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Business and Exchange Rates
A weaker pound benefits UK exporters by making their goods cheaper overseas, boosting export volumes. It allows UK exports to become more competitive on world markets. However, a weak currency can also drive up costs for UK importers and consumers as imported goods become more expensive. Exchange rates are determined by foreign exchange markets and reflect the relative demand and supply of different currencies. A weaker pound means it takes more pounds to purchase the same amount of foreign currency like dollars or euros. This hurts UK importers by increasing their costs.
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Business and Exchange Rates
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- 2. Exchange rates directlyaffect business “By making UK exports more competitive and imports into the United Kingdom less affordable, weaker sterling should boost export volumes and reduce import volumes” Bank of England, Dec 2011
- 3. E.g. UK exportersbenefit from a weak pound “The weak pound has made UK exports more attractive, and manufacturers are benefiting from the pick- up in world trade,” said Ian McCafferty, the CBI’s chief economic adviser. Financial Times May 2010
- 4. But a weakcurrency can have adverse effects Sterling has lost around 30 per cent of its value against the U.S. dollar since the financial crisis as the impact of recession, low interest rates and quantitative easing all depreciated the currency. A weak pound can hit households as the cost of imports are relatively higher and travelling abroad becomes more expensive, however UK exporters will benefit as the value of their products becomes more attractive to overseas buyers
- 5. So, how doexchange rates work?
- 6. What is anexchange rate? An exchange rate is the price of one currency expressed in terms of another currency The exchange rate determines how much of one currency has to be given up in order to buy a specific amount of another currency
- 7. For example For every £1, you can buy $1.50 US dollars This is the price of one pound, expressed in dollars i.e. the £/$ exchange rate
- 8. Changes in exchangerates - example £1 buys May September US Dollars ($) $1.60 $1.45 Euros (€) €1.15 €1.05 In the table above, you can see that in May, £1 would buy $1.60, if you wanted to convert some pounds into US dollars. Alternatively, £1 would buy €1.15 euro. What happened to the exchange rate for the pound between May and September? The value of £1 fell against both the US dollar and the Euro. For example, by September, £1 would only buy you $1.45, a fall of $0.15 from May. That means that the pound weakened against the dollar (and the euro). Putting it another way, the value of the US dollar strengthened against the pound. If you were holding dollars, you would need less of them to convert into £1.
- 9. What causes exchangerates to change? An exchange rate is a price of a currency. The price is determined by the forces of demand and supply in the currency markets. Just like the commodity markets for oil and coffee, the price of a currency will reflect the amount of the currency that consumers and businesses want to buy (demand) and sell (supply).
- 10. The floating exchangerate • The UK operates with a floating exchange rate system • This means that our currency is market determined • If the demand for sterling rises relative to supply, then the value of the pound will increase (appreciate) • If the supply of pounds on the foreign exchange market increases relative to demand, then the pound will fall (depreciate) in value
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- 12. Currency trading (2) •Much currency trading is purely speculative – i.e. currency dealers seeking to make a profit! • E.g. buy US dollars in expectation that the dollar will rise against the Euro • Other currency flows are the result of • (a) International trade flows in goods and services (which generates demand for currency) • (b) Capital flows (e.g. net flows of foreign direct investment and speculative flows of money between countries into banks etc)
- 13. Some reasons forcurrency demand • Businesses need to pay for invoices from overseas suppliers (e.g. a US supplier sending goods to the UK and pricing the invoice in dollars) • Businesses needing to convert payments they have received from customers in one currency into another (e.g. a customer in Italy pays a UK business in Euros ) • Consumers and business people buying currency before taking a trip or holiday overseas. • Businesses sending back profits (cash) from their overseas operations to the base currency
- 14. Example of currencymovements Sterling v US Dollar Exchange Rate £1= The pound weakened (fell) sharply against the US dollar during 2008-9
- 15. The Value ofthe Pound v the Euro
- 16. Effect of astronger pound on UK businesses? S Stronger A stronger pound P Pound makes it cheaper to I Imports pay for imports, but exports will C Cheaper seem more expensive to E Exports overseas customers D Dearer
- 17. Factors that determineeffect of changing exchange rates on business Low effect on business High effect on business No export sales – turnover all in Significant export sales, perhaps in domestic (UK) market many currencies All business activities located in UK Overseas operations, earning profits in foreign currency Raw materials and other supplies Significant purchases from overseas bought in UK suppliers Demand predominantly from Substantial demand from overseas domestic (UK) customers visitors to UK Demand is price inelastic Demand is price elastic Higher costs can be passed on to Higher costs usually have to be customers to maintain margin absorbed via a lower margin
- 18. Price elasticity ofdemand • An important concept for any business where demand may be affected by changing exchange rates • E.g. price elastic demand – Stronger (higher) exchange rate will increase selling price for export customers (e.g. they have to use more US$ for each £1) – Likely to result in greater reduction in quantity demanded + overall reduction in export sales
- 19. Two main problemsfor businesses • There are transaction costs involving from one currency to another Think of it in terms of the commission tourism have to have when buying foreign currency – but on a much larger scale • Currency movements add to the risks involved in business The profitability of a business contracts or overseas subsidiaries can be undermined by adverse movements in the exchange rate
- 20. Two worked examples •Stronger pound – effect on the revenues of an exporter • Weaker pound – effect on the margins of a UK importer
- 21. Example 1: StrongerPound & Export Revenue Budgeted Export Sales 2010 Exchange rate: £1 = $1.50 Selling price in export market Per unit $1,500.00 UK production cost Per unit £300.00 Selling price (revenue) in £ Per unit £1,000 Production cost (£) Per unit £500 Gross profit (£) Per unit £500 Units sold per year in US Market Qty 2,500 Budgeted revenue for year £'000 £2,500
- 22. Example 1 (cont) Ifthe US selling price remains the same in £ terms, what happens to annual revenue if exchange rate rises to £1 = $1.75?
- 23. Example 1 (cont):£1 = $1.75 Exchange rate: £1 = $1.75 Selling price in export market Per unit $1,750.00 UK production cost Per unit £300.00 Selling price (revenue) in £ Per unit £1,000 Production cost (£) Per unit £500 Gross profit (£) Per unit £500 Units sold per year in US Market Qty 2,000 Revenue per year £'000 £2,000
- 24. Example 1 -Evaluation • US$ price rises – the UK product becomes less competitive • Quantity demanded in the US falls - % fall depends on price elasticity of demand • Revenue falls from £2.5m to £2.0m
- 25. Example 2: Importer& Weaker Pound June 2009 Selling price in UK per unit £50.00 The importer Imported cost per unit € 30.00 Exchange rate £1 = € 1.20 makes a 50% Imported cost per unit £25.00 gross margin at a Quantity sold per month 5,000 rate of £1 = € 1.20 at a selling Revenue £250,000 price of £50 per Cost of Sales £125,000 unit Gross Profit £125,000 Gross Margin 50.0%
- 26. Example 2 (cont) What happens to gross profit and gross margin if the Pound (£) falls in value against the Euro (€) to parity?
- 27. Example 2: Importer& Weaker Pound October 2009 Selling price in UK per unit £50.00 Imported cost per unit € 30.00 Exchange rate £1 = € 1.00 Imported cost per unit £30.00 Quantity sold per month 5,000 Revenue £250,000 Cost of Sales £150,000 Gross Profit £100,000 Gross Margin 40.0%
- 28. Example 2 -Evaluation • A weaker pound makes it more expensive to buy imports in Euros • The bought-in cost per unit rises from £25 to £30 • The gross profit per unit falls from £30 each to £25 • Gross margin falls from 50% to 40%
- 29. How businesses canmanage exchange rate risks • Monitor and try to anticipate exchange rate movements • Used sensitivity analysis to calculate profitability at different exchange rates • Pre-buy and pre-sell currency at favourable exchange rates (hedging / currency options) • Set up bank accounts in different currencies to reduce currency transactions and offset the effects of currency movements
- 30. Exchange rates &inflation • A weaker £ makes imports more expensive • Higher import prices: – Drive up firm’s costs (cost-push inflation) – Feed directly into the consumer price index • Wages may rise in response to the rise in prices - thus triggering off a wage-price spiral • A weaker £ also leads to a rise in aggregate demand since exports rise and imports fall • Depending on the extent of spare capacity in the economy, the rise in aggregate demand could increase inflationary pressure
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