Exchange rates (Edexcel GCSE Business): Revision Notes
Exchange rates
What are exchange rates?
An exchange rate represents the cost of purchasing foreign currency. It shows UK individuals and businesses how much foreign money they can obtain for each British pound they exchange.
Understanding exchange rates is crucial for businesses that trade internationally, as these rates directly impact the costs of buying from abroad and the income from selling overseas.
Exchange rates are constantly changing throughout the day based on supply and demand in global currency markets. Even small changes can significantly impact business costs and profits.
Calculating foreign exchange costs
When businesses trade internationally, they need to convert between currencies. This affects their costs and revenues in different ways:
For exports (selling goods abroad)
When UK businesses sell products to other countries, they receive foreign currency which must be converted back to pounds. If the exchange rate is £1 = $2, then:
- Selling £500 worth of goods to an American customer generates $1000 (£500 × 2)
- The business receives this dollar amount and converts it back to pounds
For imports (buying goods from abroad)
When UK businesses purchase materials or products from overseas, they pay in foreign currency. Using the same exchange rate of £1 = $2:
- Buying $600 worth of goods from America costs the UK business £300 (£600 ÷ 2)
- The business must exchange pounds for dollars to make the purchase
Key calculation rule: To find the pound cost of foreign purchases, always divide the foreign currency amount by the exchange rate. Many students mistakenly multiply instead of divide.
How exchange rate changes affect businesses
Exchange rate fluctuations create different impacts depending on whether the pound strengthens or weakens against other currencies.
When the pound falls in value
Benefits for UK exporters: British goods become less expensive for foreign customers, making exports more competitive internationally. This typically leads to increased sales volumes.
Benefits for UK tourism: The UK becomes a more affordable destination for overseas visitors, as their money goes further when converted to pounds.
Benefits for UK manufacturers: Imported goods become more costly, encouraging consumers to choose domestically produced alternatives instead.
Challenges for import-dependent businesses: Companies that rely on foreign materials face higher costs, as they need more pounds to buy the same amount of foreign currency.
A weaker pound is often called a "depreciating" or "devaluing" currency. This can be beneficial for the overall economy as it boosts exports and tourism, even though it makes imports more expensive.
When the pound rises in value
Challenges for UK exporters: British products become more expensive for international buyers, potentially reducing export sales.
Challenges for UK tourism: Visiting the UK becomes more expensive for foreign tourists, which may decrease visitor numbers.
Benefits for UK importers: Foreign materials and products become cheaper to purchase, reducing input costs for businesses.
Mixed effects for consumers: While imported goods become more affordable, this may lead to increased competition for domestic producers.
A stronger pound is often called an "appreciating" currency. While this makes foreign holidays cheaper for UK residents, it can harm the competitiveness of UK businesses abroad.
Worked calculation example
Worked Example: Impact of Exchange Rate Changes on Business Costs
Consider a business with these June costs:
- Raw materials from USA: £10,000
- Raw materials from UK: £7,000
- Fixed costs: £11,000
- Exchange rate: £1 = $1.50
In June, this business achieves £11,000 profit. However, in July the exchange rate changes to £1 = $1.60.
Step 1: Calculate the original dollar cost of American materials \text{Dollar cost} = £10,000 \times 1.5 = $15,000
Step 2: Calculate the new pound cost using the July exchange rate \text{New pound cost} = \frac{$15,000}{1.6} = £9,375
Step 3: Calculate the saving
Since all other costs remain unchanged, this £625 reduction in expenses increases the business profit by the same amount.
Understanding the broader impact
Exchange rate movements affect different types of businesses in various ways. Manufacturing companies that export finished products prefer a weaker pound, while retailers importing goods favour a stronger pound. Service businesses like tourism operators must consider how currency changes affect their international customers' spending power.
Real-world application: Many multinational companies have operations in multiple countries specifically to create a "natural hedge" against exchange rate fluctuations. If the pound weakens, their foreign operations become more profitable when converted back to pounds.
Businesses can protect themselves against exchange rate risks through various strategies, including forwards contracts and natural hedging, but these topics extend beyond basic exchange rate understanding.
Key Points to Remember:
- Exchange rates determine how much foreign currency you get for each pound
- A stronger pound makes exports more expensive but imports cheaper
- A weaker pound makes exports cheaper but imports more expensive
- Businesses must calculate the pound cost of foreign purchases by dividing the foreign currency amount by the exchange rate
- Exchange rate changes directly impact business profits through altered import and export costs