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.
August 7th, 2007 at 10:39 am
[...] all plan out our foreign exchange spending so that we don’t get hit by what Noet calls the “spot bulaga factor” of the peso, instead of calling for intervention in the markets by the government. My question then [...]
July 23rd, 2007 at 12:49 pm
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?
July 23rd, 2007 at 11:48 am
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/
July 23rd, 2007 at 11:41 am
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 :).
July 23rd, 2007 at 10:09 am
Thanks Salve and everyone for clarifying the technical stuff. Nagets ko na rin.
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..