The effects of interest rates and exchange rates on business performance

1 Introduction

This chapter looks at how changing interest rates and changing exchange rates affect the performance of a business, and at what a business can do to protect itself against movements in either.

The two halves are connected. A country that raises its interest rates attracts foreign money looking for a better return, and buying a currency pushes its exchange rate up — so a single decision by a central bank can reach a business twice, once through what it pays to borrow and once through what its exports cost abroad.

2 How interest rate changes affect a business

A change in the central bank’s rate is reported as a story about mortgages. For a business it arrives through five separate channels, and the syllabus names all five. Some of them work on what the business sells; some on what its money costs. A business can be hit by both at once.

2.1 Discretionary spending, and market demand

Discretionary spending is what households buy when they do not have to: a new car, a holiday, a kitchen, a meal out. It is the first thing to move when interest rates move, for two reasons.

• Households with variable-rate mortgages and loans have less left over after the interest is paid, so they have less to spend on anything else.

• Saving becomes more attractive relative to spending, so some of what is left over is put away rather than spent.

So a rise in interest rates cuts market demand, and it cuts it unevenly. A business selling necessities — food, utilities, basic clothing — sees very little change. A business selling big-ticket discretionary items, especially ones customers buy on credit, is hit twice: its customers have less money, and borrowing to buy from it costs more. Housebuilders, car dealerships and furniture retailers are the classic examples.

2.2 Borrowing, and the cost of finance

The obvious channel. A business with variable-rate borrowing pays more interest immediately, which reduces profit and reduces the cash available for everything else. A business with fixed-rate borrowing pays no more until it has to refinance — and then it refinances at the new, higher rate.

Two consequences are worth stating separately, because questions test them:

• Highly geared businesses — those financed with a lot of debt relative to equity — are much more exposed than lightly geared ones. The same rate rise takes a far bigger bite out of a business that owes a lot.

• The cost of equity rises too, not just the cost of debt. Investors can now get a better return from a bank deposit or a government bond, so they demand more from shares before they will hold them. That is what pushes share prices down when rates rise.

2.3 Saving

Higher rates reward saving. For a business with cash on deposit that is straightforwardly good news — interest income rises — and for a bank or an insurer it changes the whole shape of the business.

But it works against most businesses indirectly, because their customers save more and spend less, which is §2.1 again. And it raises the bar for the business’s own projects: if cash can earn 6% sitting in the bank at no risk, a project has to beat 6% before it is worth doing at all.

2.4 Capital investment

This is the channel that connects directly to chapter 10. The interest rate is the business’s cost of finance, and the cost of finance is the discount rate used to appraise an investment.

Raise the discount rate and every future inflow is discounted harder, so every project’s NPV falls, and projects that were marginally worthwhile become marginally not. In the language of chapter 10 §9: the discount rate rises towards the project’s IRR, and any project whose IRR is below the new rate must be rejected.

2.5 Government borrowing and expenditure

Governments are the largest borrowers in most economies, so a rise in interest rates raises the cost of servicing the national debt. That money has to come from somewhere: higher taxation, or less spending on everything else.

For a business the consequences are real rather than academic. Public-sector customers cut or delay orders; infrastructure programmes are postponed, which hits construction and its whole supply chain; grants and subsidies are trimmed; and higher taxation feeds back into §2.1 by taking more out of consumers’ pockets.

2.6 Putting it together

The effects of a rise in interest rates. A fall reverses every line.

3 Exchange rate risk

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A business can be affected by variable exchange rates in three ways, and the syllabus expects you to distinguish them. Only one of the three moves cash.

3.1 Economic risk

Economic risk describes how a company’s competitiveness is affected by exchange rates.

Suppose a UK company exports to the USA and the current exchange rate is £1 = US$1.30. An item selling for £1,000 in the UK will sell for $1,300 in the USA.

If the rate moves to £1 = US$1.50 — the pound strengthens, so it buys more dollars — the US price becomes $1,500. That rise from $1,300 to $1,500 makes the product less attractive against American competitors, and sales will probably fall. Had the rate moved the other way, the exported goods would have become more competitive.

There is a mirror-image effect on imports. A US company exporting to the UK at £1 = US$1.30 sells a product costing $5,200 for $5,200 ÷ 1.30 = £4,000. If the rate moves to £1 = US$1.50, the same product costs only $5,200 ÷ 1.50 = £3,467 — so it becomes more attractive to UK buyers.

Economic risk cannot be hedged with a contract, because there is no single transaction to hedge. The only real defence is diversification — selling into several currency areas rather than one, so that a movement that hurts you in America may help you in Europe or Japan — and, over the longer term, locating production in the markets you sell to.

3.2 Translation risk

Imagine a UK company with a subsidiary in Europe. The group accounts are prepared in £, so the subsidiary’s € statement of financial position has to be translated into £ at the year-end rate.

As the exchange rate moves up and down, so does the sterling value of those translated assets and liabilities. This does not cause any adverse cash flow — nothing is actually bought or sold — but it distorts the group’s reported financial position and its reported performance, and it can move ratios such as return on capital employed and gearing without anything having happened to the underlying business.

Because it is an accounting effect rather than a cash effect, the standard response is a balance sheet hedge: finance a foreign asset with borrowing in the same currency, so that when the rate moves the fall in the translated asset is matched by a fall in the translated liability and only the net position is exposed.

3.3 Transaction risk

Transaction risk arises where a currency movement changes the amount actually received or paid on a specific export or import. It is the one that moves cash, and it is the one the rest of this chapter is about hedging.

A UK company contracts to sell a product for $39,000 to a US customer when the rate is £1 = US$1.30. Payment may not arrive for several months, and by then the rate has moved to £1 = $1.50:

That £4,000 is a straight shortfall in the company’s cash flow and could have serious consequences — it may be the whole margin on the contract.

The same uncertainty arises on purchases. A UK company agrees to pay a German supplier €100,000 for equipment when the rate is £1 = €1.40, and by the payment date the pound has weakened to £1 = €1.20:

3.4 The effect on measures of business performance

The syllabus asks for the effect of exchange rate changes on the measures by which a business is judged, and names four of them. Take a UK exporter that also buys components abroad, and suppose sterling strengthens:

4 Managing exchange rate transaction risk

The simplest way to eliminate exchange rate risk is to have every contract denominated in your own currency — but that is a matter of negotiation with the other party, and it does not remove the risk so much as hand it to them. Beyond that, the methods divide into two groups.

4.1 Internal methods

4.2 Forward contracts

A forward contract is an agreement to exchange a fixed amount of currency, on a fixed future date, at a rate agreed today. You are quoted a rate now which will be used then, whatever the real exchange rate turns out to be, and that brings certainty to the cash flow.

So a company expecting to receive $10,000 in three months can take out a forward contract at, say, £1 = $1.25 and know today that it will receive $10,000 ÷ 1.25 = £8,000.

Forward contracts are binding. The agreed amount must be bought or sold on the agreed day. Two consequences follow:

• If the rate moves in your favour you cannot take advantage of it — you are locked in. The aim of a forward contract is to remove uncertainty, not to get the best possible rate.

• If the underlying transaction falls through, you still have to honour the contract. A company whose customer fails to pay may have to buy the currency in the market simply to deliver it under the forward and immediately change it back.

Forward contracts are arranged individually with a financial institution and are known as ‘over the counter’ products. That makes them flexible — any amount, any date — and it means they carry the risk that the other party does not perform.

4.3 Currency futures

Currency futures are derivatives: their value derives from something else, here the exchange rate. They are bought and sold on futures exchanges — the London market, formerly LIFFE, has been part of ICE Futures Europe since 2014.

Because a future’s price tracks the exchange rate, a profit on the future can be arranged to offset a loss on the currency.

Imagine a US exporter expecting to receive £1m in three months. At the current rate of £1 = US$1.40 that is worth 1m × 1.40 = $1.4m. If the rate falls to 1.30, only 1m × 1.30 = $1.3m will be received — a loss of $100,000. Since futures prices move with the rate, the exporter can sell futures now at around 1.40 and buy them back later at around 1.30 to close out the position. The profit on the futures largely offsets the loss on the currency.

4.4 Currency options

An option can be exercised — the owner insists on buying or selling at the exercise price — or allowed to lapse if the market offers something better. That is the whole point of it: a forward contract binds you to a rate whether it turns out well or badly, while an option protects you against the bad outcome and lets you keep the good one.

Options are rather like insurance policies: they protect you against a loss, but you do not have to claim on them. And, like insurance policies, the protection has to be bought — an up-front, non-returnable premium is payable whether the option is exercised or not. That premium is the price of the flexibility, and it is why options are not simply better than forwards.

5 Managing interest rate risk

5.1 Fixed and floating rates

Variable-rate loans and deposits are a source of risk, because it is not known with certainty what interest will be paid or earned. Fixed-rate loans and deposits remove that risk — but they also remove any chance of benefiting from a favourable movement, and a business can be locked into an unfavourable rate for years.

So the choice is the same trade-off as everywhere else in this chapter: certainty against opportunity. There are three main ways of reducing the risk on variable-rate interest without giving up the choice entirely.

5.2 Forward rate agreements

A forward rate agreement (FRA) is the interest-rate equivalent of a forward currency contract: it lets a borrower or depositor fix an interest rate for a period starting in the future — for example, for the twelve months beginning six months from now. Like forward currency contracts, FRAs are over-the-counter arrangements agreed individually with a bank, and like them they are binding, so a favourable movement in rates cannot be taken.

5.3 Interest rate futures

These are derivatives whose value depends on the interest rate. By buying or selling futures contracts, profits can be made that largely compensate for losses caused by an adverse interest rate movement.

Interest rate futures are quoted as 100 − the interest rate. So if the rate in the economy is 4%, the futures price is 96. The consequence is worth thinking through: when interest rates rise, the futures price falls — so a borrower, who loses when rates rise, hedges by selling futures now and buying them back more cheaply later.

5.4 Interest rate options

These are options to buy or sell interest rate futures. They let a borrower or depositor enjoy a favourable interest rate movement while being protected against an adverse one, and — exactly as with currency options — an up-front non-returnable premium has to be paid to acquire that protection.

A borrower who fixes a right to pay 5% will exercise it if the actual rate turns out to be 7%, and let it lapse if the actual rate turns out to be 4%. Nobody would insist on paying 5% when 4% is available.

6 Tests

Work each one before reading the answer.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.