OFW HEDGE AGAINST INSURANCE: The OFW makes up his mind what exchange rate he wants to target, then he buys an insurance contract from DBP for a minimum insured amount of $1,000 where the insurance fee increases with the amount insured. The fees will be determined according to market conditions.
OFW HEDGE VIA OUTRIGHT FORWARD. With outright forwards, the future conversion rate of dollars to pesos is set in advance. This future rate directly is set according to prevailing market parameters. At maturity of the forward contract, the exchange of foreign currency into pesos is made at the forward rate, regardless of the prevailing market rate.
I read in the internet that the Philippine Peso will appreciate against the US dollar to P39 at the end of the first quarter this year and will appreciate further to P35 by end of 2008. Is this a possible scenario? I'm currently in a dilemma whether to convert into pesos my USD time deposit. --- Vic
The hedging facility launched by the government financial institutions is not good enough if the OFW is earning only a meager amount of $500 per month. If an OFW is earning $1,000,000 or more then he stands to benefit from the program. But how many OFW's earn more than $10,000.00/ month? --- Romeo
An estimated 8.2 million Filipinos are based abroad, many of whom regularly remit part of their earnings to the Philippines. For this reason alone, the rate of exchange between the peso and various foreign currencies will be a major socio-economic policy concern for a very long time.
Most Filipinos based overseas, whom I will call currency converters in this series, are inclined to think investing will solve the problem of an appreciating currency. Should they buy land now for their retirement? Should Vic liquidate his dollar time deposit in Saudi Arabia and go for peso deposits instead? Should OFWs go for bonds or a pension plan? What about the hedging facilities cited by Romeo?
The truth is, the real challenge is managing recipients’ cash flow and not finding the best investment outlet.
For seven and a half years from July 1997 to December 2004, the peso moved from about P27 to roughly P56 per dollar. This doubled the peso value for every dollar remittance. Of course, the actual situation of each OFW will be different on a case-to-case basis.
Over the past 37 months, the peso has been strengthening against the dollar, reversing from P56 to under P41 per dollar. This new trend leaves currency converters with three options:
• Remitt more dollars than before. This option hinges on how much more the OFW can save from current income. It’s possible there may not be much more to remit even if they wanted to.
• Reduce family expenses. To get back the same purchasing power they enjoyed, OFWs families need to roll back 37.0 percent of expenses. That is over a third of regular expenses. Very unrealistic.
• Hedge against a further appreciation of the peso. This is the most viable option but the problem is figuring out how to hedge and what instruments to use.
The first is a basic insurance policy with a “put” feature twist. Essentially, the OFW makes up his mind what exchange rate he wants to target, then buys an insurance contract from DBP for a minimum insured amount of $1,000 where the insurance fee increases with the amount insured. The fees will be determined according to market conditions. The insurance contract then is a guarantee that once the insurance matures, the OFW can exchange his dollars at the agreed rate.
(See illustration number one in the gallery)
There is another upside to this contract. If the insured exchange rate is P39 per dollar and the peso further appreciates to P35 per dollar, the OFW is fully protected because the insured rate of P39 prevails. If, however, the peso reverses to P45 per dollar, the OFW has the option to remit through DBP at the prevailing market exchange rate instead of the insurance rate of P39.
This gives someone like Vic peace of mind because he does not have to act on his dollar deposits by speculating on the future rate of the pesos versus the dollar. More importantly, the peace of mind means that his beneficiaries can plan their spending ahead of time using the exchange rate that Vic himself chose as his “protection rate”.
If Vic simply wants to do away with the cost of insurance, another hedge is a forward contract. With outright forwards, the future conversion rate of dollars to pesos is set in advance. However, Vic no longer chooses this future rate directly and instead is set according to prevailing market parameters (presumably using something like an implied forward rate calculation). At maturity of the forward contract, the exchange of foreign currency into pesos is made at the forward rate, regardless of the prevailing market rate. Like the insurance hedge, this gives Vic peace of mind because his beneficiaries future purchasing power can be planned ahead of time.
(See illustration number two in the gallery)
For currency converters, these two hedging products should be useful. Without them, OFWs are either forced to remit more, OFW beneficiaries are asked to cut back on expenses or some combination of these two extremes.
The catch is that the minimum amount of $1,000 is larger than the average size of monthly remittance of $397 per transaction for 2003 and 2004. But it would be hard for DBP to manage one million transactions for $200 than 200,000 transactions that remit $1,000 each time. There is no obvious way to bridge this gap. In fact, the initial design of the hedge was for a minimum amount of $10,000.
With a high minimum amount, OFWs may be induced to remit more amounts less frequently, like sending quarterly instead of monthly. This creates a new pressure for OFW beneficiaries to budget with a quarterly planning horizon instead of the usual monthly mindset. I think this is a “better problem” when compared with being openly exposed to foreign exchange rate movements.
It would not hurt if government can give OFW beneficiaries cash flow seminars with the hedging products. At worst, there would be no demand for it. At best, a lot of OFW beneficiaries will benefit from it and the lessons from these seminars will go a long way in making the hedge achieve its goal.
After taking care of the regular family expenses, only then can currency converters think of investment side. That, though, will be for another time.
(Noet Ravalo is a macro-financial economist by practice and profession. He was chief economist of the Bankers Association of the Philippines until 2002 and has since been doing consulting work. Since 1994, he has been asked to provide technical inputs to both the Senate and the House of Representatives on various economic and financial legislation, some of which will have big impact on Filipinos' personal finances.)
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