Level 2 Business and Economics: External Influences
Changes in Exchange Rates
Changes in exchange rates can affect businesses who trade abroad significantly. The fact that exchange rates alter everyday makes the whole thing even more uncertain. Copyright: Marja Flick-Buijs, from stock.xchng.
The exchange rate is the price of one currency expressed in terms of another. If you go abroad on holiday and the country you are visiting uses a different currency from the Pound in the UK, for example, then you will have to buy currency of the country you are going to.If you travel to Spain, then you will need to buy Euro to spend at your destination. The rate of exchange is the amount of Euro you will get in exchange for your pounds.
At the time of writing, the exchange rate between the pound and the Euro is £1 = €1.48. If you went to a bank to change £200 into Euro, you would get back €296.
At this exchange rate, 1 Euro is worth around 67p. A holiday maker from Spain travelling to the UK and changing Euro to pounds would get £135 in return.
To change pounds into another currency, multiply by the rate. E.g. at £1 = €1.48, £50 changed into Euro would be 50 x 1.48 = €74.To change a foreign currency back into pound, divide the sum by the rate. E.g. to change €90 into pounds, divide 90 by 1.48 = £60.81
Businesses of all shapes and sizes may have to trade with other businesses and customers from around the world. In doing so, they do one of two things: either they sell goods and services abroad for which they will receive payment (exports), or they buy goods and services from abroad, in which case they will have to pay for those goods and services (imports).
If a UK business is involved in exporting goods and services abroad, it will want paying in pounds. Foreign buyers will therefore have to change their currency into pounds to make the payment.
If a UK business is importing goods and services from abroad, the foreign seller will expect to be paid in their currency. The UK business, therefore, has to change pounds into that currency.
A business sells exercise equipment to companies in a variety of different countries. Its cycling machine has a price in the UK of £250.Use the currency data tables from either the BBC or the Economist and find out how much the equipment would sell for in the following countries:
- United States
Image copyright: Matt Williams, from stock.xchng.
The same business buys in a number of parts for its exercise bicycle from different countries. Use the currency tables to calculate how much it will have to pay for the parts if they are priced in the home country as follows:
- Denmark - Kr150
- Mexico - Peso 500
- India - Rupees 750
- Taiwan - Taiwan Dollars 690
For businesses that trade abroad, they face the problem of changing exchange rates. The demand and supply of currencies on the foreign exchange markets - all the businesses, banks and individuals who are looking to buy and sell different currencies - is constantly changing. As a result, the exchange rate changes minute by minute, hour by hour, day by day.
For businesses trading abroad, this has a significant effect on them.
- Firstly, it is difficult for a business to plan ahead if they are not sure what the exchange rate will be at any one time.
- Secondly, changes in exchange rates affect the demand for both imports and exports because they change the apparent price of both imports and exports.
Let us use a simple example to illustrate this point.
Changes in exchange rates have an effect on prices and businesses trading abroad might see these changed prices affecting the demand for their product or their costs of production. Copyright: Jayesh Nair, from stock.xchng.
A mobile phone retailer in the UK buys mobile phones from a manufacturer in Germany. The German manufacturer sells the phones for €40. If the exchange rate is £1 = €1.50, the UK business has to exchange £26.66 to buy the phone (40/1.50).
Now assume that the exchange rate changes and the rate goes down to £1 = €1.40. This is referred to as a fall in the value of the pound because you are now getting less Euro for every pound. The price of the phone in Germany has not changed - it is still €40. The UK importer, though, now has to exchange £28.57 to buy the phone from Germany (40/1.40).
Whilst the phone price has not changed in Germany, the effect of the fall in the exchange rate is to give the impression that the price has risen. The UK phone retailer finds that the cost of buying mobile phones has risen by £1.90 - a rise of 7.12%.
The retailer will find his costs of production rising and will have to either increase prices to the consumer - risking a fall in demand - or accept lower profit margins (the difference between the price charged and the cost of production).
If the exchange rate of the pound and the Euro rose, it would mean that a UK trader would get more Euro for every pound exchanged. For the importer this would mean that they would have to give up less pounds to get the same amount of Euro and so prices would appear to fall.
Some Terminology and Rules
It is important to remember the following:
- For businesses trading abroad who are both buying imported goods in and selling to foreign markets, the position can get very confusing especially if you are dealing with a number of different countries! You can perhaps start to see why some businesses would welcome the UK joining the Euro!
- For importers, the problem is that exchange rates affect their costs of production, which will in turn have an impact either on the price they have to charge customers or their profit margins.
- For exporters, changing exchange rates may lead to a rise in the demand for their products or make it much harder for them to be able to compete in foreign markets.
Go to the following links where you can test your understanding of the relationship between exchange rates and the price of imports and exports through an interactive animation.
Try working through the following problems. Remember that to change pounds into a foreign currency, multiply by the rate; to change a foreign currency back into pounds, divide by the rate.
Changing exchange rates can have a significant effect on possible sales. They can be either reduced or increased - it just depends on which way exchange rates are moving. Copyright: Carlos Zaragoza, from stock.xchng.
A UK fruit wholesaler buys bananas from a supplier in Honduras. The Honduran seller wants to be paid in US dollars. A bunch of ten bananas is currently selling for $20 each. The exchange rate is currently £1 = $1.75.
- How much does the UK buyer have to pay, in pounds, for each bunch of bananas?
- The exchange rate between the pound and the dollar changes. The pound has appreciated against the dollar and is now standing at £1 = $1.80.
- How much will a bunch of bananas now cost the UK importer?
- Given your answer to the question above, what do you think might be the effect on the UK importer of the change in the exchange rate?
- A UK wine merchant buys high quality red and white wine from a vineyard in France. The price per bottle of red in France is €35 and the price of a bottle of white, €30. The exchange rate is currently standing at £1 = €1.50. How much will the UK importer have to pay to buy each bottle of red and white wine in pounds?
- The exchange rate now changes to £1 = €1.40. How much do a bottle of red and a bottle of white now cost the UK importer?
- Given your answer above, what effect do you think this might have on the UK wine merchant?
- A UK business sells insurance policies to foreign businesses to protect them against damage to business premises caused by fire. The average price of each policy is £500 per year. The exchange rate is currently £1 = $1.82 and £1 = €1.48. How much would the policy cost to a US business and a business in Portugal?
- The exchange rate now alters to £1 = 1.80 and £1 = €1.50. How much do the businesses in the US and Portugal now has to pay for their policies. What might the effect of the change in exchange rates have to the UK business if they are operating in a very competitive market where there are lots of sellers of this type of insurance?