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Contents
1. National income, and the eects of economic growth rates and prices on business 3

2. International trade 19

3. Economic development and globalisation 27


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4. Organisations 33

5. Prices 43

6. Market failure and the regulations of markets 55

7. Data and information 61

8. Big data and data analysis 71

9. Financial markets and institutions 85

10. Financial mathematics 97

11. The eects of interest rates and exchange rates on business performance 113

12. Answers To Tests 119

13. Answers To Examples 129

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CHAPTER 1
NATIONAL INCOME, AND THE EFFECTS
OF ECONOMIC GROWTH RATES AND
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PRICES ON BUSINESS

1 Introduction to macroeconomics
The term macroeconomics refers to the branch of economics that deals with national and
international economics. Microeconomics, which will be dealt with later, deals with the
study of specific markets for products and services.

Macroeconomics therefore covers topics such as:


How can the size of a countrys economy be measured?
How could the economy be made to grow?
What is the unemployment rate and what aects this?
What causes inflation and how can inflation be controlled?
What determines currency exchange rates?
How to imports compare to exports?

2 National income
National income can be defined as:
the total value a countrys final output of all new goods and services produced in a year.
The word final is important. If Company A sold goods to consumers, then the value of those
sales would be part of national income. However, if Company A sold to Company B and
Company B sold to the public for the same price, then the sales revenue would appear in
both companys accounts and there would be double-counting if both amounts were
included in national income. To avoid this, only Company Bs sales would be included in
national income.
The higher the national income, the more income is available for a countrys population
There are two main measures of national income:
Gross domestic product (GDP)
Gross national product (GNP)

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A countrys gross domestic product refers to the total value of income or production taking
place in that country. It is calculated as:
Capital Exports of Imports of
Household Government
GDP = + investment + + goods and goods and
spending spending
spending services services
A countrys gross national product takes into account income earned from abroad and also
profits earned in a country being sent to foreign investors. The dierence between income
being earned abroad and profits being remitted to overseas investors is called the net
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property income from abroad. So


GNP = GDP + Net profit income from abroad

3 The circular flow of income


If an item is sold for 50, then that amount appears in two places:
The amount spent by the consumer (consumption or expenditure)
The amount received by the seller (income)
The consumption (expenditure) and income must be equal.
Of course, there is another set of flows. Companies employ people and pay wages whilst
employees can use their wages to buy goods from companies. Recognition of these two sets
of flows (wages/labour, sales of goods/purchases of goods) gives rise to the circular flow of
income.
Households provide: labour, land, capital (together known as factors of production)
Firm provides: wages, rent, interest
Firms: produce goods or provide services
Households: pay for the goods and services
Households

Goods Spending/ Income Factors


consumption

Firms

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As well as money, goods, services and factors of production moving between firms and
households, there are injections and withdrawals (or leakages) from the system.
Injections:
Government spending
Exports (money comes from abroad)
Investment (this is expenditure on goods in addition to household spending).
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Withdrawals:
Taxation
Savings (for example, money is earned, but simply kept and accumulated)
Imports (money goes abroad)
Injections will increase the circular flow of income (for example, money flowing into the
country from the sale of exports). Similarly, withdrawals will decrease the circular flow (for
example, more people deciding to save).
If an economy is in equilibrium (meaning that the circular flows are constant) then injections
into the economy must stimulate the economy. For example, if the government suddenly
printed more money and injected it into the economy by giving each person 10 to spend,
then that additional money could be spent on goods and services, increasing both
consumption and the supply of goods. To supply more goods, more factors of production
would be bought, increasing the populations income until a new equilibrium point is
reached.

4 Aggregate supply and demand


Although money spend by consumers (consumption or expenditure) must equal the value of
goods sold by suppliers (income) this does not mean that the demand for goods will always
equate to the supply of goods. A product could be very popular but suppliers are not able to
keep up with that demand. The imbalance between supply and demand can occur at the
macro-economic level also:
Aggregate demand: the total demand in the economy for goods and services; it is the
total desired demand.
Aggregate supply: the total supply of goods and services in the economy.
Aggregate demand would increase as prices decrease: lower prices stimulates demand.
Aggregate supply increases as prices increase: higher prices will encourage firms to produce
more.
An equilibrium (or balance) is reached when aggregate demand and aggregate supply are
equal: enough is produced to exactly meet demand.
Lets see what happens if these are not equal. Assume that because the economic situation
had been a little uncertain, consumers had decided to save some of their income in case of
redundancy. Then the economy picks up and consumers have more confidence to spend
their savings. Suddenly aggregate demand would have increased, but the supply of goods
might lag behind this sudden increase in demand. The likely eect is that there will be price
rises as consumers are willing to pay more to satisfy their increased demand; production will
be increased so that, once again supply will satisfy demand but at a slightly higher price

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The following graph shows what happens:

Prices

Aggregate
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Demand 2

Aggregate
Demand 1 Aggregate
supply
B
A

Output

We start at point A. Aggregate supply and aggregate demand meet at this point: the quantity
supplied matches the quantity of goods demanded.
When confidence in the economy rises and people are willing to spend more money, the
aggregate demand shifts to the right from aggregate demand line 1 to line 2. This means that
more goods are demanded at a given price.
The extra demand will stimulate producers to supply more and the equilibrium point moves
from A to B. Prices are slightly higher. Of course, as production increases, employment will
increase, so governments can increase employment by stimulating aggregate demand.
Demand can be stimulated by measures such as:
Decreasing tax so that consumers are left with more to spend
Increasing government expenditure (eg the government borrows and spends)
Decreasing interest rates so that it is cheaper for consumers to borrow and spend

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Of course, aggregate supply has limits. For example, once everyone is in employment it is
dicult to satisfy further demand. Output has reached its limit

Prices

Aggregate supply,
showing where
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Aggregate full employment is


Demand 2 reached and no
more goods can
Aggregate be made.
Demand 1

B
A

Aggregate
supply

Output

If no further goods can be made, yet demand keeps increasing, there will be a strong upward
inflationary pressure on the economy as output cannot adjust to meet demand. On the other
hand, if demand is lower than could be met by maximum demand, there is likely to be
unemployment.

Prices

Aggregate
Demand 2

Full employment

Aggregate
Demand 1 B

C
A

Aggregate
supply

Output

At equilibrium point A, aggregate demand is equal to aggregate supply but there is spare
productive capacity and there will be unemployment. The line showing aggregate Demand 1
would have to move to the right until it went through point C where full employment would
be reached. The rightward move in aggregate demand needed to achieve full employment is
known as the deflationary gap.

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At equilibrium point B, aggregate demand is higher than the maximum supply available.
Output cant increase so prices rise steeply as a way of making demand and supply match.
The line showing aggregate Demand 2 would have to move leftward to go through point C
and to achieve matched demand and supply. The distance aggregate demand would have to
reduce to achieve the match at point C is known as the inflationary gap.

5 Shifts in the aggregate demand curve


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This section is not talking about movement along an aggregate demand curve. Such
movements are caused by changes in prices that will increase or decrease demand. We are
looking at what causes demand curves to shift to the right (eg Demand line 1 moving to
Demand line 2) or to the left.
Shifts to the right increase aggregate demand and is equivalent to an economy growing.
Similarly, shifts to the left imply the economy is contracting. Controlling economic growth or
contraction will be a key concern of all governments: fast growth can lead to inflation and can
suck in imports to meet demand; fast decline can lead to mass unemployment.

Rightward shifts are caused by:


An increase in disposable income. This can be caused by, for example, lower taxes,
lower interest rates, increased welfare payments.
Consumers deciding to save less (known as a lower marginal propensity to save).
Increased government spending
A more relaxed monetary policy (for example, the government simply printing more
money
A change in net exports. When a countrys exchange rate weakens, its exports become
cheaper to foreign buyers and this stimulates demand in the economy as more goods
are demanded by overseas buyers.

Leftward shifts are caused by:


The opposite of each of the above influences

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6 Inflation
Inflation is a general increase in prices in an economy and a consequential fall in the
purchasing power of money: what can be bought for $1 now cannot be purchased by $1 in
one year.
Inflation (in particular high rates of inflation) are undesirable. For example:
It hurts people who rely on fixed incomes.
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It hurts savers (the purchasing power of savings declines).


It is very distracting and confusing (for example, employees spend huge eort
negotiating pay increases to cover inflation).
The causes of inflation are:
Demand pull. Aggregate demand is higher than the aggregate supply.
Cost push. An example of cost push inflation is where people in the manufacturing
industry, lets say coal mining, have a large wage rise. Inevitably that wage rise is passed
on and will find itself reflected in the cost, say, of electricity. The cost of electricity goes
up and thats an example of cost push inflation.
Import cost inflation. A good example of that was the huge increase in the cost of oil
that happened towards the end of 2008.
Expectation. This is where people expect there to be inflation and because they expect
inflation, they make higher wage demands and the higher wage demands inevitably
push up the price of goods that are going to be sold.
Increase in the money supply. An increase in the money supply will stimulate
demand. More people have money to buy goods and this will cause demand pull
inflation.
Governments attempt to reduce high inflation by means such as:
Increasing interest rates so that it is harder to borrow to buy goods. Additionally,
mortgage payers will have less disposable income after paying their monthly
instalments.
Legislation to limit wage rises
Cutting back government expenditure to lower aggregate demand

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7 Measures of inflation
7.1 Introduction
Inflation is measured using indices. So, if a product cost $210 in 2017 and $231 in 2018, the
inflation index over would be calculated as:
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Inflation price index = Price in 2018/Price in 2017 = $231/$210 x 100 = 110.

2017 is the base year, and an index of 110 implies an inflation rate of 10%.

7.2 Compound indices


There is no problem calculating inflation indices for individual products, but it gets more
interesting when trying to work out how inflation aects consumers as they they purchase a
wide range of products. The solution is to construct an index which takes into account typical
patterns of consumption. For example, in the UK, the Government maintains a Consumer
Price Index (CPI) based on a representative basket of goods, including items such as food,
heating, travel, clothing and entertainment.
Of course, over time, the contents of the basket will change as spending habits change. For
example, mobile phone costs will be included now whereas 30 years ago, they wouldnt have
been. Similarly, dierent foods will have increased and decreased in popularity and cigarettes
have become less important for many populations.
So, both prices and quantities of goods and services can change and this means that there are
dierent types of index:
Base year quantities or base year values (Laspayre indices)
Current year quantities or current year values (Paasche indices)
Example:
Base year Current year
Products Quantity Unit price $ Quantity Unit price $
A 20 2.00 30 2.50
B 50 3.00 60 4.00
Base-year weighted quantity index

(Current year price x Base year quantity) (2.50 x 20 + 4.00 x 50)


Index = = = 1.316
(Base year price x Base year quantity) (2.00 x 20 + 3.00 x 50)

Current-year weighted value index


(Current year price x Current year quantity) (2.50 x 30 + 4.00 x 60)
Index = = = 1.312
(Base year price x Current year quantity) (2.00 x 30 + 3.00 x 60)

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7.3 Chain indexes


Instead of relating prices back to a constant base year, it is also possible to create chain
indices where each index is an update on the previous years prices.
So:

Year 2016 2017 2018 2019

Price $ 150 164 172 195


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Index based on the previous year


164/150 172/164 195/172
= 1.093 = 1.049 = 1.134

Multiplying the indices together gives:


1.093 x 1.049 x 1.134 = 1.300
Which is the overall increase from 2016 to 2019: 195/150 = 1.300

7.4 Using indices to remove inflation from a series


When comparing one years national income to anothers (or even sales made by a company
to sales made by the company in a previous year) inflation can distort the true measure of
growth because inflation does not represent true growth.
Indices can be used to rebase each years figures do remove the eect of inflation. This can be
done either by converting all figures to present day amounts or by removing inflation from
the later figures. For example:
2016 2017 2018
Sales $m 1545 1555 1563
Inflation index 100 112 119
Update to 2018 1545 x 119/100 1555 x 119/112 (already in 2018
amounts amounts)
OR: = 1839 = 1652 = 1563
Remove inflation to (already in 2016 1555 x 100/112 1563 x 100/119
present figures in amounts)
2016 amounts = 1545 = 1388 = 1313

Either method of adjustment shows that real growth in sales was illusory: after taking inflation
into account, sales values have fallen markedly.

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8 Trade cycles
8.1 The components
A trade cycle is composed of periods of good trade characterised by rising prices and low
unemployment percentages alternating with periods of bad trade characterised by falling
prices and high unemployment percentages (Keynes).
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Output
Peak / boom
Peak / boom

Trend

Trough

Expansion Recession Expansion


Trough

Time

During expansion, manufacturing and spending are increasing. There is a danger of high
inflation as demand exceeds supply and the prices of materials and labour are bid up. Imports
are likely to increase. Public finances are good because increased profits and employment
yields increased tax.
During recessions, economies shrink. Businesses are likely to fail and unemployment will
increase. Inflation might fall though there is a phenomenon known as stagflation which is
characterised by high inflation together with high unemployment and stagnant demand in a
country's economy. Imports are likely to fall and public
In boom periods economies are likely to overheat with asset prices (shares, property etc)
becoming overvalued, only to cause large losses when a recession sets in.

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8.2 Government responses to stages in the trade cycle

Expansion and boom


Attempt to prevent the economy overheating and inflation and prices roaring away. For
example:
Increase interest rates to make borrowing (and hence the spending of borrowed
money) less attractive.
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Increase taxation
Reduce government spending
Decrease the money supply by tightening bank lending rules.

Recession
Attempt to stimulate the economy so that employment and incomes increase. For example:
Decrease interest rates.
Decrease tax.
The government can borrow money to increase its expenditure.
Increase the money supply be relaxing bank lending rules.

9 Public finance
9.1 Introduction
Public finance refers to how the government raises money and spends it.

9.2 Raising money


Governments can obtain money by:
Taxation
Borrowing
Selling state assets (privatisation)
Printing more money/quantitative easing

9.3 Taxation
Taxes can be described as:
Regressive.
Proportional.
Progressive.
A regressive tax takes a higher proportion of a poor persons salary than it does for a rich
person. A simple example is VAT. If the VAT rate is 20% it doesnt matter whether you are rich
or poor you still pay 20% on a purchase and that is proportionally more taken from a poor
persons pay than it is from a rich persons income.

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A proportional tax takes exactly the same proportion of income tax from all levels of income.
So you could have a flat rate tax which taxes everyone at say 10% from the very first dollar
earned, up to millions of dollars.

A progressive tax takes a higher proportion of income as income rises. So maybe for the first
$1,000 of income the tax rate is zero, for the next $4,000 of income the tax rate is 20%, and
anything beyond that is taxed at say 40%. A progressive tax would obviously be more
eective at redistributing wealth and income than either a regressive or a proportional tax.
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Taxes can also be described as direct or indirect:

A direct tax is paid directly by a person to the revenue authority. A good example is
income tax. A certain proportion of your income goes directly to the revenue authority.
An indirect tax is collected by the revenue authority from an intermediary, normally a
supplier of some sort. A good example of an indirect tax is VAT. You buy something, you
pay over the total purchase price, and then the seller passes some of that on to the
government.
Some taxes are charged as a fixed sum per unit sold. So if you were to buy a bottle of wine it
doesnt matter whether it costs $5, $10 or $25; a fixed sum will go to the government.
An ad valorem tax is charged as a fixed percentage of the price of the good. A good example
of an ad valorem tax is VAT

9.4 Borrowing
Governments raise funds by selling government bonds and treasury bills to investors.
Government has to pay interest on its borrowings and this can become a very significant
expense when borrowing is high. Governments with very high borrowing can find it dicult
to raise more money in this way because investors fear government default. This puts up the
interest rate that must be oered.
Most borrowing is repayable after a number of years but some bonds are irredeemable.
Borrowing is used if the government feels that taxes cannot be raised. For example, the
government might fear for its popularity. In addition, if the government takes money from
consumers through taxes then this will reduce consumer spending. Of course, the
government can spend the money raised by taxation, but the economy is unlikely to be
stimulated. Borrowing allows the government to spend more while not taking more from
consumers and this will stimulate the economy.

9.5 Selling state assets


Over the last several decades it has become common for many countries to privatise
businesses which had been owned and run by the government (nationalised industries). The
assumption is that governments are not particularly good at running businesses (perhaps
because of over-bureaucratic, slow decision-making or through political interference) and
that privatised undertakings will be better run and will oer consumers more choice, better
service and lower prices. Governments therefore went through a phase of selling of the state
gas company, electricity company, water company etc. and this raised substantial revenue. In
many economies there now isnt much left to sell o so this source of funds is negligible.

9.6 Printing money


Governments can, through their central banks, print money and spend it so introducing it to
the economy so that the economy is stimulated. Nowadays this process is called quantitative
easing and the extra money is created electronically.

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Quantitative easing is used when economies are in a poor shape and need stimulating. If an
economy was doing well releasing more money through quantitative easing will cause
inflation and will reduce the purchasing power of money, penalising, in particular, savers and
those on fixed incomes.

10 Government approaches to controlling the economy


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10.1 Fiscal policy


The word fisc is an old word which referred to the kings purse.
Where does the state get the money from?
Where does it spend it?
If the state wants to spend money it either has to raise income through taxes or borrow
money. If it wants to reduce taxes it either has to reduce expenditure or borrow money.
The three have to be in balance and how this is achieved is the governments fiscal policy
Government spending

Taxation Borrowing

In the current recession governments are seeking to spend more money and therefore to put
money into the economy to try to stimulate it. However, if they spend more by raising taxes
they may actually not end up putting very much more money into the economy. They are
taking with one hand and giving away with the other. So what most governments are doing
is increasing government borrowing. Keep taxes the same; borrow money, spend it, once its
spent it will be earned by people who will spend it again. And thats the way in which
governments hope the recession will be brought to an end.

10.2 Monetary policy


The second way in which governments attempt to control their economies is by their
monetary policy: managing the supply of money in the economy. The more money in the
economy the more economies are likely to be stimulated.

There are two main weapons.


Interest rates. If interest rates are very high people will tend not to want to borrow
money. If you dont borrow money you cant spend it, and if you cant spend it then
demand pull inflation will be relatively low. If, however, you greatly reduce the interest
rates more people will be encouraged to borrow. They spend that borrowed money on
televisions, cars, houses, whatever. Once its spent the money is in the economy, other
people earn it, demand goes up, and the economy is stimulated.
Credit controls. This is a control over institutions, typically banks, on how much they
are allowed to lend. So, for example, if you put $1,000 into a bank and the reserve
requirement was only 10%, that means that the bank could lend $900 out of the $1,000
deposited. That $900 could be deposited again and the bank could lend on $810 and so
on. Therefore, the initial deposit of $1,000 can create a much higher amount of money

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in the economy. Say however that the reserve requirement was 50% - $1,000 in the
bank; the bank only lend on $500. That $500 is put into another account, the bank can
lend on only $250 and so on. You can see that at the end of the cycles a much smaller
amount of money will be created in the economy.

11 The multiplier
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Lets say that a government introduces $100m into the economy by employing additional
doctors in a state health service. The extra doctors will receive salaries from the government
and will spend some and save some of their earnings.
Lets say they spend 75% and save 25% (25% is known as the marginal propensity to save).
So, $75m is spend by doctors and earned by other people or firms. If they also had a marginal
propensity to save, they would spend 75% x $75m = $56.25, and so on. The total additional
expenditure will therefore be:

Round Spent ($m)


1 100.00
2 75.00
3 56.25
4 42.19
5 31.64
6 23.73
7 etc
It can be shown that the sum of these amounts is:
Initial expenditure x 1/Marginal propensity to save = $100m/0.25 = $400m
So, the eect of the initial $100m is multiplied. This eect can make government intervention
or any other way in which the economy is stimulated - very eective. Success breeds
success and once the economy starts to grow it can therefore grow rapidly until the factors of
production run out.
Of course, the eect works the other way. If a government reduces expenditure, this is not
just felt once by aects a whole chain of consumption, and the economy can quickly decline.

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Tests
Question 1
What word should fill the blanks, below?
National income is the total value a countrys _____________ output of all new goods and
services produced in a year
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Question 2
Which one of the following is the correct definition for gross domestic product?
+ Capital + Exports of + Imports of
Household + Government
A GDP = investment goods and goods and
spending spending
spending services services

+ Capital - Exports of - Imports of


Household + Government
B GDP = investment goods and goods and
spending spending
spending services services

+ Capital - Exports of + Imports of


Household + Government
C GDP = investment goods and goods and
spending spending
spending services services

+ Capital + Exports of - Imports of


Household + Government
D GDP = investment goods and goods and
spending spending
spending services services

Question 3
In the circular flow of income, there are some injections and withdrawals. Label each of
the following:

Injection Withdrawal
Tax
Exports
Imports
Savings
Government spending

Question 4
A tax which raises the same amount from each person irrespective of their income is
known as a(n):
A Progressive tax
B Regressive tax
C Ad valorem tax
D Income tax

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Question 5
If a population has a marginal propensity to save of 0.2 and the government injects $100m
into the economy, how much additional expenditure will result?

Question 6
Prices
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Aggregate
Demand 2

Aggregate
Demand 1 Aggregate
supply
B
A

Output

In the above diagram, which TWO of the following would move the aggregate demand
from position 1 to position 2?
A An increase in prices
B A decrease in prices
C Decreasing interest rates
D Increasing government expenditure

Question 7
When an economy is operating at its maximum output, but aggregate demand is
higher, what is the main economic eect?
_______________________________

Question 8
Base year Current year
Products Quantity Unit price $ Quantity Unit price $
P 30 4.00 40 5.00
Q 50 3.00 60 4.00
What are the:
(a) Base-year weighted quantity index?
(b) Current-year weighted value index?

Question 9
What are the four ways in which governments can raise money?

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CHAPTER 2
INTERNATIONAL TRADE

1 Introduction to international trade


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Almost every country trades internationally through importing and exporting both goods
and services. Other international transactions also occur, such as when a company buys or
sells a foreign subsidiary or whenever profits and interest are sent to international investors or
lenders.

2 The balance of payments


The balance of payments summarises all transactions between a countrys residents and its
non-residents
Transactions include import and export of goods and services, payment of interest, payment
and receipt of interest and dividends, investment and other transfers of cash and financial
instruments.
The balance of payments can be thought of in terms of the following accounts:
Current account: mainly flows from the eects of trade and income.
Capital account: flows relating to investments and proceeds from the sale of
investments.
Financial account: flows of cash and financial instruments.
These accounts are related as follows:
Current account + capital account = Financial account
For example, if goods are imported, the current account and financial account will be equally
aected because money is either paid to or is owed to suppliers. If investments are made
abroad, both the financial account and capital accounts are aected. When dividends from
the foreign investment are received, the current account and financial accounts are aected.
In practice, errors in data collection mean that the equilibrium is never seen.
Even though the equation should always balance, governments worry about imbalances in
each part of the equation. In particular, they worry about trade deficits. A trade deficit is
where a countrys imports are consistently higher than its exports.
Does a current account deficit matter?
The USA runs a huge current account deficit; China has a huge current account surplus. The
USA is a large net importer of goods whilst China is a large net exporter. These conditions
have been present for many years, so do persistent deficits and surpluses matter?

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If the USA is a high net importer from China, then the USA needs continuous supplies of yuan,
the Chinese currency, to pay suppliers. How can it obtain these supplies, given that exports to
China are negligible? There are three methods:
Sell assets to China. For example, companies, gold, other foreign currency holdings
Borrow yuan from China eg issue government bonds to China.
Sell US$ to China in exchange for yuan. However, with floating exchange rates this will
have the eect of depressing the value of the dollar and increasing the value of the
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yuan
Countries run out of assets to sell; borrowing more will mean that there are vast interest
payments and a risk of default by the country.
Control of deficits are as follows
Selling US$ for yuan should provide a self-regulatory mechanism to the deficit
imbalance because imports will become more expensive, but this mechanism is often
not enough to control exchange rates. Exchange rates depend on other factors also
such as interest rates, speculators and economic stability.
Deliberate devaluation (where exchange rates are fixed).
Import controls to reduce the value of goods imported
Deflation reducing domestic demand so that consumers buy less in general
including less imports.
Producing goods that will successfully compete with imports and which can themselves
be exported. This is known as a supply-side mechanism because the supply of goods if
adjusted.

2 Reasons for international trade


International trade occurs for the following reasons:
Natural resources. If a country does not have the natural resources it requires it has to
import them. For example, many countries do not have their own supplies of oil and gas
so must import these from countries that do.
Access to low labour costs for production.
Economies of scale. Supplying, say, 10 million phones to the world is likely to be
cheaper per phone than just supplying 1m to your home consumers. Research and
development costs are spread more thinly and vast factories can be used to for ecient
production.
Skills. Countries often develop particular skills to a very high level and this can make
their products and services better than are available elsewhere. For example, the UK has
high financial skills; the US and Europe have high civilian aerospace skills (Boeing and
Airbus), Japan has high skills in optics (Nikon, Canon, Olympus etc).
Unique products. If a pharmaceutical company in one country discovers a uniquely
valuable drug, then doctors and patients in other countries will want to import it.
Many of the reasons for international trade can be explained by the theories of absolute
advantage and comparative advantage.

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Absolute advantage
A country has absolute advantage when it performs a task more eciently than producers in
other countries. For example, because of its climate, Spain is extremely eciency at
producing oranges, lemons, olives and tomatoes. It will always be able to produce these
goods more eciently that they can be produced in countries such as the UK or Russia. It
makes sense to import these goods from Spain rather than having to artificially heat vast
greenhouses in your own country.
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Comparative advantage
This is a more subtle concept. Staying with fruit growing in Spain and the UK, say that the
output per hectare of ground is as follows:
Units of weight Tomatoes Oranges
Spain 1200 800
UK 700 10

Spain obviously has absolute advantage when growing both products. Now lets say that in
each country we look at one hectare being planted with tomatoes and another hectare
planted with oranges. Assume that the two hectares in each country are the only resources
available.
Total output will be:
Units of weight Tomatoes Oranges
Spain 1200 800
UK 700 10
Total 1900 810

However, the UK is much, much, much better at producing tomatoes than oranges, so should
specialise wholly in that so that both hectares are used for tomatoes, allowing 2 x 700 = 1400
units of tomatoes to be produced there. If total demand for tomatoes in both countries stays
at 1,900, Spain will have to product only 500 units of tomatoes and can shift 7/12 of its
tomato production to orange production. This will allow additional orange production of
7/12 x 800 = 467 units.
Total production, with the same total resources of four hectares is now
Units of weight Tomatoes Oranges
Spain 500 1267
UK 1400 0
Total 1900 1267

So total output is much higher and the use of the land much better. Now, of course the UK
can export tomatoes to Spain and Spain can export oranges to the UK.

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3 Advantages and disadvantages of international trade


International trade allows:
Best use of resources: both absolute and comparative advantage.
Development of specialisations.
Economies of scale.
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Greater competition to drive both competitive pricing and innovation.


Lower prices for consumers.
However, there can be disadvantages certainly to individual countries:
Increased transport cost and carbon footprint as goods are moved.
The export of jobs. Goods made abroad and imported will reduce home jobs for that
sector.
Strategic weakness. For example, dependence on other countries for food or fuel can be
used politically.
Balance of payment diculties: imports imply that your own currency has to be sold to
pay for imports and this can aect exchange rates. (See later.)
Dumping. An exporter has surplus capacity, perhaps only temporarily, and dumps
goods by exporting them, aecting local companies and local employment.

4 Control of international trade


Putting up impediments to international trade is known as protectionism ie home producers
are protected from overseas competition.

Protectionist methods include:


Quotas: maximum numbers of units of products that can be imported.
Taris and customs duties: eectively a tax on imports making them more expensive
and less attractive.
Administration and legal procedures. For example, insisting on very strict inspection of
imported goods which adds to cost and delay.
Subsidies: these are given to exporters so that they can compete very eectively and
undercut overseas manufacturers. Providing direct subsidies is often not permitted
under world trade rules, but they can be provided subtly. For example, if an aircraft
manufacturer makes both military and civilian aircraft, the government could pay high
prices for military aircraft so that the manufacturer can use profits there to subsidise
civil aircraft production.
In general, economists agree that international trade bring great advantages to the
world economy. Politically, however, the issues are less clear-cut. This set of notes is
being written on the day on which Donald Trump is being inaugurated as the 45th
President of the USA. Much of his success in the election was based on bring home
American jobs and even before inauguration his tweets seem to have altered the plans
of some large US companies so that they will build their new factory in the USA rather
than in Mexico. The cars built in the USA are likely to be more expensive than those built
in Mexico because of higher labour costs. Overall American consumers will lose you

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because they will have to pay more for cars but the new factory will provide several
thousand jobs for Americans.
The promise to repatriate jobs by placing impediments to importing is very powerful
and seductive particularly amongst blue-collar workers, a category which particularly
suered by o-shoring manufacturing or allowing free import of foreign goods.

5 Exchange rates
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An exchange rate shows how much one currency is in terms of another. For example:
GBP1/USD = 1.34 or GBP1 = USD1.34 or just 1 = $1.34
Means that 1 GB Pound can be changed for 1.34 US dollars
Banks quote exchange rates showing a spread as follows:
GBP1 = $1.34 $1.31
One rate is for changing to $ and the other for changing $ to . Banks always use the
rate that leaves customers worst o, so if you went into a bank with 1,000 you would
be given only $1,310 in exchange, not $1,340.
Some exchange rates are fixed (or pegged) but most float so that they change
constantly. Floating exchange rates present problems for importers and exporters when
they are buying or selling in a foreign currency. A UK firm might have agreed to export
goods to a USA customer for $10,000 when at the time of the contract the exchange
rate was 1 = $1.34. The firm would therefore budget to receive $10,000/1.34 = 7,463.
If, however, by the time payment was received, the US$ had weakened so that the
exchange rate was 1 = $1.42, the amount received would be worth only $10,000/1.42
= 7,042. There are methods that can be used to eliminate or substantially reduce this
uncertainty (covered more fully in Chapter 11).
Apart from diculties arising from uncertainty in exchange rates, exchange rates have the
following eects on businesses:
A strengthening home currency makes exports more expensive to foreign buyers and
less competitive. Conversely, a weakening home currency makes exports less expensive
and more competitive.
A strengthening home currency makes imports cheaper and these are then more
competitive compared to goods domestically produced. Note that a company does not
have to import or export itself to suer from the eect of cheaper imports. Conversely, a
weakening home currency makes imports more expensive.
Dividends remitted from foreign subsidiaries become more valuable if the home
currency weakens.
Interest to be paid on foreign loans will become more expensive f the home currency
weakens.

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Exchange rates are aected by the following:


Speculation dealers buying or selling large amount of currency (so aecting the
exchange rate) in the hope of making profits.
Sentiment a change of government often aects a currencys value.
International trade aects the supply and demand for currencies and hence their values.
Inflation erodes the purchasing power of a currency. High inflation in a country weakens
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a currency with respect to the currency of a low-inflation country.


Interest rates raising interest rates can attract hot money into a country as higher
returns can now be earned now on bank deposits. The demand for the currency can be
expected to strengthen the currency.

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Tests
Question 1
Fill in the blank:
It makes sense for the UK to import oranges from Spain rather than grow them in
greenhouses domestically. In terms of explaining the advantages that can rise from
international trade this is known as _________________ advantage.
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Question 2
Fill in the blank:
The general name for trying to reduce international trade by quotas, taris and other means
is known as _____________________________.

Question 3
Which one of the following is NOT an advantage of international trade?
A Greater opportunities for economies of scale
B Exploiting comparative advantage
C Guaranteed access to strategic resources
D Greater competition

Question 4
An exchange rate is quoted as GBP1 =1.25 1.22
If you wanted to change 120,000 to GBP, how many GBP would you receive?

Question 5
If a countrys home currency strengthens, which TWO of the following eects will be
experienced?
A The companys exports will be more competitive
B The companys exports will be less competitive
C The company might face more competition from imports
D The company might face less competition from imports

Question 6
The current exchange rate between country A$ and country B$ is A$1 = 1.5B$
If country As inflation rate is higher than country Bs inflation rate, will the exchange
rate move towards A$1 = 1.4B$ or A$1 = 1.6B$

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CHAPTER 3
ECONOMIC DEVELOPMENT AND
GLOBALISATION
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1 Introduction to economic development


As explained in the previous chapter, there are powerful arguments for the advantages of
international trade though there are potential political problems. Over the last few decades
the progress of globalisation has been fast and many products are now produced
internationally by large multi-national companies. Examples include: Apple, Unilever, Burger
King, Nike.

2 Globalisation
Globalisation can be defined as:
The process by which the countries and businesses throughout the world are becoming
increasingly interconnected because of increased trade. Globalisation has increased the
production of goods and services. The biggest companies are multi-national companieswith
subsidiaries in many countries throughout world.
Globalisation has been caused by:
Improved communication (both physical and the transfer of information, for example,
over the Internet).
Political alliances (such as the European Union).
The growth of global industries. Some of this is driven to achieve economies of scale
and to allow increasingly complex products to be developed and sold economically.
Cost dierentials. For example, making use of low labour costs in some countries.
Trade and political agreements allowing freer movement of goods, money and people.

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3 The effects of globalisation


Production and sales occur internationally. There are various patterns:
Sometimes companies make in only one location and export production. For example,
Boeing assembles aircraft only in the USA.
Sometimes companies manufacture almost all their products abroad and the product is
then sent through the world including back to the home country. For example, the
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majority of Apple iPhones are assembled by Foxconn in China. Most Nike trainers are
made in Indonesia, China and Vietnam. The process of sending manufacturing abroad is
known as o-shoring.
Alternatively, they can set up many manufacturing operations near their markets and
this can reduce transport costs and improve the speed of delivery. For example, there is
little point in a company like Coca Cola having all its production in the USA and
spending a fortune transferring its product, which by weight is mainly flavoured,
carbonated water, across the globe. Local production makes much more sense. Even is
not all of a product is made abroad components might be and only assembly is done
locally.
Manufacturing or sub-contacting/licensing. Setting up a factory abroad and can be risky
because local laws and customs might be misunderstood. An easier way is to sub-
contract production to a firm in the country that the products will be sold in. Often the
manufacturer is also given marketing rights and a royalty is paid to the company
owning the brand or the process. Franchising is another form of international expansion
but is rather more hand-on than a simply royalty agreement. For example, many
McDonalds branches are franchises where a local business is given the right to set up as
a McDonalds outlet. They have to comply closely with McDonalds ways of doing
business.
On the downside, many people are becoming increasingly sceptical about the benefits of
globalisation as is can be seen as:
The export of jobs.
Crushing of local industries by powerful multi-nationals.
Undermining democracy as large multi-national companies are larger, richer and
therefore more powerful than many national economies.

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4 Trade agreements
Trade agreements are treaties between countries on their reciprocal taris, quotas etc. The
purpose of the agreements is to reduce the barriers to trade. For example, two countries
could agree to import/export cars from one another without taris, or with the same taris, so
that there is a level playing field. These arrangements should simplify international trade,
improve economic eciency and provide consumers with more choice. They reduce
protectionism.
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Examples of trade agreements include:


European Union (EU) a customs union, a single market and now with a single
currency.
European Free Trade Area (EFTA)
North American Free Trade Agreement (NAFTA) between the USA, Canada and Mexico.
The World Trade Organisation (WTO) is the global international organisation dealing with the
rules of trade between nations. The objectives of the World Trade Organisation are to:
Reduce the barriers to international trade
Promote free and fair trade through multilateral talks and negotiations
Arbitrate between countries that are in dispute.

5 PESTEL
PESTEL is a way of appraising the macro-environment of countries. This is important when
decisions are being made about whether to invest in a country or to export to it.
PESTEL stands for:
Political
Economic
Social
Technological
Ecological
Legal.

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Examples of PESTEL factors, all of which will aect how attractive it is to trade with a country
or to set up a manufacturing company there:
Political: elections and changes of government, war, European Union expansion, Brexit.
For example, if a country is ruled by a dictator, property rights are likely to be weak and
corruption likely to be high.
Economic: interest rates, tax rates, exchange rates, economic boom or recession.
Countries often go through dierent parts of the trade cycle at dierent times. If a
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country seems to be coming out of recession and heading towards a period of growth,
then that might be a good time to start exporting to there if possible. Similarly,
companies can withdraw from countries which are heading for an economic trough.
Social: nowadays the main social trend arises from changes in populations. In most
western countries the birth rate has fallen and there is an increasing proportion of
elderly people. This can aect recruitment but it can also aect the economies of
companies that they have to support a larger number of retirees. It can of course aect
the marketing of products. Products suited to older people may become more popular
while those suited to younger people may become less popular. However, taste and
culture are also important influences. For example, there is little point in trying to export
pork products to Muslim countries!
Technological: technological changes often come out of the blue, but once they are
invented there is really no turning back. Think how the internet has profoundly aected
the fortunes of organisations like travel agents. Think how banks have responded by
closing branches and encouraging their clients to do more and more banking online.
Some products would require a certain level of technical sophistication in user countries
and Amazon has made great use of the Internet to expand internationally.
Ecological: carbon emission restrictions/taxes, more stringent laws governing air and
water solution, concern about the possible eects of global warming. Unfortunately,
some companies are suspected of locating their manufacturing facilities in countries
which have less stringent ecological rules. It is also worth noting that Facebook is
currently building a server farm (a very large number of computer storage devices) in
Lule, Sweden. The sub-artic climate there allows Facebook to save large amounts of
money by using the naturally cold air into the building to cool overheating servers
rather than having to use energy on air-conditioning systems.
Legal: health and safety legislation, equality legislation, regulation of industries, quotas,
taris, bureaucracy.

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Tests
Question 1
What is meant by the term o-shoring?

Question 2
What does the following describe?
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The process by which the countries and businesses throughout the world are becoming
increasingly interconnected because of increased trade.

Question 4
What does the S in PESTEL stand for?

Question 4
What does the following describe?
A global international organisation dealing with the rules of trade between nations.

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CHAPTER 4
ORGANISATIONS

1 Introduction to organisations
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An organisation can be defined as:


A social arrangement which pursues collective goals, which controls its own performance,
and which has a boundary separating it from its environment.
This is, perhaps, a deceptively simple definition. Probably the most important word is social.
Organisations consist of people and we are all social animals. We have to get on with our
colleagues; ideally we would like our boss, or at least respect our boss. We have to get on with
customers; we have our own ambitions; we have our own motivations.
Early management theory tended to neglect the social side of organisations and
management and had a rather cold, militaristic approach, issuing orders and expecting them
to be obeyed without question. Modern theories have changed this considerably.
Another important aspect of the definition is that of collective goals. There has to be an
assumption that people within an organisation are ultimately aiming at the same end results,
if they are not, then chaos is likely to rule. Profit seeking organisation have profit as their goal,
but state hospitals will have a goal of curing patients. One of the functions of management is
to arrange the business and the people in it so that everyone is pulling in the same direction,
and the collective goals are ultimately established.
Through sharing skills and pooling resources organisations can accomplish tasks that single
entrepreneurs could not.

2 Types of organisations
You need to be aware of the characteristics of several types of organisation.
Commercial organisations are profit-seeking. They can be sole traders, partnerships,
limited liability partnerships and limited companies. The main advantage of limited
liability partnerships and limited companies is that if the organisation hits hard times
and has to go to liquidation, the owners of the organisation are protected. Creditors and
banks can pursue only the assets which are in the company. Sole traders and partners,
on the other hand, have unlimited liability for all the businesss debts.
Not-for profit organisations do no seek to make profits. An example of a not-for-profit
organisation could be a charity, such as a charitable hospital where objectives such as
curing patients is their aim. Instead of producing a profit and loss account, they tend to
produce income and expenditure accounts. Ultimately their income has to exceed their
expenditure or they will run out of money.
Public sector organisations are owned by the state either at a national level or at a
local level. Examples could be the defence department, many health services and
educational systems. In some economies other industries or businesses are also owned
by the state. For example, many national airlines are state-owned. Public sector
organisations can therefore be either profit-seeking or not-for profit organisations.

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Non-governmental organisations tend to be not-for-profit organisations but with an


international brief. They are not part of governments though can receive government
funding. Many United Nations organisations will fall into this category. Other examples
include groups such as those which advocate "save the whales" or organisations such as
Oxfam. There is a considerable overlap between the terms NGO and Charity. In the UK
charity is reserved for organisations which have registered as charities and which then
enjoy substantial tax advantages.
Co-operatives are owned by the people who work in the organisation. Some farmers,
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for example, set up co-operatives to market their products more eectively than they
could on their own. Usually they seek some sort of profit, but the ownership is shared
widely amongst the people who are working in the organisation.

3 Shareholders and companies


Limited liability companies are probably the predominant type of profit-seeking organisation.
Companies are owned by their shareholders who contribute capital and receive a share of the
company profits by being paid dividends by the company. Limited liability means that if the
company goes becomes bankrupt, shareholders liability is limited to losing their shares: their
private wealth is protected. Note that the companys liability for its debts is unlimited.
Once a company grows, it is normal for the day-to-day management of the company to be
carried on by directors and management who are can be quite separate from the
shareholders. Large companies have thousands of shareholders and there is no way a large
group of people like that could possibly run the company.
Directors should run the company for the benefit of shareholders (the shareholders are the
owners, after all). This means running the company with the objective of maximising
shareholder wealth.
Shareholder wealth has two sources:

Dividends paid to them out of profits


The value of the shares they own.
Most companies also obtain capital by borrowing from banks and other investors. Interest has
to be paid to suppliers of loan capital.

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Cash earned by a company is therefore used for three purposes:


The payment of dividends to shareholders. As companies activities become riskier,
shareholders will want higher dividends to compensate for the risk.
Loan interest
The residual cash can be used to invest in company assets. These should produce more
profits which in turn should lead to higher share prices.
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The amounts of dividend and interest that has to be paid to suppliers of capital compared to
the amount of capital raised is known as the cost of capital.

It can be thought of as being similar to an interest rate: capital is deposited at a bank and a
return is earned. If the company is to increase in value any return it earns must exceed the
cost of capital so that the company has a surplus left for investment. If the returns earned are
below the cost of capital the company will not be able to pay the interest and dividends that
the suppliers of capital require and the company will lose value.

In general, the riskier a companys activities the higher the cost of capital required by
suppliers of capital.

4 Measurement of company performance


Two important measures of company performance are used by shareholders are:
Return on capital employed
Return on equity
Earnings per share

4.1 Return on capital employed


The return on capital employed is defined as:
Operating profit before tax and interest
x 100
Capital employed
Usually, the closing capital employed figure is used. If the average of the opening and closing
capital employed is used, the ratio is known the return on average capital employed.
Capital employed = Share capital + retained profits (reserves) + long term loans.
Statement of profit and loss $000
Revenue 20,000
Cost of sales (14,000)
Gross profit 6,000
Operating expenses (2,000)
Operating profit 4,000
Interest (1,000)
3,000
Tax (900)
Profit after tax 2,100

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Statement of financial position $000


Non-current assets 20,000
Current assets 3,000
23,000

Share capital 1 shares 5,000


Retained profits 12,000
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Total equity 17,000


Long-term/non-current
4,500
liabilities
Current liabilities 1,500
23,000
In the example above,
Operating profit before tax and interest 4,000
ROCE = x 100 = x 100
Capital employed 17,000 + 4,500
= 18.6%

The higher the ROCE the better the company is at using its capital to generate profits.

4.2 Return on equity


The return on equity is defined as:
Operating profit after interest and before tax
x 100
Shareholders equity

Usually the closing equity figure is used. This measure focuses more on how the company
performance aects shareholders.
In the example above ROE =
3,000
x 100 = 17.6%
17,000

4.3 Earnings per share


EPS is defined as:
Profits after interest, tax and preference shares
Number of equity shares
(Preference shares are a relatively rare type of share which give fixed dividends. Equity
shareholders are regarded as the true owners of companies and it is they who benefit most
from better earnings.)
So, if a company manages to earn more earnings without having to issue more share, this is
good for the equity shareholders. If a company issues shares and the money raised does not
begin to make decent profits, the EPS will fall.

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4.4 Short-run, long-run performance


Directors of companies, particularly of companies listed on the stock exchange, are under
immense scrutiny and pressure to continually improve companies results. Disappointing
results often lead to a drop in share price.
To avoid a fall in current profits the directors could cut back on expenditure such research
and development, training, redecorating and so on. That would cause current years profit to
increase but would, of course, cause diculties and profit falls in future years when no new
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products would have been developed (you need research and development to do that), good
sta leave because they are not receiving the training they want and need, and the premises
look shabby and unappealing to customers.
This is an example of what can be called the short term-long term conflict: short term results
are improved at the expense of long term results. It is a particular problem for listed
companies where directors might be in oce temporarily and want good current
performance to allow them to move to a better job. It is less of a problem in private and
family companies where emphasis is more likely to be for the long-term benefit of the
company and for future generations.
To avoid undue pressure from short term influences, longer term measures of performance
are needed. One of the most commonly used is to try to estimate all future cash inflows that
the company will receive and to base share values on that. So, although research and
development might hurt this years results, the promise of a successful new product and the
additional cash flows that will arise from that will increase the value of the company, its
shares and its shareholders.
Of course, receiving an inflow of cash in 10 years time is not as valuable as receiving it now
and the technique of discounting is used to reduce the important co future inflows to their
present value equivalents. The share price is supported by the present value of future inflows
to the company.

5 Stakeholders
The term stakeholder refers to any person or institution in any way aected by organisation.
Stakeholders can be broken down into three groups though this is not particularly helpful:
Internal stakeholders are those who are definitely inside the organisation. Examples
are employees, directors and the managers.
Connected stakeholders are outside the organisation but connected by way of a
contract of some sort. Good examples here will be suppliers, customers, and lenders.
Shareholders are usually regarded as connected stakeholders.
External stakeholders are entirely outside the organisation with no contractual
relationship. The best example for this is will be the people living nearby a factory. They
are obviously aected, but have very limited contractual rights over what the factory
does. The government is also an external stakeholder.
Why is the study of stakeholders important? Really the reason is that usually what
stakeholders want will be in conflict. Shareholders want higher profits but employees want
higher wages; customers want better quality at lower prices, shareholders want better profit;
customers may want the operation to run 24 hours a day, 7 days a week but employees might
want to only work 5 days a week, 8 hours a day. If your organisation was an airport the local
populace would want you to run fewer flights (and certainly not after about 11 oclock at
night), whereas your customers and your shareholders may want you to run services more
frequently.

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There is no easy way of resolving these conflicts. Basically it comes down to management
trying to get stakeholders to compromise. They have to try and keep most people happy
most of the time, bearing in mind, however, that some stakeholders may be able to stop co-
operating altogether. For example when employees want better wages, they could go on
strike and ultimately this can aect the profits which are enjoyed by the shareholders.
Management has to be aware that there are conflicts and try its best to manage these.
About the only tool or model available for the analysis of stakeholders is Mendelows matrix.
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Level of interest
Low High
Low

Minimal eort Keep informed

Power

Keep satisfied Key player

High

It sets out on one axis the power that a stakeholder can wield. And along the other axis their
interest, by which we mean how likely is it that the stakeholder will take action.
Stakeholders who have high power and high interest are known as key players. Management
really needs to keep those people happy. They have the power and they have the willingness
to do something about it if they are upset.
Some stakeholders have high power but they are not likely to take action even if
management does something which they dislike. They may be unwilling to take action
because of professional or ethical reasons. For example, medical sta in hospitals are very
unlikely to take industrial action. Management doesnt have to be quite so careful with these
people. However they have to be kept satisfied, otherwise they could be provoked to take
action and turn into key players.
People with low power but high interest have to be kept informed. They cant do much about
it themselves but they might be able to influence key players to take action on their behalf.
Finally we have people with low power and low interest. Management can nearly ignore
these people. After all, what are they going to do if they dont like whats happening?

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6 The principal-agent problem


In Section 3 above, we described how shareholders own companies but directors run them
on a day-to-day basis on behalf of the shareholders.
Shareholders are known as the principals.
Directors are known as the agents.
It is the duty of agents to act in the best interest of their principals.
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Shareholders and directors are two types of stakeholder and what they want can be in
conflict. For example:
Shareholders want larger profits but directors want larger fees, flashy cars and first class
travel.
Shareholders want a certain level of risk but the directors might want to take an
unjustifiable gamble on the companys future because if it comes o their reputation
will be enhanced.
The conflict is known as the principle-agent problem and it has been very serious in some
companies.
Corporate governance can be defined as The way in which companies are directed and
controlled and this should be in ways that ensure that shareholder requirements are
paramount. After a number of high profile financial scandals, many countries brought in
corporate governance rules. In the UK these rules are known as the UK Corporate Governance
Code and all listed companies are expected to comply with it otherwise their listing on the
Stock Exchange will be jeopardised if they cant justify why they have departed from the
code.

The main provisions are:


The chief executive ocer and the chairman have to be separate people. This splits
power at the top and should prevent a bullying CEO imposing his or her views on the
board.
There should be a balance of executive and non-executive directors (about 50/50).
Non-executive directors play no role in day to day company management, but attend
board meeting and can vote. Their purpose is to warn and advise the executive
directors.
A remuneration committee composed of non-executive directors decided on
executive directors remuneration.
A nomination committee (principally non-executive directors) recommends new or
replacement directors.
An audit committee (non-executive directors) liaises with both internal and external
directors.
Directors are responsible for the long-term strategy of the company
Directors are responsible for designing and implementing a good system of internal
control.

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Tests
Question 1
Is the following statement true or false?
Limited liability means that the companys liability for its debts is limited

Question 2
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Is the following statement true or false?


Publicly owned/state organisations are not-for-profit organisations

Question 3
What are the two main types of capital that a company can raise?

Question 4
Fill in the blank:
The amounts of dividend and interest that has to be paid to suppliers of capital compared to
the amount of capital raised is known as ______________________

Question 5
Allocate the following stakeholders to the correct categories
Internal External Connected
Employees
Suppliers
Customers
Government
Lenders
Directors
Shareholders

Question 6
Match the terms principals and agents to the gaps in the following sentence:
Shareholders are the_____________, directors are the ________________

Question 7
If a listed company has 6 executive directors, approximately how many non-executive
directors should it have?

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Question 8
What is the return on capital employed for the company shown below?
Statement of profit and loss $000
Revenue 30,000
Cost of sales (18,000)
Gross profit 12,000
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Operating expenses (7,000)


Operating profit 5,000
Interest (2,000)
3,000
Tax (800)
Profit after tax 2,200

Statement of financial position $000


Non-current assets 30,000
Current assets 5,000
35,000

Share capital 1 shares 5,000


Retained profits 21,000
Total equity 26,000
Long-term/non-current liabilities 7,000
Current liabilities 2,000
35,000

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CHAPTER 5
PRICES

1 Introduction price behaviour


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Microeconomics is the branch of economics that deals with the price and cost of
manufacturing of goods, and with the reactions of suppliers and customers to prices.
Its probably self-evident that as the price of a product rises, the quantity demanded is likely
to fall. For example, if airfares rise, fewer people will choose to travel. Similarly, if a market
trader is left at the end of the day with fruit that will soon go o, the price of fruit will be
lowered to try to stimulate demand.
This chapter looks at how prices and sales quantities can depend on one another. It also
examines how prices can aect supply (higher prices will encourage more production) and
will how price mechanisms can ensure that demand equals supply.

2 Demand curves

2.1 The demand curve

P, price

Q, quantity

For most goods, as price increases the quantity demanded will reduce. This diagram shows a
linear decrease; in practice the demand curve is likely to be curved.
Movement along the demand curve depends on the price of goods. As the price, P, increases,
the quantity demanded, Q, decreases. We are moving along the demand curve

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A shift in the demand curve, from the solid to the dotted line below can be caused by:
Consumers income. In general higher incomes will shift the demand curve to the right
so that at a given price, more goods are sold. There are some goods, known as inferior
goods, where the demand curve would move leftwards as income increases because
people change to better goods in preference. For example, you could argue that the
demand for cheap brands of coee will suer as income rises and consumers more
often pick premium brands.
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P, price

Q, quantity

Substitutes and complements. A substitute product is one that can be bought as an


alternative. For example, olive oil and sunflower oil are substitutes for some purposes. If
the price of olive oil increases, the demand to sunflower oil is likely to increase as
consumers switch. Complementary products are often bought together. For example,
cars and petrol. If the price of cars reduces, more are bought, but more petrol will also
be bought even though its price has not changed. Petrols demand curve will shift to
the right.
Fashion and taste. A fashionable item will have high demand and consumers may be
prepared to pay a high price. Advertising can increase the quantity of goods demanded
at a given price and the demand line will shift rightwards.
Expectation of future price changes. If consumers think the price will rise, then current
demand is increased as they stock-up on the goods. The curve will shift rightwards.

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3 The elasticity of demand


This determines the slope of the demand curve.
If demand is elastic, then demand for the good is price sensitive and a small change in price
will cause a relatively large change in demand. That is shown by the less steep line below.

P, price
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Relatively inelastic
(a change in price
causes a small
change in demand)

Relatively elastic,
or price sensitive

Q, quantity
If demand is inelastic, then demand for the good is price insensitive and a change in price will
have a relatively small eect on demand.
Elasticity largely depends on whether the goods are essential or luxury. If goods are essentials
(like basic food) then higher prices will not aect demand greatly. If goods are luxuries (or at
least purchase of them is discretionary), then a rise in price can cause a steep fall in demand.
For example, the purchase of foreign holidays is markedly aected by the price of those
holidays.
The price elasticity of demand is defined as:
The proportional (or percentage) change in demand
The proportional (or percentage) change in price
Because an increase in price will normally cause a decrease in demand, technically this
measure is negative, but the negative sign is usually ignored.
Price elasticity of demand >1 means that a relatively small change in price will cause a
relatively large change in demand, so demand is elastic.
This has the consequent that revenue will increase if prices are reduced because the increase
in demand more than compensates for the fall in price.
Price elasticity of demand 0 < 1 means that a relatively small change in price will cause a
relatively small change in demand, so demand is inelastic.
This has the consequent that revenue will decrease if prices are reduced because the increase
in demand will not compensate for the fall in price.
Price elasticity of demand = 1 means that revenue will be constant if the price is changed
slightly.

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4 Calculation of the price elasticity of demand

P, price
12

10
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1000 2000 3000 4000 Q, quantity

In the above diagram, say that at a price of $8, demand is 1,200 and that at a price of 6,
demand is 2,200.
There are two approaches to calculating the elasticity:

Arc elasticity uses the mid-point of the two quantities and prices as the basis point ie

1,700 = (2,200 + 1,200)/2)for quantity and 7 for price.


Proportional change in demand = (2,200 1,200)/1700 = 0.588 or 58.8%
Proportional change in price = (8 6)/7 = 0.286 or 28.6%
Price elasticity of demand = 58.8/28.6 = 2
Point elasticity uses the starting points eg start price at 8 and demand at 1,200
Proportional change in demand = (2,200 1,200)/1200 = 0.833 or 833%
Proportional change in price = (8 6)8 = 0.25% or 25%
Price elasticity of demand = 83.3/25 = 3.3
Note that elasticity of demand change constantly along a demand curve, even if the demand
curve is a straight line.

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For example, in the table below, demand increases by 1,000 units for each $1 decrease in
price:
Price $ Demand Q
12 5,000
11 6,000
10 7,000
9 8,000
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8 9,000
7 10,000
6 11,000
5 12,000
4 13,000
3 14,000
2 15,000
1 16,000

The arc price elastic of demand from $12 to $11 is:


(6,000 5,000) 5,500
= 0.18/0.087 = 2 (very elastic)
(12 11)/11.5
The arc elasticity of demand between $3 and $2 is:
(15,000 14,000)/14,500
= 0.069/0.4 = 0.175 (very inelastic)
(3 2)/2.5
Remember:
If the price elasticity of demand is greater than 1, an increase in price will decrease the
revenue because volume falls o rapidly: the product is very price sensitive
If the price elasticity of demand is less than 1, an increase in price will increase the revenue
because volume is not much aected by price: the product is price insensitive
If the price elasticity of demand is 1, a change in price does not cause any change in revenue
because price and quantities are move in a way that is precisely compensating.

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5 The supply curve


P, price
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Q, output or supply

As you would expect, the higher the price oered to suppliers, the more goods will be
produced. Suppliers increase production and more suppliers enter the market because they
see more profits at higher prices.

5.1 Movement along and shift of the supply curve


The price of goods. As the price, P, increases, the quantity supplied, Q, increases. Here we are
moving along the supply curve.
Movement of the supply curve to the right (from the solid line to the dotted line in the
diagram below) means that more units are supplied at a given price. Alternatively it means
that the same quantity will be produced for a lower selling price.

P, price

Q, output or supply

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A rightwards shift can be caused by:


Lower average costs of production. So, even if selling prices fall, because costs have
fallen is still worthwhile producing the same volume of goods.
Subsidies for raw materials or labour or lower tax and duty on purchases. These
eectively lower the cost of production.
More ecient use of existing factors of production by, perhaps ordering materials more
accurately or rearranging work rotas (again the cost of production falls)
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Improvements in technology, such as the introduction of more ecient processes or


automation

A shift to theleftin whichless will be suppliedat every price could be caused by:
Increase in average cost of production
Taxation of raw materials
A switch in production to more profitable products productive capacity is simply
removed.

5.2 Price elasticity of supply


The price elasticity of supply is defined as:
The proportional (or percentage) change in quantity supplied
The proportional (or percentage) change in price

Price elasticity of supply >1 means that a relatively small change in price will cause a
relatively large change in supply, so supply is elastic.
Supply could be elastic if:
There is spare capacity in producers factories.
If inventory available that can be easily released and sold.
If it is easy to employ more factors of production.
Additional sources of the product are easy to create

Price elasticity of supply 0 < 1 means that a relatively small change in price will cause a
relatively small change in supply, so supply is inelastic.
Supply could be inelastic if:
Suppliers are operating close to full capacity.
There are low levels of stocks so that there are no surplus goods to sell.
Additional sources of supply are dicult to create eg expensive, complex factories are
needed.
If it is dicult to employ factors of production, e.g. if highly skilled labour is needed and
this is in scarce supply
With agricultural products supply is inelastic in the short run because food takes time to
grow. Imports would relieve shortages.

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5.3 The equilibrium of supply and demand


Combining the demand and supply curves produces the following diagram:
P, price

Supply
Demand
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Q Q, quantity

At a price P, the quantity supplied will exactly match the quantity demanded: quantity
supplied and demanded = Q. This is the point in which the market is in equilibrium.
In the diagram below, if the market price were P1 then there would be excess demand:
P, price

Demand
Supply

P1

Qs Qd Q, quantity

Qd would be demanded, but only Qs would be supplied and obviously Qd > Qs. The excess
demand is Qd Qs.
The market is now in disequilibrium and the excess demand will cause rises to rise and, in
turn, cause supply to increase until equilibrium is reached again

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In the diagram below, if the market price were P2 then there would be excess supply:
P, price

Demand
P2
Supply
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Qs Qd Q, quantity

Qs would be supplied but only Qd would be demanded and obviously Qs > Qd. The excess
supply is Qs Qd.
The market is now in disequilibrium and the excess supply will cause rises to fall and, in turn,
cause demand to increase until equilibrium is reached again.

Supply and demand curves can be applied to many markets to explain the equilibrium points
and also movements in prices:

The price of materials


The price of labour
The price of air fares and hotel rooms
The price of money (interest)
The price of currencies (exchange rates)

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Tests
Question 1
Which of lines A or B in the diagram below shows the product with the greater price
elasticity of demand?
P, price
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Q, quantity

Question 2
P, price
P, price

Demand
P2 Supply
Demand
Supply

P1

Qs Qd Q, quantity Qs Qd Q, quantity

With respect to the diagrams above, which TWO of the following statements are
correct?
A At price P2 there is excess demand
B At price P1 there is excess supply
C At price P2 there is excess supply
D At price P1 there is excess demand

Question 3
Is the following statement true or false?
When the price elasticity of demand is greater than one, an increase in price will cause an
increase in revenue

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Question 4
Calculate the arc elasticity of demand for the data below:
Price Quantity sold
15 20,000
20 16,000

Question 5
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Would the following normally shift a demand curve to the left or right?

Shift to right Shift to left


Increased advertising
Lower incomes
An item becoming fashionable
The price of a substitute falling

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CHAPTER 6
MARKET FAILURE AND THE
REGULATIONS OF MARKETS
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1 Introduction to problems with markets


The previous chapter showed how demand and supply are brought into equilibrium by the
operation of prices moving so that demand will become equal to supply and this will lead to
the ecient allocation of resources. However, this requires markets to work well. For example,
prices and output must be capable of moving and there must be a price.
Not all markets will work properly (and then consumers generally suer) and governments
will often intervene.

2 Monopolies
A monopoly occurs when there is only one supplier of a good or service.
An example could be a pharmaceutical company which has a patent on a uniquely eective
drug. Other suppliers cannot start production because they have no patent rights. This allows
the pharmaceutical company to charge very high prices because demand for this very
desirable product will be high. The supplier can make super profits and there will be
permanent excess demand.
In a properly functioning market, more producers could have entered to increase supply and
to reduce prices. More patients could benefit from the drug at lower prices and this is a much
more desirable allocation of resources.

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Monopolies or monopolistic behaviour can arise as follows:


A true monopoly as described above: only one supplier. Monopolies can be created by
taking over rivals so that only one supplier remains.
A natural monopoly, a form of true monopoly but it exists because there are extremely
high fixed costs. For example, electricity distribution will be unlikely to have rival
networks.
Restrictive trade practices. For example:
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Cartels: where several suppliers collude to keep prices artificially high.


Predatory pricing: where a rich supplier drops the selling price to drive others
from the market.
Tied selling: where goods have to be bought from one supplier.

Market allocation (agreements not to compete in some markets).


Governments seek to regulate these types of behaviour and markets. For example, in
the UK, the Competition and Markets Authority is responsible for:
Investigating mergers which could restrict competition.
Conducting market studies and investigations in markets where there may be
competition and consumer problems.
Investigating where there may be breaches of UK or EU prohibitions against anti-
competitive agreements and abuses of dominant positions.
Bringing criminal proceedings against individuals who commit the cartel oence.
Enforcing consumer protection legislation to tackle practices and market
conditions that make it dicult for consumers to exercise choice.
Also in the UK, industries such as telecoms, electricity, gas, water are regulated by
government agencies. For example, Ofgem is the Oce of Gas and Electricity Markets and its
principal objective is to protect the interests of existing and future electricity and gas
consumers.

3 Public goods
A public good is a product or service that one individual can consume without reducing its
supply to another individual, and from which no one is excluded.
Examples include public roads, street lighting, defence and law enforcement.
Public goods are:
Non-rivalrous, meaning that one persons consumption does not aect anothers:
consumers are not rivals.
Non-excludable: no consumer can be excluded from consumption even if they have
not contributed to its supply.
Public goods can also be considered to be non-rejectable: even if you dont want a
nuclear deterrent you might have one.
Public goods are not supplied by markets because of the diculty of charging inevitable
consumers who might not actually want the product or service and who will benefit anyhow
even with making a contribution. This is the free-rider problem. Public goods are therefore
provided by the state and are financed by tax revenues. Governments must decide on the
appropriate levels of tax and service.

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4 Externalities
An externality is the cost or benefit that aects a party who did not choose to incur that cost
or benefit.
For example:
People living near airports bear the cost of noise and air pollution.

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Airlines to not bear the full consequences of air pollution.


Car manufacturers do not bear any cost of the road infrastructure.
Society at large benefits from university education as a more skilled workforce should
improve the economy.
Externalities interfere with the ability of market forces to optimise the allocation and use of
resources. For example, lets say that there is a strong correlation between the level of car
ownership in a country and lung disease in the country. Increased lung disease will be both a
personal cost through ill-health and a public cost through the supply of medical care.
If the cost of healthcare problems is not reflected in the costs of manufacturing and running
cars then the cost of cars will be lower than should really be the case and demand will be
higher. Car manufacturers have shifted what should be their costs to costs within the health
sector. The cost of supplying health services is higher than it should be so governments might
decide that they can aord to supply less.
Of course, pricing externalities is dicult but that does not mean that no attempt should be
made in an eort to achieve a fairer and better allocation of costs and benefits. Governments
attempt to correct for negative externalities by:
Taxes and subsidies to correct economic unfairness. For example, tax airports on noise
production and use the money raised to soundproof neighbouring houses.
Regulation. For example, limit decibel levels and restrict flying hours.
Law suits where those negatively aected claim damages from those positively
aected.
Negotiation between the aected parties.
If there are positive externalities, then producers might not be adequately rewarded for the
side-benefits created, and consumers might not properly value what those benefits are.
Take the example of a bee-keeper. The price of honey will determine the supply and demand
of honey. However, bees will be performing the vital task of pollinating the crops of nearby
farmers. That is a positive externality. More bees would mean more pollination and higher
crop yields but the bee-keeper would not benefit and would not be encouraged to have
more bees. Government intervention could help by subsidising the price of honey or by
paying bee-keepers a grant to encourage them to increase their stock.
The term merit goods is applied to a commodity or service, such as education, that is
regarded by society or government as deserving public finance because otherwise they will
be under-consumed. For example, flu vaccinations. If people had to pay for a vaccination then
many would decide not to have one. If they are free then there will be greater uptake and at
some point there will be major positive externalities when a big enough proportion of the
population is vaccinated to achieve herd immunity that should stop an epidemic.

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5 Minimum and maximum prices


From time to time governments experiment with setting minimum and maximum prices for
products and services. Minimum prices help suppliers and maximum prices help consumers.

Minimum prices
Lets say that a government is concerned about the future of the dairy industry and that many
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farmers are stopping milk production. One way to keep farmers in business is to set a
minimum price per litre of milk so that farmers are more or less guaranteed goods profits.
However, a minimum price for producers is also a minimum price for buyers and there is likely
to be excess supply: lots of farmers will produce at the artificially high price, but many
consumers will not want to buy at that high price.
The consequences are therefore:
Over-production
Producers being attracted to a business where there is already surplus supply
Waste of resources. Perhaps the land and farmers could be employed for something
that consumers did want.
Ineciency on production: why be ecient if the selling price is so high and price
competition is non-existent?

Maximum prices
Lets say that a government is concerned about the high price of petrol (opinion polls might
have shown that this of major concern to voters and the government wants to stay popular).
So the government sets a maximum price per litre. Or the government might want to set
maximum prices to try to hold down inflation.
The maximum price will increase demand, but will suppress production because profits for
producers are held down. Furthermore, the development of new sources of energy for cars
will be inhibited because the new technology has to compete with artificially suppressed
prices.
When there are maximum prices, demand will begin to exceed supply and there is no price
mechanism to correct this.
Demand and supply do have to be balances (simply a matter of physical quantities having to
match) and this can only be achieved by:
Rationing
Queuing
Providing vouchers to limit supply to quotas for each person
These approaches then usually give rise to black markets for goods where some people will
be willing to pay very high prices to get their hands on scarce goods. An example is seen with
ticket touts for very popular shows or sports events.

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Tests
Question 1
What is meant by the term predatory pricing?

Question 2
What does the following sentence describe?
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A product or service that one individual can consume without reducing its supply to another
individual, and from which no one is excluded.
A A merit good
B A public good
C An externality
D A market allocation

Question 3
Indicate whether the following eects are likely consequences from minimum or
maximum prices being set
Minimum price set Maximum price set
Rationing
Over-production
Queueing
Wasted resources

Question 4
What does the following sentence describe?
A commodity or service that is regarded by society or government as deserving public
finance because otherwise they will be under-consumed.

Question 5
What does the following sentence describe?
The cost or benefit that aects a party who did not choose to incur that cost or benefit.

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CHAPTER 7
DATA AND INFORMATION

1 Data and information


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The most common definition of information is:


Information = data with meaning
Data is the raw fact and figures. But generally, of itself, data isnt very meaningful. For
example, a list of all outstanding invoices in value order is not very useful to a credit
controller. That data only becomes useful if first of all it is sorted by customer, and then
perhaps sorted and presented by the age of the invoice. Then it has become meaningful as
the user can interpret it and do something with it.
Presenting data in the form of graphs and charts will also enhance its usefulness and the
ability of people to interpret it.

2 The characteristics of good information


What are the characteristics of good information - and here the word ACCURATE can be
used as a mnemonic:
Accurate. High quality information should be accurate; that doesnt necessarily mean
accurate to the very last cent. It means accurate enough for the purposes for which it is
going to be used. For example, the board of directors might be perfectly happy with
accounts rounded to nearest thousand or even the nearest million dollars.
Complete. The information should be complete; it should include everything that
needs to be included to make proper decisions.
Cost-beneficial. It should be cost beneficial. There is no point in gaining information at
a huge cost, if the benefits derived from that, whether financial or otherwise, are
minimal. We are not in the business of information for informations sake. We should
require information either to make more profit or to run an organisation more
eciently.
User-targeted. The information should be presented in a way that is useful to the user.
For example, senior managers may want summaries; account ssta needs much more
detailed information.
Relevant. It should be relevant. You shouldnt supply people with more information
than they need, or information that they can do nothing with otherwise they may be
confused or overlook the important information.
Authoritative. It should be authoritative. The source of the information should be one
which can be relied upon. Those of you who have used the Internet should be well
aware of this. You put a term into a search engine, all sorts of material comes out. Some
of it is from authoritative sources, other information is from amateurs, yet other is from
charlatans.

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Timely. It should be timely. Information should be supplied quickly enough to help you
make a better decision. Some information has to be provided very quickly - within
seconds, or even fractions of a second in some industrial processes. For other purposes
you might easily be able to wait for a week or even two weeks before the information is
required to enable you to make a decision on time. usually faster information means
more expensive information.
Easy to use. It should be well-presented and well-documented. Easy to use might mean
that its more beneficial to see information in the form of graphs than in the form of
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tables.

3 Graphs and charts


Displaying data and information on graphs and charts can have the following advantages:
The data is turned into information because graphs and charts often convey meaning
better. You can see lines and bars and immediately comprehend how the data are
changing
The information makes more of an impact and thus becomes more memorable. A graph
of profit dipping into a loss can have more impact than a string of positive figures
becoming negative.
Relationships can be uncovered. For example, if a chart shows revenue and costs and
the lines are converging, it is clear that costs are running too high and are catching up
with revenue.

3.1 Bar charts and column charts


The graph below is a column chart:

It is fairly obvious that the gap between sales and cost of sales is growing over the four years.
Even though sales have increased substantially, the rise in costs is much less.

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The chart below is a bar chart of the same data:


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Once again the improvement in gross profit is obvious.

Line chart
Eectively this shows the same information but joins up the gaps to product continuous
lines. The divergence is obvious.

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Scattergraph
Although a scattergraph can be used to plot a value against time, it is more often used to
show how two non-time variables relate to each other, such as sales/advertising, cost/
production volume or home fuel consumption/weather temperature.
2016
Average KWH electricity
Month
temperature consumed
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January 6 12,000
February 8 11,000
March 11 10,000
April 14 8,000
May 18 6,000
June 22 4,000
July 25 3,000
August 29 1,000
September 26 2,500
October 20 5,000
November 15 9,000
December 10 9,500

14,000

12,000
KWH electricity consumed

10,000

8,000

6,000

4,000

2,000

0
Average temperature

In the table above, the data was presented in date order, but the graph shows how electricity
consumption falls as temperatures rise.
A trend line has been drawn through the points to emphasise the relationship.

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Pie chart

S America
14% Europe
Sales
28%
Europe 1,200
Asia 1,300 N America
N America 1,250 29%
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S America 600 Asia


30%

A pie chart is good for showing the proportions of the elements that make up a population.
Here you can instantly see that South America is the smallest market segment.

3.2 Frequency distributions


A frequency distribution show how many times (frequency) a given quantity, or group of
quantities occurs in a set of data.
For example:
If there are 100 apartments in a block and a frequency distribution could describe the
number of people living in each apartment:
Number of
Frequency
inhabitants
14 1
22 2
30 3
25 4
8 5
1 6
Total 100

This is known as a discrete frequency distribution because the number of inhabitants can only
be certain numbers: 0, 1, 2, 3. You cant have 3.54 inhabitants.

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Continuous frequency distributions allow any values and there, values have to be lumped
together to be of any use. In the apartment block there are 294 inhabitants (= 14 x 1 + 22 x 2
+ 30 x 3 + 25 x 4 + 8 x 5 + 6 x 1). If we looked at the heights of these inhabitants we could
have something like this:
Frequency Height range
10 0.8 - <1.0m
22 1.0 - < 1.2m
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45 1.2- < 1.4m


69 1.4 - < 1.6m
73 1.6 - <1.8m
67 1.8 - <2.0m
8 2.0 - <2.2m
Total 294

Frequency distributions are commonly shown on two types of chart:


Histograms (frequency density charts)
Ogives (less then charts)

Histograms
A histogram looks very like a column chart, but there are no gaps between the columns. A
histogram of the above data would look like:

There is only one complication that you need to be aware of: the area of the columns
represents the frequencies, not the height. If each range of data in the distribution is the same
(above the height range ia always 0.2m), then the heights are proportional to the frequency.
However, if the data has been like this, where the 1.6 - <=2 is 4cm, not the normal 2, the
height of that bar has to be halved but its width doubled.

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Frequency Height range


10 0.8 - <1.0m
22 1.0 - < 1.2m
45 1.2- < 1.4m
69 1.4 - < 1.6m
140 1.6 - <2.0m
8 2.0 - <2.2m
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Total 294

Ogives
Ogives, or less-than curves, plot cumulative frequencies.
Using the original height table, an extra column with cumulative numbers and also change
the range to the upper end of each interval:

Cumulative Upper end of


Frequency Height range
frequency range
10 10 1.0 0.8 - <1.0m
22 32 1.2 1.0 - < 1.2m
45 77 1.4 1.2- < 1.4m
69 146 1.6 1.4 - < 1.6m
73 219 1.8 1.6 - <1.8m
67 286 2.0 1.8 - <2.0m
8 294 2.2 2.0 - <2.2m

So, this table shows, for example, that 146 people are less than 1.6m tall.

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Plotting the cumulative frequency (y axis) against the heights give a chart like:
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These usually have this characteristic swan neck shape.


Ogives can be used to find the median height (where 50% are taller and 50% shorter) and
quartiles (25%/70% and 75%/25% splits).

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Tests
Question 1
Which of the following should be more meaningful to users?
A Data
B Information
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Question 2
Good information can be described by the mnemonic ACCURATE. What do the letters
stand for?

Question 3
Name two charts used to display frequency distributions.

Question 4
Say whether the following are discrete of continuous data
Discrete Continuous
Number of children under 10 in each family
Weight of individuals in a population
Distance between cities
Family income rounded to the nearest $000

Question 5
Draw the following data on a cumulative frequency curve:
Family income Frequency
0 - <2,000 5
2000 - <3,000 20
3000 - <5,000 500
5000 - <10,000 100
10,000 - <20,0000 4

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CHAPTER 8
BIG DATA AND DATA ANALYSIS

1 Big data
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The term big data refers to extremely large collection of data that may be analysed by
computer to reveal patterns, trends, and associations, especially relating to human behaviour
and interactions.
Note that two processes are implied:
The collection of the data and its storage
The analysis of the data to provide useful information

2 The characteristics of big data


In 2001 Doug Laney, an analyst with Gartner (a large US IT consultancy company) stated that
big data has the following characteristics, known as the 3Vs:
Volume: a very large amount of data. More than can be easily handled by a single
computer, spreadsheet or conventional database system. The commonest fourth V
that is sometimes added is veracity: Is the data true? Can its accuracy be relied upon?
Variety: a disparate non-uniform data of dierent sizes, sources, shape, arriving
irregularly, some from internal sources and some from external sources, some
structured, but much of it is unstructured.
Velocity: data arrives continually and often has to be processed very quickly to yield
useful results
Some texts add a fourth V, veracity: the data should be true.

2.1 Volume
The volume of big data held by large companies such as Walmart (supermarkets), Apple and
EBay is measured in multiple petabytes. Whats a petabyte? Its 1015 bytes (characters) of
information. A typical disc on a personal computer (PC) holds 109 bytes (a gigabyte), so the
big data depositories of these companies hold at least the data that could typically be held on
1 million PCs, perhaps even 10 to 20 million PCs. These numbers probably mean little even
when converted into equivalent PCs. It is more instructive to list some of the types of data
that large companies will typically store:
Retailers. Via loyalty cards being swiped at checkouts: details of all purchases you
make, when, where, how you pay, use of coupons. Via websites: every product you have
every looked at, every page you have visited, every product you have ever bought. (To
paraphrase a Sting song Every click you make Ill be watching you.)
Social media (such as Facebook and Twitter). Friends and contacts, postings made,
your location when postings are made, photographs (that can be scanned for
identification), any other data you might choose to reveal to the universe.

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Mobile phone companies: Numbers you ring, texts you send (which can be
automatically scanned for key words), every location your phone has ever been whilst
switched on (to an accuracy of a few metres), your browsing habits. Voice mails. Internet
providers and browser providers. Every site and every page you visit. Information about
all downloads and all emails (again these are routinely scanned to provide insights into
your interests). Search terms you enter.
Banking systems. Every receipt, payment, credit card payment information (amount,
date, retailer, location), location of ATM machines used.
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2.2 Variety
Some of the variety of information can be seen from the examples listed above. In particular,
the following types of information are held:
Browsing activities: sites, pages visited, membership of sites, downloads, searches
Financial transactions
Interests
Buying habits
Reaction to ads on the internet or to advertising emails
Geographical information
Information about social and business contacts
Text
Numerical information
Graphical information (such as photographs)
Oral information (such as voice mails)
Technical information, such as jet engine vibration and temperature analysis
This data can be both structured and unstructured:
Structured data: this data is stored within defined fields (numerical, text, date
etc) often with defined lengths, within a defined record, in a file of similar records.
Structured data requires a model of the types and format of business data that will
be recorded and how the data will be stored, processed and accessed. This is
called a data model. Designing the model defines and limits the data that can be
collected and stored, and the processing that can be performed on it.
An example of structured data is found in banking systems, which record the
receipts and payments from your current account: date, amount, receipt/
payment, short explanations such as payee or source of the money.
Structured data is easily accessible by well-established database structured query
languages.
Unstructured data: refers to information that does not have a pre-defined data-
model. It comes in all shapes and sizes and this variety and irregularities make it
dicult to store it in a way that will allow it to be analysed, searched or otherwise
used. An often quoted statistic is that 80% of business data is unstructured,
residing it in word processor documents, spreadsheets, PowerPoint files, audio,
video, social media interactions and map data.

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2.3 Velocity
Information must be provided quickly enough to be of use in decision making. For example,
in the above store scenario, there would be little use in obtaining the price-comparison
information and texting customers once they had left the store. If facial recognition is going
to be used by shops and hotels, it has to be more-or less instant so that guests can be
welcomed by name.
You will understand that the volume and variety conspire against the third, velocity. Methods
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have to be found to process huge quantities of non-uniform, awkward data in real-time.

3 Processing big data


The processing of big data is generally known as big data analytics and includes:
Data mining: analysing data to identify patterns and establish relationships such as
associations (where several events are connected), sequences (where one event leads to
another) and correlations.
Predictive analytics: a type of data mining which aims to predict future events. For
example, the chance of someone being persuaded to upgrade a fight.
Text analytics: scanning text such as emails and word processing documents to extract
useful information. It could simply be looking for key-words that indicate an interest in a
product or place.
Voice analytics: as above with audio.
Statistical analytics: used to identify trends, correlations and changes in behaviour.
Google provides web-site owners with Google Analytics that will track many features of
website trac.

The analytical findings can lead to:

Better marketing
Better customer service and relationship management
Increased customer loyalty
Increased competitive strength
Increased operational eciency
The discovery of new sources of revenue.

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4 The relationship between data variables


In a longitudinal study measurements are taken of the same variable at dierent points in
time. For examples, sales each month or profit over a number of years.
In a cross-sectional study data from a number of members of a population is examined at a
single point in time. For example, the gross profit percentage achieved by 12 branches of a
company in 2018.
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Other sorts of study measure two variables and try to see how one variable moves with the
other (eg cost and production volume, or advertising expenditure and sales).
For simple patterns, linear regression and the coecient of correlation are used to provide
information about how two variables are related. More complex patterns, particularly
longitudinal studies, such as sales over time are likely to require investigation using time
series analysis.

5 Linear regression
Linear regression is a method of fitting the best straight line through a set of points.
In business, typically the line would connect points showing:
Cost and volume
Selling price and sales volume
Hours worked and units produced
Linear regression will give constants which fit a line of the type:
y = ax + b
where:
y is the dependent variable (cost, hours, volume sold)
x is the independent variable (units made, selling price).
The constant a, for example, could be the additional cost for each additional unit made; b
would be the cost even if no units were made (the fixed cost).
Be warned: linear regression will give the best straight line it can through any set of points.
For example, if you numbered the days in the year 1 365 and you noted the day each person
was born and the amount of money they had in their bank account, linear regression would
suggest the best relationship it could between these variables. Obviously there would not
actually be a good relationship.
To test the relationship you must calculate the coecient of correlation (r), or the coecient
of determination (r2). r can vary between:
r = +1, meaning perfect positive correlation where all points lie on the line and as one
variable increases, so does the other.
r = -1, meaning perfect negative correlation where all points lie on the line and as one
variable increases, the other decreases.
r = 0 means no correlation.
If r = 0.7, the coecient of determination, r2 = 0.49 or about 50%. This means that 50%
of the change in one variable is explained by the change in the other.

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You should be aware of the following before you rely on any prediction based on linear
regression:
If r2 is low, then one variable is not well-associated with the other, so any predictions are
liable to be poor.
The more points (readings) the better: simply more evidence for the association.
Extrapolation (predicting outside the range examined) is dangerous as we have no
direct evidence of what happens in other regions. For example, costs might suddenly
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increase.
Other known influences (such as inflation) should be removed before the analysis.
Even good correlation does no prove cause and eect: both variables might have
moved together under the influence of another variable.

6 Example of linear regression


If there is a reasonable degree of linear correlation between two variables, we can use
regression analysis to calculate the equation of the best fit for the data. This is known as least
squares linear regression.
If the equation relating two variables, and y, is y = a + bx
then the values of a and b may be calculated using the following formulae:

n xy x y
b=
n x 2 ( x )
2

a=
y b x
n n
[Note that the symbol means the sum of]

Example 1
The following table shows the number of units produced each month and the total cost incurred:

Units $000
January 100 40
February 400 65
March 200 45
April 700 80
May 600 70
June 500 70
July 300 50
Calculate the regression line, y = a + bx

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7 The correlation coefficient


Pearsons correlation coecient is a measure of how linear the relationship between
variables is.
As mentioned above correlation coecient of +1 indicates perfect positive linear correlation,
whereas -1 indicates perfect negative linear correlation. The further away from + or 1, the
less linear correlation exists.
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The correlation coecient may be calculated using the following formula (which is given to
you in the examination)

n xy x y
r=
n x 2
( x ) n y 2 ( y )
2 2

Example 2
Using the data in the previous example calculate the correlation coecient

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8 Spearmans rank correlation coefficient


The coecient of correlation calculated above is known as Spearmans correlation coecient.
Another measure of correlation (ie how well the two variables line up) is Spearmans rank
correlation coecient. It is not much used in cases as shown above where actual values are
known, such as output and costs. It is used when two variables are ranked ie placed in order.
Spearmans rank correlation coecient is calculated as:
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6d 2
r = 1
n ( n 1)
2

where n is the number of pairs of data and d is the dierence between the rankings in each
set of data.
r will be between -1 and +1 and it is interpreted in the same way as for Spearmans
coecient.

Example 3
The positions of seven students in their examinations in accountancy and law are as follows
Student Accountancy position Economics position
A 1 3
B 4 7
C 2 1
D 5 6
E 3 2
F 7 4
G 6 5

Judge whether the position of the students in Statistics correlates with their position in
Economics.

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9 Time series analysis


Linear regression expects that the relationship between two variables will be strictly linear
explained a straight line. Time series analysis is more adaptable and recognises that the
following eects could be present:
1 A trend: this is an underlying smooth increase or decrease of an amount as time passes.
2 Seasonal variations: cycles of variation repeating in less than a year. Could be spring,
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summer, autumn and winter, or sales for each day of the week.
3 Cyclical variations: cycles of variation repeating in more than a year. Typically, the long-
term trade cycle is given as an example.
4 Random eects: non-repetitive and non-predictable variations.
Time series analysis investigates the first two of these.
Time series analysis graph
The figure below shows a rising trend with regular seasonal variations.

High seasons

Sales

Trend

Time

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6 Analysis of time series


6.1. Method 1 moving averages
Look at this data:
Year Qtr Time series Sales $000
2012 1 1 989.0
2 2 990.0
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3 3 994.0
4 4 1015.0
2013 1 5 1030.0
2 6 1042.5
3 7 1036.0
4 8 1056.5
2014 1 9 1071.0
2 10 1083.5
3 11 1079.5
4 12 1099.5
2015 1 13 1115.5
2 14 1127.5
3 15 1123.5
4 16 1135.0
2016 1 17 1140.0

You can see from the graph that there is some sort of trend (the line increases overall) and
there are seasonal variations with a dip occurring at times 7, 11, 15, corresponding to the 3rd
quarter each year. Quarter 2 tends to look high each year. So, if we are going to try to forecast
what sales will be in the third quarter of 2010, we would first try to project the trend then
superimpose the seasonal eect on that to decrease it appropriately.
Performing a time series analysis is rather tedious and it is likely that in any exam question,
much of the work will have been done for you and you have to interpret and apply the
results. However, for the purposes of explanation, we will carry out the full process on this
data.

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Year Qtr Time Raw 4-part Centred Seasonal Seasonal


series data moving moving variation variation
average average (additive) (multiplicative)

2012 1 1 989.0
-8.1 = 994 1002.1
2 2 990.0 0.9919 = 994/1002.1
997.0
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3 3 994.0 1002.1 -8.1 0.9919


1007.3
4 4 1015.0 1013.8 1.2 1.0012
1020.4
2013 1 5 1030.0 1025.6 4.4 1.0043
1030.9
2 6 1042.5 1036.1 6.4 1.0062
1041.3
3 7 1036.0 1046.4 -10.4 0.9901
1051.5
4 8 1056.5 1056.6 -0.1 0.9999
1061.8
2014 1 9 1071.0 1067.2 3.8 1.0036
1072.6
2 10 1083.5 1078.0 5.5 1.0051
1083.4
3 11 1079.5 1088.9 -9.4 0.9913
1094.5
4 12 1099.5 1100.0 -0.5 0.9995
1105.5
2015 1 13 1115.5 1111.0 4.5 1.0041
1116.5
2 14 1127.5 1120.9 6.6 1.0059
1125.4
3 15 1123.5
1131.5
4 16 1135.0

2016 1 17 1140.0

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The first four columns are as before.


The next column is called 4-part moving average. It is 4-part because we believe the data
repeats over four seasons. If we though it repeated over, say, five days in the week, we would
create the 5-part moving average.
The moving average is the average of the four components in the cycle. So here:
997 = (989 + 990 + 994 + 1015)/4
Then, moving down one season:
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1007.3 = (990 + 994 + 1015 + 1030)/4


Progressing down the data, the four-part moving average contains one element from each
season. This is really where isolating the trend happens because the high season and low
season components tend to cancel out.
The trouble with four-season moving averages (or any even periodicity) is that the moving
average is not really opposite any season. To get a figure which is centred on a season,
adjacent moving averages are themselves summed. This is not necessary if we start with, say,
5 seasons in the repetitive cycle).
Therefore:
1002.1 = (997.0 + 1007.3)/2
1013.8 = (1007.3 + 1020.4)/2
This data represents the trend line and if plotted on a graph would look like:

This example yields a very smooth trend; you would not always expect such a linear result.
The trend figure has gone from 1002.1 to 1120.9 in 11 seasonal increments, so the increase
per season is (1120.9 1002.1)/11 = 1.7.
The seasonal variations are obtained by comparing the raw data for each season to the
trends. The comparisons can either be done by subtraction (the additive model) or by
proportions (the multiplicative model).

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The variations are grouped by season and averaged out:


Additive: Multiplicative:
1 2 3 4

-8.1 1.2
4.4 6.4 -10.4 -0.1
3.8 5.5 -9.4 -0.5
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4.5 6.6
Average 4.2 6.2 -9.3 0.2

The analysis has now been completed, and the results can be used to make forecasts. Lets
say we want to forecast season 3 for 2016. The approach is:
1 Project the trend
2 Adjust for the seasonal variation appropriate for that season.
The last trend figure we have is for season 2 of 2015 and that was 1120.9. Season 3 of 2016 is
five seasons further on, so the predicted trend figure would be:
1120.9 + 5 x 1.7 = 1129.4
Season 3 has an adjustment amount of -9.3 or 0.9957. Applying these adjustments to the
trend would result in predictions of:
Additive: 1129.4 9.3 = 1120.1
Multiplicative: 1129.4 x 0.9911 = 1119.4
This method of predicting future amounts is more sophisticated than linear regression, but
neither, of course, guarantees an accurate answer. However, they are at least using historical
evidence on which to base forecasts and this must surely be better than pure guesswork.

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Tests
Question 1
What are the 4Vs of big data?

Question 2
A sales director has carried out a linear regression exercise to examine the connection
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between sales revenue and advertising. The coecient of correlation is 0.96.


Does this show that more advertising causes sales increases?

Question 3
A comparison of the ratings of two guests who each visited four hotels show the
following rankings:
Guest 1 Guest 2
ranking ranking
Hotel 1 2 3
Hotel 2 4 5
Hotel 3 3 1
Hotel 4 1 2

What is the Spearmans Rank Coecient:


6d 2
r = 1
n ( n 1)
2

Question 4
The seasonal variations for the sales of a product are:
Season 1: -$20,000
Season 2: $4,000
Season 3: $25,000
Season 4: - $9,000
The trend has been calculated as $2,000 per season and the trend figure for season 3 of 2017
is $73,000
What is the forecast figure, including the seasonal adjustment for Season 4 of 2018?

Question 5
Which of the following elements of a time series are analysed sing the moving averages
technique?
A Cyclical variations
B Seasonal variations
C The trend
D Random variations

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CHAPTER 9
FINANCIAL MARKETS AND
INSTITUTIONS
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1 Introduction
Financial markets and institutions primarily deal with money, investments and risk
(insurance). They are an essential part of any modern economy despite the excesses that led
to the 2008 financial crash.

2 Financial intermediaries
2.1 The purpose of money
Money has a number of important functions:
It is a means of exchange. If there were no money then all transactions would be by
bartering ie the exchange of goods. Money immeasurably frees up the flexibility with
which goods and services can be exchanged.
It is a store of value. The amount of money in your current or deposit account
represents value or wealth that can be spent in the future.
It is a unit of account. The price of an item represents what it is valued at. The amount of
an expense is a measure of the cost of the item or service. Comparisons can be made,
for example, when deciding to heat you home by electricity or gas.
It can act as a deferred payment. Rather than paying for something immediately you
can be given credit and you can pay for the item later. The provision of credit is an
important way of stimulating an economy. If everyone were given a months credit on
all purchases, they could immediately go out and buy another months supply of goods,
which increases suppliers sales and profits.

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2.2 Flows of money and credit


This diagram represents the flows of money and credit in a modern, fully-functioning
economy:

Businesses Individuals
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Financial
intermediaries

Government Overseas

The diagram shows that every sector has dealings with every other. For example:
Businesses and individuals: individuals buy from businesses; businesses employ
individuals and pay wages.
Businesses and government: businesses pay tax and governments sometime sprovide
grants.
Businesses and overseas: imports and exports.
However, these interactions would be more dicult without financial intermediaries. For
example:
A business could pay its employees cash (and this used to be common), but now it is
more convenient and more secure to pay wages and salaries into employees bank
accounts.
Businesses could pay their tax to government by loading cash into a wheelbarrow and
delivering it to the countrys treasury, but a transfer via a bank makes more sense.
When going on holiday we could take our own currency and negotiate with an
individual on a street corner, but changing currency in a bank or withdrawing cash from
and ATN might reduce the chance of being mugged.

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2.3 Banks as financial intermediaries


Banks form the most important category of financial intermediary and they perform the
following functions:
Safe storage: banks store cash in their vaults and can impose strict security. If they
didnt exist, cash would have to be stored locally by its owners in much less secure
circumstances.
Risk reduction: if a bank is lending money it has the technical and legal expertise to
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properly appraise the borrower for credit worthiness and to ensure that loan
documentation is in order. Additionally, each bank will lend to a wide range of
borrowers and any one debt going bad should not put the bank at risk.
Maturity transformation: you might be saving for your holiday and will therefore want
to withdraw your money in a few months. However, companies might want three or five
year loans to finance their expansion. Banks can make use of lots of short-term deposits
to create long-term loans.
Consolidation: lots of small deposits allow several large loans.
Credit creation: by issuing credit cards and organising loans and overdrafts, banks help
to create money by giving people the means to spend more.
Intermediation: borrowers and lenders are matched. This is not on a one-to-one basis
but surplus funds are matched with parties needing to raise loans.
Transfer of money: the clearing system for cheques or internet banking allow funds to
be easily transferred eg between purchaser and supplier.

2.4 Other financial intermediaries


Insurance companies: these have a role in spreading risk and safeguarding wealth.
They can also act as investment vehicles, taking premiums from customers and
investing in shares.
Investment trusts and unit trusts: investors money is used to buy shares and other
investments. They allow investors to spread their risk. For example, a funds might
specialise in European shares and investors cash will be used to buy shares in perhaps
20 major European companies. Alternatively, a fund might specialise in emerging
markets and investments will be in a number of shares from those markets. No
investment or unit trust fund will ever invest in just one share.
Pension funds: allow investors pension contributions so be invested in a wide range of
shares.
Venture capitalists: specialise in placing investors money into young ventures and
start-ups.

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3 Financial markets and financial instruments


3.1 What is a financial instrument?
A financial instrument are assets that can be traded and which permit ecient flows of capital
between investors and those needing capital for their operations. Financial instrument are
contracts that create a financial asset of one entity and a financial liability or equity
instrument of an other entity.
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Examples are:
Equity shares
Preference shares
Debentures and bonds
Convertibles
Loans and overdrafts.
Lease contracts.
Certificates of deposits.
Government bonds.
Bills of exchange.
The instruments dier in their rights and obligations and their term (ie how long they last).

3.2 Equity shares


Investors can subscribe for new equity shares or buy equity shares that have already been
issued. Shareholders are entitled to vote at company meetings and to receive dividends is the
directors declare them.
Shareholders in private companies can find it dicult to sell their shares as there is no market
that determines a share price nor to facilitate finding someone who wants to buy the shares.
However, once a company is listed on a public stock exchange the shares will have a market
price and the stock exchange allows buyers and sellers to be easily matched. Listed shares are
therefore much more liquid than private shares because they can be easily sold and turned
into cash.
Equity shares are long term, usually permanent, sources of finance. The market value equity
shares in successful companies can rise steeply making large gains for investors. If the
company does badly, equity shareholders stand to make losses on their shares or they lose
their investment if the company fails.

3.3 Preference shares


Relatively uncommon. They promise a fixed dividend each year, but their value is static.
Preference shareholders often have no vote at company meetings.
Preference shares are long term sources of finance but might be redeemable (repayable) at
some date in the future.

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3.4 Debentures and bonds


Debentures, or loan certificates, or bonds are the written acknowledgement of a debt. They
are issues by companies to investors and are often secured on company assets to provide
more safety for lenders. They state the fixed rate of interest that will be paid and they can be
irredeemable or redeemable. If the latter, they will state when the debt will be repaid.
They can be quoted on the bond market and this gives investors more liquidity.
Debentures are a relatively safe form of investment because:
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They are usually secured on company assets


The interest is fixed and must be paid before dividends
If the company is wound up, debenture-holders are repaid before shareholders
However, debentures will normally not enjoy much benefit from the growth of the company.

3.4 Convertibles
Convertibles start life as debentures but give investors the option of converting the
debentures to shares. This allows investors to take a wait-and-see approach. Invest in safe
debentures, then convert to shares if the company seems to be doing well.

3.5 Loans and overdrafts


These are usually provided by banks. The loans can be short term (roughly <1 year), medium
(1 5 years) or long term (usually >5 years).
Overdrafts are, strictly speaking, repayable on demand and are therefore not suitable for long
term capital requirements. Instead, they should be used for short term liquidity problems
such as having o buy inventory before a very busy sales period. The subsequent sales will
allow the overdraft o be repaid.

3.6 Lease contracts


Leasing finance is provided by banks and specialist finance companies. Leases eectively
allows assets to be rented rather than purchased outright and they provide a very important
source of liquidity, particularly for machinery.

3.7 Certificates of deposit


A certificate of deposit is the evidence that a deposit has been made with a bank at a fixed
rate of interest and which is repayable on a set date. Depositors do not have to wait until the
repayment date of the bond to get their money back because the certificates and be traded
on the money market.

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3.8 Government bonds


Government bonds (or Treasury bills or gilts) are issued by governments when they need to
borrow. They are for fixed rates of internet and are usually repayable by a certain date. They
can be traded on the stock exchange and provide liquidity for the government and a place to
invest money for the public and companies.
Consider a 5% Treasury Bond.. It will look something like:
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$100 5% $100

This means that if you own this piece of paper you would receive $5 interest every year (5% x
$100, the nominal value).
If the current interest rate in the economy is 5%, then the market value of this bond will be
$100 so that by buying it at $100 you earn the current rate of interest. If, however, interest
rates in the economy rose to 7%, then the market value of the bond would fall as it is only
paying $5 per year. The market value will fall until a purchaser earns 7% per year if the bond is
purchased. So:
Interest 5
x 100 = x 100 = 7
Market value Market value
Market value = 5 x 100/7 = $71.43

[Buying something for $71.43 and earning $5 pa is equivalent to a rate of interest of 5/71.43 =
7%

Similarly, in interest rates fell below 5%, the market value of the bond would increase so that
investors would earn the appropriate rate of interest.

3.9 Bills of exchange


A bill of exchange is a non-interest-bearing instrument primarily in international trade that
binds one party to pay a fixed sum of money to another party at a predetermined future date.
They are very like cheques and are used for the transfer of funds. They are not so common
now as other forms of payment (eg e-banking) have become popular.

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4 Central banks
A central bank is a bank that acts for the government. In the UK the central bank is the Bank of
England; in the USA it is the Federal Reserve.

In general, a central bank carries out the following functions:


It is the Governments banker. For example, receiving tax and the proceeds of the issue
of Treasury Bonds.
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Manages the national debt (Government borrowing) ensuring that repayments are
made when due and finding buys for new issues of bonds.
It is the central note issuing authority.
Management of foreign exchange movements and balances.
Setting interest rates.
Controlling credit.
Overseeing the financial system (since 2014 in the UK since 2014, the independent
Financial Conduct Authority performs many regulatory tasks).
A lender to the banking system. For example, if a bank suers a run, meaning that
many people want to withdraw their money at the same time), the bank will need to
raise cash (remember that depositors money will have been lend on again by banks, so
is not available to repay depositors). The central bank is often known as the lender of
the last resort because they will nearly always provide funds to banks. The interest rate
charged influences the economys interest rates and this is how interest rates are
controlled.
Controlling inflation. In the UK it is the Bank of Englands responsibility to control the
rate of inflation.

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5 The structure of interest rates


A yield curve links the expected yield from bonds of a similar nature but with dierent
maturity dates. They give clues as to how investors expect interest rates to move in the future.
If there were four bonds of similar risks, maturing in 3 months 1 year, 5 years and 20 years,
how would you expect your annual returns to vary? In general you should require a higher
return (yield) from the 10 year bond because you are locking your money away for 10 years
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and that subjects you to more risk than tying up money for just 3 months.
It can also imply that interest rates are likely to rise. So, if you are going to lock money away
for ten years in a fixed interest bond, and you expect interest rates to rise over the ten years,
then you would demand a higher yield to anticipate future rises in interest rates.
The normal yield curve should therefore look something like:
Return (or yield)

Time to maturity

Sometime yield curves invert and can look something like:


Return (or yield)

Time to maturity

This implied that interest rates are expected to fall, so it might be worthwhile locking into a
long-term bond at a lower interest rate because the actual interest rate might be even lower
in the future.

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6 Credit creation by banks


When you deposit money in a bank, the bank lends that money on to customers, who in turn
will place that money in their accounts. The reserve ratio describes the proportion of each
deposit that has to be kept as cash by the bank. So if there was a reserve ratio of 25%, the
depositing and lending cycles would look like:
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Deposit Bank keeps Bank lends


1ST customer deposits 1000.00 250.00 2nd customer borrows 750.00
2nd customer deposits 750.00 187.50 3rd customer borrows 562.50
3rd customer deposits 562.50 140.63 4th customer borrows 421.88
4th customer deposits 421.88 105.47 5th customer borrows 316.41
5th customer deposits 316.41 79.10 6th customer borrows 237.30
6th customer deposits 237.30 59.33 7th customer borrows 177.98
And so on

So the original $1000 that the first customer had has provided funds of 750.00 + 562.50 +
421.88 + etc. It can be shown that if the reserve ratio is r%, then the total amount of
credit created is:
Original deposit x 1/r.
In the example above this would be 1000 x 1/0.25 = 4,000.
By altering the reserve ratio that banks must use the central banks can allow credit and the
money supply in the economy to either expand or shrink and this is an important method of
monetary control.
Higher reserve ratios also keep banks more stable because they retain a higher proportion of
cash.

7 Foreign exchange markets


Chapter 11 will explain the risks that can arise from foreign exchange transactions. Here we
explain a little about how foreign exchange rates and currencies are managed.

7.1 Fixed and floating exchange rates


A government can attempt to fix (peg) its currencys exchange rate with respect to another
currency or group of currencies. This provides certainty for importers and exporters because
they know exactly how much imports and exports represent in their own currency.
So that the fixed exchange rate is maintained the government must purchase or sell its
currency to achieve a perfect match of supply and demand for its currency otherwise
market forces will inevitably move the exchange rate. If the prevailing sentiment of the
market is that a currency is overvalued, holders of the currency will want to sell it before it
falls in value. To maintain its price the government will have to buy it up and to do this will
have to use its reserves (eg gold or another currency) to pay for the purchases. If investors
panic there will be a run on the currency and it becomes very expensive, or impossible, for
the government to prevent a devaluation.
Fixed exchange rates do not respond to the health of an economy. For example, if an
economy is not producing goods that are popular abroad, the exchange rate and the price of

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any exported goods will be fixed. However, it might be better to allow the currency to
devalue so that exports become cheaper to foreign consumers. This will stimulate the
economy (and tax receipted by the government) because more goods can be made and
successfully exported.
With floating exchange rates, the rates are allowed to change constantly in response to
market forces. This introduces uncertainty for importers and exporters but governments
never have to spend reserves to support their currency. In addition, exchange rates vary in
response to an economys health and this provides a self-correcting mechanism.
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In fact, no currency is wholly fixed or floating. In a fixed exchange rate regime, market
pressures can aect the exchange rate and a "black market" can develop which better reflects
supply and demand for the currency. The central bank might then then be forced to revalue
or devalue the ocial rate so that the rate is in line with the unocial one. In a floating
exchange rate regime, the central bank may also intervene to ensure to dampen exchange
rate volatility
There are some variants on the pure fixed and floating approaches such as margins around an
adjustable peg. In this system the exchange rate is allowed to vary freely within a range
around a peg, but if there were a fundamental imbalance the peg would be moved (ie a
devaluation or revaluation).

7.2 Single currency zones


On January 1, 2002, countries ocially introduced the Euro banknotes and coins to replace
their national currencies.There are now 19 countries whose currency is the Euro.
Claimed advantages of the Euro single currency zone:
The Euro would have the enhanced credibility because it is the currency of a large
geographic area and would have more stability against speculation than individual
currencies would be.
Greater stability should lower risk and reduce interest rates
Greater convenience for individuals travelling within the zone because money does not
have to be changed.
Greater convenience and certainty for importers and exporters within the zone. This
should stimulate trade and job creation.
Claimed disadvantages of the Euro single currency zone:
Inability to respond to individual countries economic needs. For example, all countries
in the zone must have the same interest rates, but some might want lower rates to
stimulate their economies.
Dierent countries will be at dierent stages of their economic cycles.
Loss of national sovereignty eg dierent views on tax, government spending and
inflation. In fact, much of the Euros troubles stem from there being a single currency
but very diverse economic policies in each country.

7.3 Foreign currency reserves


Foreign currency reserves represents the amount of foreign currency and gold held by a
central bank. The reserves can be used to buy buy and sell a countrys own currency to
maintain an exchange rate and to guarantee the countrys external debt. Its rather like you
telling someone to whom you owe money, Dont worry, because I have assets which I can
give you or sell to generate funds that I can pay you with.

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The most important foreign currency used as a reserve currency is the US$.
Typical 2016 amounts, measured in US$, of foreign currency reserves held were:
China: 3,000B
Japan: 1,200B
Germany: 200B
UK: 160B
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From time-to-time governments and central banks impose exchange controls and intervene,
not only to maintain a rate of exchange which is quite dierent from what would have
prevailed without such control, but also to require the buyers and sellers of foreign currencies
to dispose of their foreign funds in particular ways.
For example, if savers thought that their currency was going to devalue they could opt to
change it into US$. That will, of course, cause the currency to weaken and the government
could simply ban all currency exchange of, say, more than say $100.
In the UK in the 1960s when the economy was very weak, the government laid down a
maximum amount of 50 that citizens could change to a foreign currency when visiting
abroad.

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Tests
Question 1
What is meant by the phrase maturity transformation?
A The provision of pension funds
B Allowing short term deposits to become long term loans
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C Changing debentures into shares


D Creating credit by lending out deposits

Question 2
An investor owns par value $12,000, 6% government bonds.
What will the market value of these be if the interest rate in the economy is 4%?

Question 3
Does an inverted yield curve mean that investors expect interest rates to rise or fall?

Question 4
Would you expect the rate of interest charged on a convertible to be higher or lower
than charged on a straight debenture?

Question 5
If a country wants to fix its exchange rate, but there is downward pressure on it, does
the country have to spend its reserves to buy its currency or sell its currency and earn
reserves?

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CHAPTER 10
FINANCIAL MATHEMATICS

1 Introduction
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This chapter looks at the calculation of interest on investments and also at the techniques of
present values and internal rates of return.

2 Interest
2.1 Simple interest
A sum of money invested or borrowed is known as the principal.
When money is invested it earns interest; similarly when money is borrowed, interest is
payable. Note that interest is not permitted in Islamic finance.
With simple interest, the interest is receivable or payable each year, but is not added to the
principal for the calculation of future interest.

Example 1
A man invests $200 on 1 January each year, starting 2018. On 31 December each year simple
interest is credited at 10% but this interest is put in a separate account and does not itself earn
interest.
Find the total amount standing to his credit on 31 December following his third payment of
$200.

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2.2 Compound interest


With compound interest the interest is added each year to the principal and in the following
year the interest is calculated on the total.

Example 2
A man invests $500 now for 3 years with interest at 10% p.a.
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How much will be in his account after 3 years?

Example 3
A man invests $800 at 6%p.a. for 5 years.
How much will be in his account at the end of 5 years?

3 Effective Rate and APR/AER rates


For simplicity, the previous compound interest examples have assumed that interest is
calculated only once a year. However, in practice interest may be calculated on a monthly (or
even daily) basis. This is straightforward if the interest rate is also quoted per quarter, as the
following example shows.
Suppose that you save $1000 in an account that pays 2% interest every quarter. How much
do you have in one year, if the interest is paid in the same account?
To solve this we can use the formula for compound interest used above which says that a
principal P accumulates to

P (1 + r)n over a period n, if the rate is r.


The rate r = 0.02 is measured in quarters, so we also have to measure the period n in quarters.
One year is four quarters, so the capital accumulates to:

1,000 x (1 +0.02)4 = $1082.43 pounds.


You can see that over the year interest totalling $82.43 has been added to the principal of
$1,000 and this represents an eective interest rate of 8.243% pa. The eective interest rate
can also be called the annual equivalent rate (AER) or annual percentage rate (APR).

Example 4
A credit card company charges a nominal rate of 2% per month.
If a customer has purchased $100 worth of goods on his credit, calculate the amount she will
owe after one year, and also the annual percentage rate (APR)

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However, interest rates are usually not quoted per quarter even if interest is paid
quarterly.The rate is usually quoted per annum (p.a.).
It may seem logical to quote the rate as 8.243%. After all, we computed that
$1000 accumulates to $1082.43 in a year. However, it would be common to quote 2% per
quarter as being 8% per year. 8% is the nominal rate, but that is, of course, not really the
interest ratethat is actually charged.
To compute the eective interest rate from the nominal interest rate first divide the
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nominal rate by the number of periods in the year then use that rate to work out the
compound interest.

Example 5
Suppose that an account oers a nominal interest rate of 8% p.a. payable quarterly.
(a) What is the AER?
(b) What if the nominal rate is the same, but interest is payable:
(i) monthly
(ii) weekly
(iii) daily?

4 Discounting
Here is a simple choice. Would you rather have:

1. $1,000 now, or
2. $1,000 in one years time?

Most people would prefer option 1 because it is:

Safer
Gives immediate enjoyment
Even if you do not need it now, you can invest it for a year.

The value of investment can be evaluated by looking at interest rates. If the money could be
placed on deposit at 6% for a year, then the two options really are:

1. $1,000 x 1.06 = $1,060 in 1 year, or


2. $1,000 in one year.

So earlier flows are worth more than later ones.

Instead of projecting amounts into the future (which calculates the terminal values), it is more
normal to bring all amounts back to the present. So, for option 2, we want to find out how
much would need to be received now to become (be identical to) $1,000 in one year.

So, if p is received now and invested at 6% to become $1,000, the following must be true:

p x 1.06 = 1,000

p = 1,000/1.06 = 943.40.

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$943.40 is known as the present value of receiving $1,000 in 1 year at a discount rate of 6%.

This means $943.40 is equivalent to receiving $1,000 in 1 year if interest rates are 6%. [Check
$943.30 invested at 6% becomes $943.40 x 1.06 = $1,000]

So the two original options can be rephrased as:

Would you rather have:


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1. $1,000 now, or
2. $943.30 now?

Obviously, option 1 is preferable.

Example 6
(a) By working out the present values of the options, indicate which of the following options
is preferable:

$3,000 received now or


$4,000 received in 4 years
Interest rate = 7%
(b) By working out the present values of the options, indicate which of the following options
is preferable|:

$3,000 received in 2 years or


$3,800 received in 5 years
Interest rate = 10%

5 Discounted cash flow tables


The above examples should help you to realise that:

Cash flow 1
Present value = or [or Cash flow x (1 + r)-n
(1+r)n

where:

r = discount rate as a decimal

and

n = number of years in the future the flow occurs.

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You can see this in previous example 1 where the present value of $4,000 received in 4 years
at an interest rate (discount rate) of 7% is:

4,0001
PV = = 4,000 0.736 = 3,052
(1+ 0.07)4

0.763 is known as the discount factor for 4 years at 7%.


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Instead of having to work this out manually, discount tables are routinely provided. They are
at the start of this set of notes, but here is an excerpt:

You will see that with a discount rate of 7% and a period of 4 years, the discount factor is as
was previously calculated, 0.763.

It is common in investment appraisal to have a number of years with equal flows: this would
be termed an annuity. For example, the same rent might have to be paid for several years.

So, if a payment of $1,500 had to be made after one, two, and three years, with a discount rate
of 9%, the calculation could be set out as:

Time Cash flow $ Discount factor Discounted cash flow


(see table above) $
1 1,500 0.917 1,375.50
2 1,500 0.842 1,263.00
3 1,500 0.772 1,158.00
Total 3,796.50

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However, a faster way of working this out would be to add up the discount factors and
multiply their total by $1,500:

Time Cash flow $ Discount factor Discounted cash flow


(see table above) $
1 1,500 0.917
2 1,500 0.842
0.772
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3 1,500
1,500 2.531 3,796.50

This would normally be written out as:

Time Cash flow $ Discount factor Discounted cash flow


(see table above) $
1-3 1,500 2.531 3,796.50

Once again, this type of calculation is made easier by the use of tables known as Annuity
Tables or Cumulative Discount Tables. Heres an excerpt:

You will see that at a discount rate of 9% and for three periods (n = 3), the annuity discount
factor from this table is 2.531, as was calculated above.

It is important to realise that if you are using discount factors straight from annuity tables,
then the cash flows must start after 1 year and occur every year up to the stated number o
periods.

Therefore, if any other pattern of flows occurs the discount factor will have to be adjusted.

So, if $200 is to be received in years 4 10 with a 5% discount rate, the required calculation
would be:

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Cumulative discount factor years 1 10 7.722


less: cumulative discount factor years 1 3 2.723
Cumulative discount factor years 4 10 4.999

Therefore, the present value of the cash received is $200 x 4.999 = $999.8

Note: the cumulative factor for years 1 3 has to be removed to leave 4 10. The commonest
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error made is to remove the cumulative factor for 1 4, but that would only leave a factor for
years 5 10.

Example 7
(a) What is the present value if $100 is to be received in years 6 9?
Discount rate = 5%
(b) What is the present value if $100 is to be received in years 3 10 except year 5 ?
Discount rate = 4%
(c) What is the present value if $200 is to be received in years 0 5?
Discount rate = 10%

6 The cumulative discount factor formula and perpetuities


You will see a formula at the top of the annuity tables:

1(1+ r)n
Annuity factor =
r

Some people prefer to write this as:

1 1
Annuity factor = 1
r (1+ r)n

This will give the figures in the tables (a pointless exercise in itself!) but might need to be used
if the discount rate or the number of periods is no on the tables.

Example 8
(a) Work out the cumulative discount factor for n = 7 and the discount rate = 8%
(ie r = 0.08), and check to the figure in the tables.
(b) Work out the cumulative discount factor for n = 12 and the discount rate = 5.5% (ie r =
0.055).

As annuity is an annual cash flow. As the annuity becomes longer (ie more years of flow) the
annuity becomes close to a perpetuity, which is an equal cash flow for ever ie in perpetuity.
Obviously no set of flows is for ever, but after 20 years or so, at moderate discount rates,

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discount factors are so small that further flows can be ignored (for example, the 20 year 10%
factor is 0.149) and for convenience the flows can be treated as a perpetuity.

Notice what happens the annuity factor formula as n, the number of years of flow, becomes
very large

1 1
Annuity factor = 1
r (1+ r)n
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An n becomes large this term becomes very small and the formula can be simplified to

Perpetuity factor = 1
r

So, the present value of receiving $1,000 from time 1 to infinity at a discount rate of 10% is:

1,000
PV = =$10,000
0.1

Note that as with annuities, perpetuities start at time 1 and occur every year. So, if the pattern
is something else, the perpetuity factor will have to be adjusted.

7 Using present values in investment appraisal net present


value approach.
It was shown above that flows of cash occurring at dierent times cannot be directly
compared. For comparison all flows are discounted to their present values.

For investment appraisal the cash outflows (usually the initial investment) and inflows
(usually the future income and sale of the non-current asset at the end of its life) are all
discounted to their present values. Outflows are negative, inflows are positive and when
added up the net total is known as the net present value (NPV).

If the NPV > 0 the present value of the inflows exceeds the present value of the outflows, so
the business would be richer. The investment would be worthwhile and should be accepted.

If the NPV< 0 the present value of the outflows exceeds the present value of the inflows and
this means that the business would be poorer if it invested. The investment should be
rejected

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Illustration
For example: an investment in new machinery would cost $25,000 and would
produce additional cash inflows of:
Year 1 $8,000
Year 2 $15,000
Year 3 $10,000.
The machinery could be sold for $2,000 at time 3.
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Is the project worthwhile if the discount rate is 8%?

Solution
Time Flow Amount $ Factor@ 8% Discounted
cash flow $
0 Initial investment (25,000) 1 (25,000)
1 Additional income 8,000 0.926 7,408
2 Additional income 15,000 0.857 12,855
3 Additional income 10,000 0.794 7,940
3 Scrap proceeds 2,000 0.794 1,588
Net present value (NPV) 4,791

As the NPV is positive, the project should be accepted

Example 9
An investment requires expenditure of $10,000 now and $12,000 at time 1. Income will be $5,000,
$15,000 and $7,000 in years 2, 3 and 4. There are no scrap proceeds.
Is the investment worthwhile when evaluated at a 9% discount rate?

Example 10
An investment requires expenditure of $18,000 now will yield income of $8,000 pa for times 2 - 5
Is the investment worthwhile when evaluated at a 10% discount rate?

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8 Net present value approach care needed


To carry out NPV you have to identify relevant cash flows. The rules are similar to what you
met earlier with relevant costing. Look for cash flows that are future incremental costs or
income caused by the investment decision.

In particular:


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Cash flows are what you need, so look at income before depreciation.
Reapportionment of existing fixed costs is irrelevant.
Sunk or past costs are irrelevant.
Opportunity costs are relevant ie cash flows forgone because of a decision
Ignore all interest and other finance flows. These are taken account of by
discounting.

Example 11
An investment requires expenditure of $15,000 now will yield income of $5,000 pa after
depreciation for times 1 3 then $4,000 after depreciation of year 4. The machine can be sold for
$3,000 in year 4. Research expenditure of $5,000 has been incurred on the new product that would
be made by the machine.
Is the investment worthwhile when evaluated at a 6% discount rate?

9 Discounted cash flow internal rate of return (IRR)


The internal rate of return (IRR) is defined as:

IRR = discount rate where NPV = 0

It is sometimes referred to as a breakeven discount rate.

If the discount rate to be used is greater than the IRR, then the project is not worthwhile. That
would be like borrowing at 10% and investing in a project which generated 5%: obviously
you would lose out.

If the discount rate to be used is less than the IRR, then the project is worthwhile. That would
be like borrowing at 5% and investing in a project which generated 10%: obviously you
would make money.

The IRR will tell you nothing about accepting/rejecting a project that the NPV has not already
told you.

Estimating the IRR requires you to work out the NPV of the project at two discount rates.
There is nothing special about the two rates chosen, but many people try 10% and 15%, or
5% and 15% or 10% and 20%.

For example:

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NPV at 5% = $1,000

NPV at 15% = -$1.300

These results can be shown on a graph:


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At a low discount rate the future positive cash flows stay relatively large after discounting so
the NPV is likely to be positive.

At a high discount rate the future positive cash flows are considerably reduced after
discounting so the NPV is likely to be negative

The IRR must be between 5% and 15% and this has to be estimated. However, the line joining
the two discount rates and NPVs is usually curved and this makes estimation more dicult. To
simplify matters it is assumed that the line is straight and this will result in an estimation of
the IRR rather than a precise figure.

Simplifying, and drawing some triangles:

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Our aim is to work out the distance BF as the IRR will then be estimated as 5+BF

The triangles ABF and ACD are similar, meaning that they have the same proportions.
Therefore, for each, the base/height must be equal:

BF/AB = CD/AC
BF = AB x CD/AC
= 1000 x (15 5) /(1,000 + 1,300) = 4.3

Therefore, point F must be 5 + 4.3 = 9.4%, and this is the estimate of the IRR.

Note that if someone had calculated the IRR using the NPVs at, say, 4% and 16%, the IRR
estimate would be slightly dierent.

Some people are happy sketching diagrams such as those above. Others prefer to use a
formula (not given in the exam):
NA
IRR = A%+ (B% A%)
(NA NB )

Where
A% = lower discount rate tried
B% = higher discount rate tried
NA = NPV at A%
NB = NPV at B%

So, in the above example

A% = 5, B% = 15, NA = 1,000, NB = -1,300

1,000 1,000
IRR = 5%+ (155) = 5+ 10 = 9.4%
(1,000 (1,300)) 2,300

Note the bottom line carefully: NA NB;

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NA = 1,000 and NB = 1,300.

So, NA NB = (1,000 (- 1,300)) = 2,300 [the two negative signs make a plus]
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Tests
Question 1
A business has five annual cash inflows of $1,500 pa starting at time 3.
What is the present value of these flows at a discount rate of 7%?
A 6,245
B 5,372
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C 4,148
D 5,021

Question 2
A business has cash inflows of $400 pa for times 0 8, except time 5.
What is the present value of these flows at a discount rate of 10%?
A 2,534
B 1,018
C 1,886
D 2,286

Question 3
A business will receive rent of $10,000 pa on a 500 year lease.
What is the present value of the rental receipts if the discount rate is 5%?
A $200,000
B $100 million
C $1 million
D $5 million

Question 4
A business will receive rent of $10,000 pa on a 999 year lease, starting at year 3.
What is the present value of the rental receipts if the discount rate is 5%?
A $200,000
B $172,770
C $185,900
D $181,410

Question 5
A business will receive rent of $10,000 pa on a 999 year lease, starting at year 0. At time 2 the
business will also receive $1,000 to cover the legal fees involved in setting up the lease.
What is the present value of the receipts if the discount rate is 7%?
A $153,730
B $152,857
C $143,730
D $142,857

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Question 6
A business is considering implementing solar heating throughout its factories. This will cost
$900,000 after one year and the savings are estimated to be $400,000 two years from now
and $600,000 three years from now.
Discount rate = 10%
What is the NPV of the project?
A 111,710
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B 37,100
C +37,100
D 37,510

Question 7
A business owns some land that could be sold for $1 million and which cost $800,000 two
years ago. Alternatively, the land could have apartments build on it for a present cost of $5
million. The apartments would bring in rent of $550,000 pa in perpetuity from time 1
onwards.
Discount rate = 10%
What is the NPV of the project?
A 4,700,000
B 5,500,000
C 4,500,000
D 6,500,000

Question 8
At 10% NPV = $1,200
At 20% NPV = $-500
What is the estimated IRR?
A 17%
B 27%
C 19%
D 20%

Question 9
At 8% NPV = $1,200
At 12% NPV = $500
What is the estimated IRR?
A 18.9%
B 10.8%
C 14.9%
D 17.3%

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Question 10
A project with conventional cash flows (cash out now, received in the future) has an IRR of
12%. The discount rate is 9%.
This means that;
A The NPV will be positive, but the project should be rejected
B The NPV will be negative, but the project should be accepted
C The NPV will be negative and the project should be accepted
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D The NPV will be positive and the project should be accepted.

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CHAPTER 11
THE EFFECTS OF INTEREST RATES AND
EXCHANGE RATES ON BUSINESS
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PERFORMANCE

1 Introduction
This chapter looks at how changing interest rates and interest rates can aect the
performance of a business. It also looks at how businesses can protect themselves against
unfavourable exchange rate and interest rate movements.

2 Exchange rate risk


2.1 Types of risk
A company can be aected by variable exchange rates in the following ways:
Economic risk
This describes how a companys competitiveness can be aected by exchange rates. For
example, if a UK company is exporting to the USA and the current exchange rate is 1 =
US$1.3, then an item selling for $1,000 in the UK will sell for $1,300 in the USA.
If the exchange rate moved to 1 = US$1.5 (ie the strengthens against the $ so that it buys
more $), the price in the USA would become $1,500. The price increase in the USA, from
$1,300 to $1,500, means that the product is less attractive and competitive there and sales
will probably fall.
If the exchange rate had moved the other way then goods exported would be more
competitive in the foreign market.
There is a similar eect on imports. If a company in the USA were exporting to the UK when
the exchange rate was 1 = US$1.3, then a product costing $5,200 in the US would cost
$5,200/1.3 = 4,000 in the UK. IF the exchange rate now moved to 1 = US$1.5, the item
would cost only $5,200/1.5 = 3,467 so it has become more attractive to UK purchasers.
Note that the above example shows that UK companies can suer because of exchange rate
movements even if they neither import nor export: imports have simply become cheaper and
provide stronger competition for local goods.
Translation risk
Imagine a UK company has a subsidiary in Europe. The group accounts of the UK company
will be in . To prepare the subsidiarys statement of financial position will have to be
translated into at the year-end rate.
Although this does not cause adverse cash flows, as the exchange rate moves up and down
so too will the value of translated assets and liabilities. This can have a distorting eect on the
groups accounts and of the groups performance.

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Transaction risk
Transaction risk arises from currency movements aecting the amounts received and paid for
exports and imports.
For example, a UK company contracted to sell a product for $39,000 to a USA customer when
the exchange rate was 1 = US$1.3. When the payment is received (and this could be several
months after the contract was agreed) the exchange rate has moved to 1 = $1.50 so instead
of ending up with 39,000/1.3 = 30,000, the company will receive only 39,000/1.5 = 26,000.
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The 4,000 dierence is a shortfall in the companys cash flow and could have serious
consequences.
Similar cash flow uncertainty and problems arise on buying goods from a foreign supplier. If a
UK company agrees to pay a German supplier 100,000 for a piece of equipment when the
exchange rate is 1 = 1.4 and the has weakened to 1 = 1.2 when payment is made,
instead of the goods costing 100,000/1.4 = 71,429, the company will have to pay 100,000/1.2
= 83,333 to obtain 100,000. Around an extra 12,000.

3 Combatting exchange rate transaction risk


Obviously, a simple 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.
If thats not possible, then there are several other approaches:
Forward contracts
Currency futures
Currency options

3.1 Forward contracts


A forward contract is a contract to exchange an agreed amount of currency at an agreed date
in the future and an agreed exchange rate. In essence you are quoted a rate which will be
used in the future irrespective of what the real exchange rate does and this brings certainty to
the cash flows.
Forward contracts are binding and the agreed amounts of currency must be bought or sold
on the agreed day. This can mean that a company could have done better making use of a
favourable exchange rate movement when it comes to change the money, but it has to stick
with the binding contract.
The aim of forward contracts is to bring certainty to cash flows and to remove risk. Their aim is
not to give participants the best possible exchange rate.
Forward contracts are arranged on an individual basis with financial institutions and are
known as over the counter products.

3.2 Currency futures


Currency futures are derivatives, which means that their value depends on (derives from)
something else here exchange rates. Futures can be bought and sold on futures markets
such as the London International Financial Futures and Options Exchange(LIFFE, pronounced
'life'). The value of futures goes up and down with exchange rates.
So, imagine you an exporter in the USA and you were going to receive 1m in three months
from a UK customer. Currently the exchange rate is 1 = US1.4, so the exporter is hoping for
1m x1.4 = $1.4m. If the exchange rate went down to 1.3 then fewer US$ would be received:
1m x 1.3 = $1.3m).

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Remember, futures prices move with the exchange rate so to compensate for the exchange
rate loss, the company could sell futures now (at around 1.4) then buy them later (at around
1.3) to close out the transaction. The profit on the futures will largely compensate for the loss
made on the exchange of the money.

3.3 Currency options


Currency options give their owner the right, but not the obligation, to buy or sell an asset at an
agreed price.
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The agreed price is known as the exercise price or the strike price.
An option to sell is a put option (think: put something up for sale); an option to buy is a call
option.
Options can be exercised ie the option owner can insist on buying or selling currency at the
exercise price or can be allowed to lapse.
For example, the US exporter above takes out an option to sell (a put option) at an exercise
price of 1.43. What will be done if the exchange rate available when 1m is received is:
(i) 1.50
(ii) 1.38?

(i) The exporter can either get 1m x 1.5 = $1.5m or 1m x 1.43 = $1.43m by exercising the
option. So, in this case the exporter would allow the option to lapse.
(ii) The exporter can either get 1m x 1.38 = $1.38m or 1m x 1.43 = $1.43m by exercising the
option. So, in this case the exporter would exercise the option.

Options are rather like insurance policies: they protect you from losses but you dont have to
make a claim on them. However, like insurance policies, to acquire this protection an up-front
non-returnable premium has to be paid.

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4 Interest rate risk


Variable rate loans and deposits are also sources of risk because it is not known with certainty
what interest will have to be paid or will be earned.
Fixed rate loans and deposits will remove all risk, but then there is no chance of benefitting
from favourable movements and businesses could get locked into unfavourable interest rates
for many years.
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There are three main methods to reduce risk arising from variable rate interest.
Forward rate agreements
Interest rate futures
Interest rate options

4.1 Forward rate agreements


Forward rate agreements (FRA) are like forward rate currency contracts: they allow a borrower
or depositor to fix a n interest rate for a period in the future eg starting in 6 months and
ending after 12 months. They are over the counter, individually agreed arrangements.

4.2 Interest rate futures


These are derivatives whose value depends on the interest rate. By arranging to buy or sell
future contracts, profits can be made on the contracts that will largely compensate for any
losses made on interest rate movements. The value of interest rate futures will be
approximately 100 interest rate. So if the interest rate in the economy is 4%, interest rate
futures will be quoted at 96.

4.3 Interest rate options


These are options to buy or sell interest rate futures and allow borrowers or depositors to
enjoy favourable interest rate movements whilst protecting themselves against adverse
movements. Up-front non-returnable premiums have to be paid to acquire the options that
provide this protection.

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Tests
Question 1
A company in the US is quoted an exchange rate as 1US$ = 0.9332 0.9245
The company is going to receive 1m from the sale of machinery.
How many US$ will this produce?
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Question 2
What are the three types of currency risk that a business can experiences?

Question 3
What does the following describe: a right but not an obligation to buy or sell a certain
amount of currency on a certain date.

Question 4
What does FRA mean and what are FRAs for?

Question 5
A company is planning to change $ to in three months and has taken out a currency option
at 1 = US$1.25.
In three months the rate of exchange is 1 = $1.30.
Will the company exercise its option or allow it to lapse?

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ANSWERS TO TESTS

Chapter 1
Question 1
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Final

Question 2
D

Question 3

Injection Withdrawal
Tax X
Exports X
Imports X
Savings X
Government spending X

Question 4
B

Question5
$100m/0.2 =$500m. This is the multiplier eect.

Question 6
C and D. A and B move along the demand curve but they do not change its position.

Question 7
Inflation. The excess demand pushed prices up. It can also suck in imports.

Question 8
a) Base-year weighted quantity index
Index = (Current year price x Base year quantity)/(Base year price x Base year quantity)
= (5.00 x 30 + 4.00 x 50)/(4.00 x 30 + 3.00 x 50) = 1.296

b) Current-year weighted value index


Index = (Current year price x Current year quantity)/(Base year price x Current year
quantity)
= (5.00 x 40 + 4.00 x 60)/(4.00 x 40 + 3.00 x 60) = 1.294

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Question 9
Taxation
Borrowing
Selling state assets
Printing money/quantitative easing
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Chapter 2
Question 1
This is an example of absolute advantage

Question 2
Protectionism

Question 3
C
Having to import strategic resources does no give assured supplies.

Question 4
120,000/1.25 = 96,000

Question 5
B, C

Question 6
The higher inflation rate in country A means that its currency is losing value faster than
country Bs. Therefore, A$1 must buy fewer B$ in the future than it does now. Therefore the
exchange rate will move towards A$1 = 1.4B$.

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Chapter 3
Question 1
It is when company moves some of its operations abroad usually to exploit lower
manufacturing costs.

Question 2
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Globalisation.

Question 3
Social changes and social forces

Question 4
This describes the World Trade Organisation.

Chapter 4
Question 1
False. Shareholders liability is limited but the company is liable for all its debts.

Question 2
False. Many state owned organisations are not-for-profit, but not all are. For example, a state
owned airline can be expected to produce a profit.

Question 3
Share capital and loan capital.

Question 4
Cost of capital

Question 5
Internal External Connected
Employees X
Suppliers X
Customers X
Government X
Lenders X
Directors X
Shareholders X

Question 6
Shareholders are the principals, directors are the agents

Question 7
There should be a balance of executive and non-executive directors, meaning a 50/50 split, so
there should be at least 6.

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Question 8
The return on capital employed is defined as:
Operating profit before tax and interest 100 x 5,000
x 100 = = 15.2%
Capital employed (26,000 + 7,000)

Chapter 5
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Question 1
B
High price elasticity of demand implies high price sensitivity. For a given change in price
product Bs demand changes more than product As

Question 2
C, D

Question 3
False.
Elasticity>1 means the item is price sensitive. A small change in price will lead to a relatively
large fall in quantity so that revenue falls.

Question 4
Price Quantity sold
15 20,000
20 16,000

Mid-point of price range = 17.5; mid-point of quantity range = 18,000


Elasticity = [4,000/18,000]/[5/17.5] = 0.78

Question 5
Shift to right Shift to left
Increased advertising X
Lower incomes X
An item becoming fashionable X
The price of a substitute falling X

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Chapter 6
Question 1
Predatory pricing is where a rich supplier drops the selling price to drive others from the
market.

Question 2
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Question 3
Minimum price set Maximum price set
Rationing X
Over-production X
Queueing X
Wasted resources X

Question 4
Merit goods

Question 5
An externality.

Chapter 7
Question 1
B Information can be defined as data with meaning

Question 2
Accurate
Complete
Cost-beneficial
User-targeted
Relevant
Authoritative
Timely
Easy to use

Question 3
Histogram; ogive (or cumulative frequency curve)

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Question 4
Discrete Continuous
Number of children under 10 in each family X
Weight of individuals in a population X
Distance between cities X
Family income rounded to the nearest $000 X
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Question 5

Cumulative
Family income Frequency
frequency
0 - <2,000 5 5
2000 - <3,000 20 25
3000 - <5,000 500 525
5000 - <10,000 100 625
10,000 - <20,0000 10 635

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Chapter 8
Question 1
Velocity, volume, variety, veracity

Question 2
No. Even a very high coecient of correlation does not prove cause and eect. The results are
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consistent with a causal relationship but do not prove it. For example, the increase in
advertising might have coincided with an improvement in the economy and that sales might
have increased because of that.

Question 3

Guest 1 Guest 2
d d2
ranking ranking
Hotel 1 2 3 -1 1
Hotel 2 4 4 0 0
Hotel 3 3 1 2 4
Hotel 4 1 2 -1 1
d2 6

What is the Spearmans Rank Coecient:


6d 2
r = 1
n ( n 1)
2

n = 4 n2 = 16
6 6
r =1 = 0.4(low correlation)
4 15

Question 4
From season 3 2017 to season 4 2018 is 5 increments of season. The projected trend is
therefore $73,000 + 5 x 2,000 = 83,000
The appropriate seasonal adjustment is -$9,000, so the seasonally adjusted projection is
$74,000.

Question 5
B, C

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Chapter 9
Question 1
B

Question 2
Annual interest = 6% x 12,000 = $720. This must be equivalent to 4% on the amount invested:
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720/Market value = 4%
Market value must be 720/4% = $18,000

Question 3
Interest rates are expected to fall.

Question 4
It should be lower because the convertible holder enjoys a wait and see approach to
deciding whether to convert the securities into shares. This benefit means that less interest
should be required.

Question 5
It must sell its reserves in exchange for its currency

Chapter 10
Question 1
B We need the 3 7 for the five flows. 1 7: annuity factor = 5.389; 1 2: annuity factor =
1.808. Factor for 3 7 = 5.389 1.808 = 3.581. PV = 3.581 x $1,500 = 5,372

Question 2
D 1 8 except time 5 = 5.335 0.621 = 4.714

0 8 = 1 + 4.714 = 5.714
PV = $400 x 5.714 = 2,286

Question 3
A 10,000/0.05 = 200,000

Question 4
D 1 infinity: 1/0.05 = 20

1 2 5% factor = 1.859
3 infinity = 18.141
PV = 18.141 x 10,000 = $181,410

Question 5
D Rent PV factor (time 0 infinity) = 1/.07 +1 [for time 0] = 15.2857

Rent PV = 15.2857 x 10,000 = 152,857.

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Other time 2 receipt = 1,000 x 0.873 = $873


Total PV = $873 + $152,857 = $153,730.

Question 6
B NPV = - 900,000 x 0.909 + 400,000 x 0.826 + 600,000 x 0.751 = -37,100

Question 7
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C The cost of the land is irrelevant as that is a sunk (past) cost. However, the land could
now be sold for $1m and this is an opportunity cost of building on it as that cash inflow
will not be received.

Opportunity cost = $1 million; PV of rental income = $550,000/0.1 = $5,500,000

NPV = $4,500,000

Question 8
A IRR = 10 + 1,200 x (20 10)/(1,200 + 500) = 17%

Question 9
C IRR = 8 + 1,200 x (12 8)/(1,200 - 500) =14.9%

Question 10
D If IRR > D/c rate, NPV will be positive and the project should be accepted.

Chapter 11
Question 1
If the company goes to its bank with $10,000, the bank will give it only 9,245 (worse than
9332, and the bank always wins). So, 0.9245 is the rate for changing $ to . Therefore 0.9332
must be the rate for changing to
Therefore, 1m will yield 1m/0.9332 = $1.0716m.

Question 2
Transaction, translation and economic risk.

Question 3
This is a currency option.

Question 4
FRA = forward rate agreement. They allow organisations to fix future interest rates.

Question 5
If changing $ to 1.3 is a less favourable rate than 1.25, so the company will exercise its
option and change $ to at 1.25.

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ANSWERS TO EXAMPLES

Chapter 8
Example 1
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Note: x should be the independent variable, units; y is the dependent variable, cost, because
cost depends on units.
x (000) y xy x2 y2
January 1 40 40 1 1,600
February 4 54 260 16 24,225
March 2 45 90 4 2,050
April 7 80 560 49 6,400
May 6 70 420 36 4,900
June 5 70 350 25 4,900
July 3 50 150 9 2,500
28 420 1,870 140 26,550

n xy x y
b=
n x 2 ( x )
2

(71,870) (28 420)


(7140) (28 28)
1,330
= = 6.7857
196

a=
y b x
n n
420 6.7857 28
= 32.8572
7 7
y = 32.86 + 6.79x
or: y = 32,857 + 67.9x

$32,857 represents the fixed costs per month because $32,857 will be incurred even if
nothing is produced (ie x = 0)

Each unit made then causes costs to increase by $67.90. $67.90 is the variable cost per unit.
(if and y are actual units and $s)

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Example 2
n xy x y
r=
(n x ( x ) )(n y ( y ) )
2 2 2 2

7 1,870 28 420
=
(7140(28)2 )(726,550( 430)2 )
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1,330
= = 0.98
(1969, 450)
Note that the coecient of determination, r2 = 0.982 = 0.96

This implies that 96% of the variation in cost can be explained by the variation in output.

Using the results of the linear regression exercise


Usually the results of a linear regression exercise are used to predict future amounts.
For example, lets say that the company planned to make 475 units in March of the following
year. Then using the equation we have derived, the predicted cost would be:
y= 32,857 + 67.9x = 32,857 + 67.9 x 475 = $65,110

Example 3
Using Spearman's coecient:
6d 2
r = 1
n ( n 1)
2

where d is the dierence between the rank in Accountancy and the rank in Economics for
each student.
Rank Rank
Student Accountancy Law d d2
A 1 3 2 4
B 4 7 3 9
C 2 1 1 1
D 5 5 1 1
E 3 2 1 1
F 7 4 3 9
G 6 5 1 1
d = 0 2
d = 26

6 26 156
r = 1 = 1 = +0.536
7 ( 49 1) 336

The correlation is positive 0.536, meaning that as performance in one paper increases so does
performance in the other, but the correlation is not particularly strong.

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Chapter 10
Example 1

Interest for
$ Principal
the year @10%
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1/1/2018 200
31/12/2018 200 20
1/1/2019 200
31/12/2019 400 40
1/1/2020 200
31/12/2020 600 60
Total interest 120

Interest for
$ Principal
the year @10%

1/1/2018 200
31/12/2018 200 20
1/1/2019 200
31/12/2019 400 40
1/1/2020 200
31/12/2020 600 60
Total interest 120
There will be $720 in total to the investors credit.

Example 2
$
Now payment 500.00
Year 1 interest 50
550
Year 2 interest 55
605.00
Year 3 interest 60.50
$665.50
The amount (A) at the end of the nth year at a rate r of interest (expressed as a decimal) is
given by:
A = P(1+r)n
So, in the above example $665.50 = $500 (1.1)3
This is also known as the future value (or terminal value)

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Example 3
A = $1,070.58 = $800 (1.06)5

Example 4
Amount owed after 12 months = P (1 + r)n
= 100 (1.02)12
= $126.82
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APR = actual interest over the year = (126.82 100)/100 100 = 26.82%

Example 5
For interest payable quarterly, the year is divided into four periods so:
(a) 1 + APR = (1 + 08/4)4 = 1:08243;
so the APR (or AER) is 8.243%.
This is the example we considered above.

(b) (i) If interest is paid monthly, there are 12 periods so:


1 + APR = (1 + 08/12)12 = 1.08300
APR = 8.3%
(ii) If interest is paid weekly, there are 52 periods so:
1 + APR = (1 + 08/52)52 = 1:08322
APR = 8.322%
(iii) If interest is paid daily, there are 365 periods so:
1 + APR = (1 + 08/365)365 = 1.08328
APR = 8.328%

Example 6
Option 1: Present value = $3,000
Option 2: Present value = 4,000 x 0.763 = $3,052

Option 2 is therefore preferable.

Option 1: Present value = 3,000 x 0.826 = $2,478


Option 2: Present value = 3,800 x 0.621 = $2,360

Option 1 is therefore preferable

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Example 7

19 5% annuity factor = 7.108


15 5% annuity factor = (4.329)
69 5% annuity factor 2.779

PV = $100 x 2.779 = $278


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1 10 4% annuity factor 8.111


12 4% annuity factor (1.886)
year 5 4% annuity factor (0.822)
5.403

PV = $100 x 5.403 = $540

15 10% annuity factor 3.791


0 10% annuity factor 1.000
05 4.791

PV = $200 x 4.791 = $958

Example 8
1 1 1 1
Annuity factor = 1 n
= 1 = 5.206
r (1+ r) 0.08 (1.08)7
1 1 1 1
Annuity factor = 1 n
= 1 = 8.619
r (1+ r) 0.055 (1.055)12

Example 9
Time Flow $ Factor Discounted
cash flow
0 Investment (10,000) 1.000 (10,000)
1 Investment (12,000) 0.917 (11,004)
2 Income 5,000 0.842 4,210
3 Income 15,000 0.772 11,580
4 Income 7,000 0.708 4,956
Net present value -258
So, marginally, the investment is not worthwhile.

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Example 10
Required discount factor = 3.791 0.909 = 2.882
PV of inflows = 2.882 x 8,000 = $23,056
PV of outflow = $18,000
NPV = $5,056

So, project is worthwhile.


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Example 11
Depreciation charged = (15,000 3,000)/4 = 3,000
Time Flow $ 6% Factor Discounted
cash flow
1 Investment (15,000) 1.000 (15,000)
2 investment 5,000 + 3,000 = 8,000 2.673 21,384
4 Income before depreciation 4,000 + 3,000 = 7,000 0.792 5,544
4 Scrap 3,000 0.792 2,367
Net present value 14,295
Therefore the project is worthwhile.

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