated.
The investor then makes a decision what he thinks the actual peso-dollar rate will be in one year. If the forecast is that the peso will be stronger than the implied forward rate then stay with peso investment. If the forecasted peso rate is weaker then go dollar investment.
The effect is for people to make investment choices today by "looking ahead" using current interest rate information. In the future, the actual peso-dollar rate is evaluated versus what you calculated in the past rather than for its "spot bulaga factor". The spot FX rate then is a reflection of interest rate information IN THE PAST (which is what SHOULD HAPPEN) rather than the daily dynamics of big players moving markets or churning the trades (sell in the morning but buy back the same volume in the afternoon ... volume neutral but the rate has moved).
Oh if you're wondering what that threshold rate will be, it is at R where:
1,000,000 + 6%(1,000,000) = R x {20,000 + 4%(20,000)}
R = P50.96 per dollar
The shortcut way is to say that the increment is 2% (i.e., 6-4) of the spot rate P50 which is P1. The P51 rate found via the shortcut is not too far from the actual calculation above.
guest post on MoneySmarts:
Let me put my teacher cap on. Example na lang. Mas madaling intindihin. What if investor has P1 million to invest. Choices are a peso one-year Treasury at 6% versus a one-year US Treasury at 4%. What will investor do? Answer = he needs to read Salve's blog to find out what implied forward rates will do.
Let the peso-dollar rate be P50 to one so that the P1 million is $20,000. For as long as peso returns are higher, the investment decision is obvious (go with peso treasury). But what comprises the return are (a) the outright interest and (b) the value of the currency upon maturity. So, "return" is interest rate LESS depreciation.
Implied forward rates will calculate the "break-even" exchange rate to make the investor neutral between peso or USD investment. Since the peso has higher interest, we know that the peso can afford to weaken versus the dollar before the advantage of the interest rate (6% - 4%) is totally eliminated.
The investor then makes a decision what he thinks the actual peso-dollar rate will be in one year. If the forecast is that the peso will be stronger than the implied forward rate then stay with peso investment. If the forecasted peso rate is weaker then go dollar investment.
The effect is for people to make investment choices today by "looking ahead" using current interest rate information. In the future, the actual peso-dollar rate is evaluated versus what you calculated in the past rather than for its "spot bulaga factor". The spot FX rate then is a reflection of interest rate information IN THE PAST (which is what SHOULD HAPPEN) rather than the daily dynamics of big players moving markets or churning the trades (sell in the morning but buy back the same volume in the afternoon ... volume neutral but the rate has moved).
Oh if you're wondering what that threshold rate will be, it is at R where:
1,000,000 + 6%(1,000,000) = R x {20,000 + 4%(20,000)}
R = P50.96 per dollar
The shortcut way is to say that the increment is 2% (i.e., 6-4) of the spot rate P50 which is P1. The P51 rate found via the shortcut is not too far from the actual calculation above.
So, what's the rate of P50.96 tells me? What is "implied forward rates" in the first place & how can u get info abt it?
Lance,
As I understand it, R=50.96 exchange rate is the break-even point. As long as the exchange rate continues to trade below 50.96, you're better off sticking to the peso investment. On the other hand, if the exchange rate trades above 50.96 and persists/continues to trade above it, then peso investment will lose and you have to shift to a dollar investment.
One has to keep abreast then with exchange rates, and forex forecasts.
Correct me if I'm wrong.
i'm not sure if i understand correctly, but is this correct?
let R = implied forward rate
let FDPR = forecasted dollar to peso rate
if(FDPR > R)
{
invest(dollar);
}
else if(FDPR
sorry i think my first post got truncated..
i'm not sure if i understand correctly, but is this correct?
let R = implied forward rate
let FDPR = forecasted dollar to peso rate
if(FDPR>R)
invest(dollar);
else if(FDPR
really sorry. nata-truncate yun comment ko.. :(
i'm not sure if i understand correctly, but is this correct?
let R = implied forward rate
let FDPR = forecasted dollar to peso rate
if(FDPR greater than R)
invest(dollar);
else if(FDPR less than R)
invest(peso);
else
invest(peso or dollar);
sorry, old habits. I think I can better express my confusion this way. :P
another question. so is the implied forward rate only used for fixed interest investments? and also, how does the investor decide what will be the exchange rate in one year?
Let me try answering that question. (Please correct me if I'm wrong).
50.96 Peso/US$ after one year is the breakeven point if you chose to invest using US$.
Meaning if you invested in Peso 1M + 6% of 1M = 1.06M Pesos
If you invested in US$ (20K + 4% of 20K) * 50.96 = 1.6 M Pesos
You invest in US$ if you think the peso is going to lose value so that the interest rate doesn't matter.
You would have made a mistake if for example the Peso's value appreciated to 45 and you chose to invest in US$.
US$ (20K + 4% of 20K) * 45 = 0.936 M Pesos only. But of course if you are not going to convert to Peso (keep your money in US$), you earned 4% for your 20K (you now have 20,800US$ after one year) but you didn't earn any forex income.
I didn't understand anything in the article. Hope you wuold use normal speak. Regular Reader. Thanks
Lance, 50.96 in this example means that you are better off holding pesos (and earning 6%) than holding dollars (and earning 4%) as long as the USD/PHP exchange rate remains below 50.96.
@joey: IMO ( I hope I am right).
All things equal (fixed, inflation etc.), peso at 6% and dollar at 4% - you go for the peso because its 6%.
More so, if you think that the peso will strengthen against the dollar, as what happened the past year from 56 to 45 + 6% interest. So, if you need dollars, your pesos would have afford more green bucks.
Now, if you think, the dollar would appreciate in value against the peso + 4% - you go for the dollar.
The guidance that you should ask yourself is, where is the peso heading months from now? or where is the dollar going? Remember, you can ask the same for Euro or Yen - and put your money where you will get a better interest, and a better direction (appreciation).
Well, with the way things are going now I don't think we have a choice.
We have to stick to our peso investments because it seems that Glorieta is determined to hold the Peso below 50.
SONA is coming and she will certainly boast it there the peso appreciation.
I am not sure however if she realizes that what she's doing is actually hurting some sectors of our economy particularly exporters of goods and services.
I just pray that the "positive impact" of strengthening peso will be felt by the masses in their daily lives, but everyone knows the reality.
Lance and Joey, the others who commented before me have explained the issues quite a bit. Good work, guys :-). I'm afraid when it comes to finances, we can't avoid the jargons and the formulae, but good thing we can all reach the experts who are willing to share their knowledge without a fee, so they can explain to simple people like us.
Melvin, gcol said it well. In the example, P50.96 is the break-even point. That means if the peso moves from 51 to 51 onwards, go for the dollar investment under the interest rate scenario in the example. If the peso moves from 50.96 to 50 to 49 etc., you'll earn more in the peso investment.
By using the implied forward rate calculation, you have some sort of "guide" whether you should invest your money in pesos or in dollars.
Mikoy, another way of saying this would be, if you think the peso will depreciate beyond the break-even point, it makes more sense to invest then in dollars (keeping in mind the interest rates on the two types of investments in the example). Yung di mo kikitain dun sa mas mababang interes, mababawi mo dun sa pag-depreciate ng peso.
If you think the peso will keep appreciating from 50.96, it is even more obvious to keep your money in pesos because of the higher interest rates.
hi,
we are ofws and we attended a seminar given by one bank 2 years ago and their forecast then is that the dollar will go up to 70-75 range. What will happen if I change our savings now in to peso and then dollars will go up to 50 again.. We are so confuse so better not to look at the exchange rate. Our govt. kept on telling we re heroes but kpt on bleeding us to death.
Thanks Salve and everyone for clarifying the technical stuff. Nagets ko na rin. :D Meron ulit ako natutunan na bago.
Similar to others out there I'm also a bit confused whether to hold on to my dollar investments or cut my losses and change to peso right away. Other than the implied forward rate, do I have any other factors to consider? My investment is for the long term btw..
jon mariano, you actually get the same amount of money (more or less).
Meaning if you invested in Peso 1M + 6% of 1M = 1.06M Pesos
If you invested in US$ (20K + 4% of 20K) * 50.96 = 1.059968 M Pesos (roughly the same with the peso investment, that is why it is the break-even point)
But, you're right. It gets more interesting if the peso is going to lose value against the dollar (same as falling, depreciating, weakening).
Your second comment was right on the money :).
surebull, not even Gloria nor the Philippine central bank can "keep" the peso at a certain level. If it does that, the economy will be in bad shape because it has to use precious money to "defend" the peso in the foreign exchange markets.
There are losers and gainers, whichever way the peso goes. Noet Ravalo's point in his article here http://business.inquirer.net/money/advice/view_article.php?article_id=77529
is that we don't have to be affected adversely all the time by the "spot bulaga factor" of the peso IF we have the right tools and if we know how to plan. That would of course require a stricter reading regimen for all of us who have an aversion for technical stuff, but I think the prize is worth the price.
check out my earlier blog post on the implied forward rates: http://www.inquirerbloggers.net/moneysmarts/2007/07/18/4-warnings-signs-you%e2%80%99ve-missed-the-forex-lessons-from-the-asian-crisis/
dear mikoy, i suggest you talk to a financial planner or a banker to get their advice especially if you are talking about a big amount, all the time keeping an objective view on the quality of their advice.
You need to consider your foreign exchange needs in the future (i.e. are you going to need dollars for travel requirements, investing in other countries, business in other countries.) Remember that even if you bought your dollars at 50, and you are holding on to them now and not selling them, what you have is merely paper loss. You will realize your loss only when you shift your dollars to pesos. If, let's say, the peso goes back to 53 in five years and that's when you exchanged your money, you will realize forex gains.
Another situation: You bought your dollars at 53 and are angsty that the peso will continue to strengthen. You unload and exchange your dollars for pesos at 45. That's an ouchy P8 loss per dollar. Then your mother in the US wants you to travel next month. You buy dollars again to travel at P46. That's getting hit with a double whammy.
The key question therefore is, where do you think the peso will go? Another is: what will be your dollar requirements in the coming years?
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