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

1. Exchange
Rates

2. 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

3. 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

4. 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

5. So, how do exchange rates work?

6. What is an exchange 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 exchange rates - 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 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).

10. 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

11. Currency trading (1)

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 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

14. Example of currency movements
Sterling v US Dollar Exchange Rate £1=
The pound
weakened
(fell) sharply
against the US
dollar during
2008-9

15. The Value of the Pound v the Euro

16. 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

17. Factors that determine effect 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 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

19. 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

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: Stronger Pound & 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)
If the 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 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

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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