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The foreign exchange market (Background (Strong/weak currencies (Strong,…
The foreign exchange
market
Background
Also known as the forex
Where the exchange rate it determined
Exchange rate
Def -
The price of one currency in terms of another
The value of one currency in terms of other currencies is
determined by market forces of supply and demand in the currency markets
Unless the government intervenes to fix a price
Strong/weak currencies
Strong
If the value of a currency is high in relation to other currencies
Could be because of a high level of demand or a fall in supply
Weak
If the value of the currency is low
Could be because of low levels of demand for it
Increases and decreases in the exchange rate
Appreciates
When a currency increases in value
Depreciates
When it falls in value
The value of a currency affects the price of a firm’s products abroad, which will affect sales abroad (exports)
If the value of £1 changes from €1.4 to €1.1, then a £100 product would sell for €110 not €140
This change in the price abroad in terms of foreign currency can
have a significant impact on UK firms exporting abroad
Changes in the value of a currency will also affect the cost of buying supplies from abroad (imports)
The stronger the value of the pound, the more euros are received in return for a pound, and so fewer pounds have to be spent buying something from abroad
Changes in the value of a currency are particularly significant now that so many businesses operate globally and economies are increasingly ‘open’, meaning they are trading more with other countries
It is possible for the pound to increase in value against one currency while decreasing in value against another
When analyzing currency changes, managers will focus on the changes in markets in which they sell their products and those from which they buy materials or resources
Demand for pounds from abroad
External demand for the UK currency
Comes from foreign individuals and organisations who want to change their currency into pounds to buy UK goods and services
The more expensive the price of a £, the more
foreign currency has to be changed to buy it
This will reduce the quantity demanded of pounds
The demand for pounds will be a downward-sloping curve
The more expensive the pound is, the lower the quantity demanded of pounds
Will depend on the price elasticity of demand for UK products in foreign currencies
If demand for UK exports is very price sensitive (inelastic)
An increase in price in the price of UK products abroad following an increase in the value of the pound will lead to a large fall in the quantity demanded of pounds
The demand for £'s is derived from the demand for UK products
The demand for UK products will depend on
Uniqueness
Brand power
Quality
Reliability
See Fig 1
Supply of pounds to the foreign currency market
The supply of pounds to the foreign currency market depends on the desire of individuals and organisations to change their pounds into foreign currency
If the value of the £ increases
The £ has more purchasing power abroad
Makes foreign goods and services cheaper as fewer £'s are required for any given amount of foreign currency
An increase in the value of the £ should lead to an
increase in the quantity demanded of foreign products
The supply of pounds to the foreign currency market is upward-sloping – a higher value of the pound increases the quantity supplied
If the demand for imports is price inelastic
The lower price of imports will lead to a relatively smaller increase in the quantity demanded of products from abroad and the total spending on imports will fall
If demand for foreign products is price elastic
The total spending on imports increases – although the price is lower in pounds, a significant increase in the quantity demanded increases the overall amount spent
The supply of pounds is downward-sloping
An increase in the price of pounds leads to fewer being supplied
See Fig 2
Reaching equilibrium in the currency markets
In a free market, the price of the currency will adjust until the quantity supplied (QS) equals the quantity demanded (QD)
The price mechanism adjusts to bring about equilibrium
See Fig 3
If there is an excess supply (a surplus) in the currency, the value of the of the £ will fall, reducing the quantity supplied and the quantity demanded falls
This continues until it reaches equilibrium
If there is excess demand (a shortage) quantity of £'s and the quantity will fall until equilibrium is reached
Shifts in demand for a currency
An increase in the demand for a currency will shift the
demand curve outwards and will usually lead to a higher exchange rate
The demand for pounds in the foreign currency markets may increase because
An increase in incomes overseas
Leading to more demand for UK products (assuming they are normal products)
The more income elastic demand is, the greater the shift will be
An increase in UK interest rates relative to the return available elsewhere
Attracts foreign investors searching for high returns in UK banks and other financial institutions
Speculators that believe the £ will increase in value against other currencies
Means that speculators will buy £'s now in the hope of selling later at a higher price
Speculation can be a major factor that can change the value of a
currency rapidly
News of possible government policy changes, rumors about economic indicators about to be published and gossip about trade
deals can all change a currency’s value
Shifts in supply of the currency to the foreign currency market
An increase in the supply of pounds to the foreign currency market may be due to
An increase in UK incomes
Leads to more demand for imports
More £'s will have to be supplied to change into foreign currency to buy products abroad
An increase in overseas interest rates
Leading to money flowing out of the UK in search of higher returns abroad
Speculators that believe the £ will decrease in value against other currencies
The danger being is that speculators bring about what they expect, they worry that the £ will fall and so sell the currency, thereby putting pressure on the £ to fall and so it loses value
Speculators can do this deliberately by selling at a higher price, pushing the price down if other start to sell as well, they can then buy the currency back at a lower price
Changes in supply of and demand for a currency
An increase in demand for a currency will lead to an increase in P and an increase in the E (assuming that S is upward sloping (Fig 4a)
A decrease in S of a currency will lead to an increase in P but a fall in E (Fig 4b)
Why do changes in exchange rates matter?
If the £ falls in value it means that it is cheaper relative to the relevant foreign currency
If a UK business keeps its P the same in £, the P in overseas currencies will be less
Should increase the QD of products from abroad
Means that a UK business needs to be ready and able to export more
Can stimulate economic growth within the UK and help employment
Managers of UK businesses may decide to maintain the same P in terms of the foreign currency (perhaps because contracts have been negotiated or price lists printed already)
Lead to a higher profit margin and may lead to higher returns for investigators
In the £ increases in value and the P in £'s is kept the same, the P in foreign currency is now higher than it was
This is likely to reduce sales
The business might keep the overseas P the same, which may reduce profit margins
Changes in the value of the pound will also affect import prices
Many products we buy are imported (M) or have imported elements
Changes in P of M affects UK firms costs and therefore profits
If a UK business buys in supplies and the £ strengthens this will reduce its M costs
May lead to higher profit margins or enable the firm to
reduce its prices
A strong £ means that customers can buy products from overseas competitors more cheaply, which might reduce the UK firms domestic sales as customers switch to overseas producers
The scale of this effect depends on how easy it is to switch and how similar overseas products are to UK ones
An understanding of the exchange rate is crucial
to modern-day business
It is particularly important to monitor and try to anticipate changes because the exchange rate is out of the control of any one business
The price is determined by millions of transactions happening
all the time and a single manager cannot influence this
The D and S conditions in currency markets can change suddenly, and this can lead to major movements in the value of a currency
The markets can be strongly influenced by speculators, which can make it hard to predict what a currency will be worth in the future
This makes financial planning difficult and can quickly change the competitive position of a business
The McBurger index
Sometimes currencies may be over- or undervalued compared with the longterm value that would be reached with the underlying D and S conditions
Pressure from speculators or government policy may push the
value high or low in the short term
To identify the long-term underlying value of a currency, The Economist magazine uses the ‘McBurger index
This helps to decide whether a currency is over- or undervalued
The McBurger index compares the actual exchange rate with what it would need to be to keep prices of burgers in different countries comparable
A McDonald’s burger is chosen because it is a fairly standardized product in different countries
A crude measure of what is known as ‘purchasing power parity’ (PPP)
PPP is usually calculated by comparing the costs of similar baskets of goods
If the basket were to cost £150 in the UK and US$300 in the USA, the PPP rate would be £1: US$2.
Overcoming exchange rate problems
Possible exchange rate changes clearly make planning difficult and can change the cost position of a business or its competitiveness abroad very quickly
The exchange rate is an example of a PESTEL factor that is outside the direct control of a business but is a very significant influence on its sucess
There are administration costs of changing currency which
reduce the profits that can be made from overseas trade
While managers cannot themselves directly influence the exchange rate, they can take steps to reduce the impact
Target markets that use the same currency may find that there is enough demand within that country to meet its targets in their own market
A decision to do this may reduce export opportunities and the ability to buy the best inputs at the best prices
Operate in several overseas markets
Unfavourable changes in the currency of one market may be offset by more favourable changes in the currency of another country
Buy currency in advance at a set price
So that they know what their exchange rate will be (this is known as a ‘futures market’)
Speculate in currencies to try to offset any movements
Set contracts in their own currency
It must be remembered that one currency may be moving in a different direction against others, so it is important to analyse with which markets a particular business is trading
The impact of an exchange rate
The impact of a change in the exchange rate on a business depends on
What proportion of its sales are exported
What proportion of its inputs are imported
The degree of competition in the market from overseas businesses
How much the value of the currency has changed (and in what direction) against the currencies in its exports and import markets
The price elasticity of demand for exports and imports
The availability of alternative markets to export to or other suppliers to switch to
The exchange rate is only one factor that affects the competitiveness of a business
A strong pound may make it more difficult to export, but not impossible
Sales depend on the overall value for money which, in turn, depends on factors such as the design, the quality, the effectiveness of the marketing, and the speed of delivery
Managers can take steps to overcome adverse exchange rate changes or to protect themselves against them
Adopting learner production techniques to drive down costs, for example, may enable businesses to remain price competitive abroad even if the currency is strong
Government intervention in the foreign currency markets
Floating exchange rate
If the value of a currency is determined entirely by market forces of supply and demand
Given the significant impact of currency changes on businesses and households, a government may want to influence the value of its currency
It may even want to stabilize the value of its currency and fix its value - known as a 'fixed (or pegged) exchange rate
Can be achieved by buying and selling currency and/or using interest rates
To increase the value of its currency, a government can
Buy its own currency using foreign currency reserves that it will
have acquired in other periods
When selling its currency to bring the value down
By buying its own currency, the government shifts the demand for it to the right, increasing the E P
To limit to such intervention is the amount of foreign currency that the government holds or is willing to borrow from foreign banks or governments
Increase interest rates
The interest rate is the return given to savers in a country’s banks and can be influenced by the government
A high interest rate will attract investors into the country in
search of high returns
Although it is likely to reduce demand domestically because of the higher costs of borrowing
See Fig 6
The euro
The official currency of 16 of the 27 countries in the EU
These countries have given up their own currencies, such as the German mark and French franc, to adopt the euro.
It is managed and administered by the European Central
Bank (ECB) in Frankfurt
The benefits of belonging to the ‘Eurozone’
There are no transaction costs for converting on currency to another
Managers do not have to worry about the effects of currency fluctuations with other Eurozone countries, which provides greater stability and makes planning easier
It is easier to compare prices of suppliers, which may allow a manager to find a better deal and force suppliers to be price competitive
Joining the Eurozone does involve
Giving up your own currency
Can be politically unpopular
Accepting a Eurozone interest rate set by the ECB
May be changed to alter the value of the euro relative to other currencies
A particular government may find that the ECB increases the interest rate to increase demand for the euro even though, within its own country, it would want to reduce the interest rate to stimulate demand
Governments must be prepared to give up control over their domestic interest rates
Accepting a value of a currency that may be determined by the
behavior of different countries rather than your own
In 2012, countries such as Greece and Spain were struggling with debt levels in their countries; this put downward pressure on the euro which worried stronger economies such as Germany
These countries were bailed out by the ECB to try and support them whilst they made the necessary changes to their spending plans