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Business and Exchange Rates
 

Business and Exchange Rates

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A revision presentation which outlines the relevance of exchange rates to business decision-making.

A revision presentation which outlines the relevance of exchange rates to business decision-making.

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    Business and Exchange Rates Business and Exchange Rates Presentation Transcript

    • Exchange Rates
    • Exchange rates directly affect 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
    • E.g. UK exporters benefit 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
    • But a weak currency 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
    • So, how do exchange rates work?
    • What is an exchange rate? An exchange rate is the price of onecurrency 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
    • For example For every £1, you can buy $1.50 US dollarsThis is the price of one pound, expressed in dollars i.e. the £/$ exchange rate
    • Changes in exchange rates - example £1 buys May September US Dollars ($) $1.60 $1.45 Euros (€) €1.15 €1.05In the table above, you can see that in May, £1 would buy $1.60, if you wantedto convert some pounds into US dollars. Alternatively, £1 would buy €1.15 euro. What happened to the exchange rate for the pound between May andSeptember?The value of £1 fell against both the US dollar and the Euro. For example, bySeptember, £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 thepound. If you were holding dollars, you would need less of them to convert into£1.
    • What causes exchange rates 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).
    • The floating exchange rate• 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
    • Currency trading (1)
    • 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)
    • Some reasons for currency 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
    • Example of currency movements Sterling v US Dollar Exchange Rate £1= The pound weakened (fell) sharply against the US dollar during 2008-9
    • The Value of the Pound v the Euro
    • Effect of a stronger 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
    • Factors that determine effect of changing exchange rates on businessLow effect on business High effect on businessNo export sales – turnover all in Significant export sales, perhaps indomestic (UK) market many currenciesAll business activities located in UK Overseas operations, earning profits in foreign currencyRaw materials and other supplies Significant purchases from overseasbought in UK suppliersDemand predominantly from Substantial demand from overseasdomestic (UK) customers visitors to UKDemand is price inelastic Demand is price elasticHigher costs can be passed on to Higher costs usually have to becustomers to maintain margin absorbed via a lower margin
    • Price elasticity of demand• 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
    • Two main problems for 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
    • Two worked examples• Stronger pound – effect on the revenues of an exporter• Weaker pound – effect on the margins of a UK importer
    • Example 1: Stronger Pound & Export RevenueBudgeted Export Sales 2010Exchange rate: £1 = $1.50Selling price in export market Per unit $1,500.00UK production cost Per unit £300.00Selling price (revenue) in £ Per unit £1,000Production cost (£) Per unit £500Gross profit (£) Per unit £500Units sold per year in US Market Qty 2,500Budgeted revenue for year £000 £2,500
    • Example 1 (cont)If the US selling price remains the same in £ terms, what happens to annualrevenue if exchange rate rises to £1 = $1.75?
    • Example 1 (cont): £1 = $1.75Exchange rate: £1 = $1.75Selling price in export market Per unit $1,750.00UK production cost Per unit £300.00Selling price (revenue) in £ Per unit £1,000Production cost (£) Per unit £500Gross profit (£) Per unit £500Units sold per year in US Market Qty 2,000Revenue per year £000 £2,000
    • Example 1 - Evaluation• US$ 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
    • 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%
    • Example 2 (cont) What happens to gross profit and gross margin ifthe Pound (£) falls in value against the Euro (€) to parity?
    • 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%
    • 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%
    • How businesses can manage 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
    • 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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