Sterling Crashes – The effects on gap years and hedging

Creative Commons License photo: Peter

I received an email from a friend yesterday. She is currently taking a year out and taking on some voluntary work to promote peace in the middle east. It’s such a fantastic thing to do in my opinion and I have a lot of respect for her for doing it!

However, it seems like even she can’t avoid the credit crunch which is impacting us all at home. I’ve written about the fall in the value of the Pound before on this blog. £1 would buy you $2.05 at the start of the year, now it would buy you about $1.50.

And that’s really, really bad news for anybody who has income denominated in Pounds and costs denominated in dollars. If the gap year cost $8,000 at the start of the year, that would have worked out around £4,000. That cost has now increased to over £5,300. That’s a huge shortfall in funding and now she thinks she might have to cut the gap year short which would be a real shame. My prediction is that we’ll see a bounce in the value of the British Pound soon but obviously the exchange rate is very volatile. That’s a big problem: the cost of everything (accommodation, food, etc.) in terms of your home currency can change dramatically from day to day.

The volatility of exchange rates poses extra risks both importers and exporters. Somebody (or some company) buying products in dollars and selling them in pounds will have seen their costs rise by 33% in just the past few months. That could easily make the difference between a healthy profit and a huge loss.

Reducing or hedging the risk

Creative Commons License photo: michale

So let’s set the scene. I’m an importer of widgets from the US. I import $1 million of widgets per month. The exchange rate is $2 to £1. So my imports cost me £500,000.

However, I believe the pound is overvalued. I reckon the UK is going to go into recession soon and the pound is going to be a lot weaker. I go to my bank manager and I ask him to guarantee an exchange rate for the next year. Obviously, my bank manager probably won’t guarantee me a rate of $2 per £1 for a whole year. The reason for that is simple: if the pound does indeed get weaker, he’ll lose out. A more realistic rate he might offer is $1.8 per £1. Providing the pound stays at the $2 level, my bank manager would have made a cut of $0.20 per £1; giving my bank a profit of $100,000.

I’m now paying £550,000 for my currency. That’s more than the £500,000 it would have cost me without the agreement, so essentially I’m paying £50,000 for the service of being able to “lock in” my exchange rate for a year. But because I believe the pound will fall in value, I don’t mind. If I could predicted a fall to $1.5 per £1, I would have known my costs would rise to £660,000. So I predict that agreeing a rate for my currency in advance would save me £110,000, in addition to giving a more stable cashflow.

What I’ve just described is an “exchange rate derivative” (or a future). The activity is known as hedging.

Hedge Funds

In amidst the credit crisis, hedging has a bad name and reputation. Imagine my company is publicly floated on the stock market at the price of £2 per share. However, a hedge fund believes that my company is overvalued or expects sales to be poor in the next quarter. The hedge fund makes an agreement with somebody (e.g. a bank) that it will sell shares in my company at the price of £1.80 in one years time. So my bank manager is sitting there and thinking: great! I’m getting a £2 share for the price of £1.80… a profit of 20p instantly! If shares in my company then fell to £1.50, the hedge fund makes a profit of 30p by offloading something worth £1.50 for £1.80.

Creative Commons License photo: Alex // Berlin _ as+photography

But here is the moral issue. A hedge fund is making a profit out of the fact that my company is doing badly. In fact, the worse my profits are and the more people I have to make redundant, the more money the hedge fund will make. Isn’t this profiting from somebody elses misery?

I hope the similarities between the currency hedge and the company hedge are fairly obvious. Hedge funds make a profit out of the fact that my widget company performs badly. My widget company makes a profit out of the fact that the British economy is doing badly.

But whilst there may be a debate to be had over the morals of short selling, it isn’t in doubt that hedging can serve a positive purpose. My friend, who no longer has enough money to complete the gap year she had been planning for a long time, could have avoided being in the situation she is currently in by hedging the Pound. She would have had the knowledge that whatever happened to the British economy and the British Pound, her costs would always be the same. If the Pound fell, she would have made a profit. If the Pound later rose, she would have paid well over the odds for her gap year. But at least the cost of the gap year would be fully known and the risks from currency fluctuates eliminated.

UK cuts VAT to 15%

A Cookie Crumbles
Creative Commons License photo: CarbonNYC

Everybody who lives in the UK should read about the “exceptional” pre-budget report this year. There are some big tax changes which probably affect you. To sum it up, there is a new 45% band of income tax; VAT is falling to 15% for 13 months; excise duties on alcohol, tobacco and petrol are rising.

I wrote about the possibility of VAT cuts two weeks ago. Given VAT is falling from 17.5% to 15%, we should see a fall in the price of goods by 2% from Monday, assuming that the full VAT cut is passed on. In my previous article, I discussed whether retailers are likely to absorb the VAT cuts as extra profit, pass it on as-is or perhaps even cut prices by even more than 2%.

Worth keeping an eye on anyway and not making any big purchases of electronics or gadgets quite yet until we see how retailers are going to react.

For full details, see the government’s full pre-budget report, “Facing global challenges: Supporting people through difficult times”.

How will UK VAT cuts save you money?

Creative Commons License photo: Phillip

There has been a lot of discussion in the UK lately about a possible cut in Value Added Tax from 17.5% to 12.5%. I’m not sure how likely it is that this will happen – the radio news seems to believe it is inevitable but many other news organisations seem to disagree.

A cut in VAT from 17.5% to 12.5% could lead to big discounts on every item sold in the UK. The savings can be fairly substantial – £26 off an iPhone PAYG or £72 on a £1,000 plasma TV. However, it would depend on how and whether those cuts were passed onto the consumer.

Retailers could leave prices unchanged. Imagining a £100 product, £17.50 would have previously gone towards the UK government. After the VAT cuts, the government would only take a cut of £12.50 leaving the retailer with an extra profit of £5 per unit.

Look K-mart is having a sale!
Creative Commons License photo: Cosmic Kitty

Retailers can increase their turnover at a time where their costs may be rising but they cannot afford to raise prices for fear of losing customers. But perhaps with retailers knowing that Christmas is coming up, people would buy their product without an additional discount. Hence there would be no need to pass on the VAT cut.

Retailers could pass on part or all of the VAT cut. If the entire VAT cut was passed onto the consumer, the £100 product would now cost £92.81. The retailer makes the exact same amount of money they did before; but its great news for the consumer as consumers save a lot of money. In a time when peoples disposable income levels are falling, this increase in demand could ensure retailers get the sales they need.

Retailers could discount prices by even more. The retailer may want to cut the price of the product from £100 to £90. However, that might not be too attractive to them – it represents a loss of £10 for every product sold. However, given that the government is absorbing so much of the price cut themselves this may make it a lot more attractive for retailers to cut their prices.

Warp Speed Ahead
Creative Commons License photo: Olaf

So how does this affect you? I personally believe that if Mr Darling did cut VAT, it would take several weeks, even months for that to filter through to the prices that we pay at the shop every day. Companies have price promises to honour; companies have catalogues which cannot be reprinted immediately, etc. And with Christmas coming up, consumer spending should hopefully pick up anyway. So we would be unlikely to see any big price cuts this year.

However, New Year 2009 could be a bumper one for new year sales. If Christmas sales figures aren’t as high as retailers expect, I believe retailers could offer much bigger discounts than in past years.

If there are some big purchases you were planning to make, it may well be worth waiting until after the pre-budget report and possibly the new year.

Free Delivery on – Charges Scrapped

Creative Commons License photo: joiseyshowaa

In a move which should improve price transparency, Amazon has essentially scrapped the delivery charge on its website.

To qualify for free super saver delivery, you now only need to spend £5 rather than £15. Given very few things cost under £5, this isn’t a tough feat! For orders under £5, you’ll still have to pay a delivery charge which is likely to dwarf the cost of your purchase. One book costs £2.75+VAT to ship and an electronic item £5.88+VAT to ship. In most cases, you will find it cheaper to buy a really cheap item in order to get your order up to £5 to avoid paying delivery. Use the Filler Item Finder for this. For example take a pack of 8 Duracell AA batteries for £3, or get a cheap kids book for 60p which you can recycle or use as a stocking filler.

I hate hidden prices online so I think it’s a fantastic move. A few weeks back, a company tried to charge me P&P for a ticket. Fair enough you might say but I think it was £1 for an e-ticket (because it actually costs them £1 to send an email!) or £1.65 to pick it up from the box office in person (because they pay their box office staff about £1.65 per half minute). Ebay has a certain problem with really cheap items with extortionate shipping fees. In some ways, Amazon Marketplace has had the same issue in the past… I remember buying an SD card for about £1.50 and paying £4.50 for P&P. Anyway, great news.

Going to London

I’m moving to London tommorow morning 🙂 I’m leaving the countryside for the city so the pace of life will be totally different! And I’ve got a whole van load of stuff to move!

It’s especially exciting going to London with it being one of the most populous places in the world and with so much to do, and things to cater to every taste. London being the Olympic City is an extra bonus; I can’t wait for London 2012 and I’ve already applied to work or volunteer there for a bit!

Anyway, it might take me a while to get settled in so if things so quiet on this blog or you don’t hear back from me via e-mail – you know why!

Music Festival Rip-Off?

Creative Commons License photo: burge5000

I’m going to Reading Festival this weekend which 80,000 music fans are expected to attend. It’s my second music festival and I can’t wait! Reading Festival certainly isn’t cheap. For many teenagers of my age with only part-time jobs, the cost of Reading Festival (£155 + p&p, other spending) is at least a whole months wages. £155 could buy a lot else. So are music festivals a big rip off? Well, obviously it’s a personal and a subjective opinion. I’d argue that at £155, it’s great value. Here’s why.

Two facts: Tickets for Reading Festival sold out very quickly – less than two hours. Tickets on the black market (eBay) have gone as high as £300 each. A friend of mine was offered £500 for his ticket.

As an economist, this indicates to me that, in fact, music festival tickets are under priced. In economics, we have something which is called the equilibrium price. This is the price for which supply equals demand. For example, if 80,000 people want a ticket at a price and 80,000 tickets are available at that price, the market is said to be in equilibrium.

Carling Leeds Festival 2004
Creative Commons License photo: Ian Wilson

In the case of Reading Festival, it is obvious that at the price of £155, more people want tickets than the number of tickets which are available. So the organisers could increase the price of a ticket and still sell out to capacity.

Why is that a problem? Surely the fact that tickets are “too cheap” is good news for festival goers such as you and I. We’re saving money after all aren’t we? Kind of.

Firstly, it’s a waste of everybody’s time to queue up overnight for tickets, or to have to keep refreshing a website to buy them.

Secondly, there is the problem of the black market. People are buying tickets for £155 and selling them on the black market (i.e. eBay) for double that. That means £150 of profit has gone towards a ticket tout, who has served no useful purpose at all, as opposed to towards the organisers who could put the money into improving the festival for everyone.

Roskilde Festival 2004 - Det første indtryk
Creative Commons License photo: Stig Nygaard

The black market is also a dangerous and difficult place to deal. Many fans bought tickets on unofficial sites such as SOS Tickets and never received them. They’re now disappointed they can’t go and may have difficulty in getting their money back. And the sole reason why people had to turn to the black market in the first place is because they can’t get them from legitimate agents, so it’s as a direct result of below equilibrium prices.

There are several reasons why Reading festival may have been under priced. It’s possible that the organisers wanted publicity from queues outside stores, and being able to announce that it sold out within 2 hours on the news headlines. Or they simply didn’t expect demand to be so high.

Reading Festival tickets are cheaper than they should be. For the lucky ones amongst us who were at the front of the line to get tickets, that’s great news – we’re getting a bargain. But for everyone else, it’s bad news. It leads to a secondary market, and that’s a recipe for being ripped off, scammed and paying vastly over-the-odd sums: most of which doesn’t even go to the festival organisers.

THINK! Driving Challenge

I received an e-mail from the team at AMV BBDO about the THINK! Driving Challenge which I wanted to share with all of you.

It is a website which demonstrates just how difficult it is to talk on the mobile phone whilst driving: an issue which is quite close to my heart. Last year I was crossing at a crossroads: opposite was a stationary car. The driver was obviously distracted for some reason and moved off harshly whilst we were crossing. Thankfully she stopped the car a few inches before she knocked us out.

Anyway, give it a go before you proceed any further down the post so it’s not spoilt for you!

DfT Driving Challenge

Nicola Davies writes:

Just over a year on from the introduction of the tough new penalty of three penalty points and a £60 fine for using a mobile phone whilst driving, the Driving Challenge directly builds upon a film made by the University of Illinois 10 years ago which demonstrates the psychological principle of ‘inattentional blindness’.

I wrote about a gorilla/basketball video several years ago which demonstrated this inattentional blindness.


Client: Department for Transport
Agency: AMV BBDO
Creative: Gary Hoff, Stuart Woodall, Sean Vrabel
Account Management: Kate Gault, Giovanna Cucchi, Olivia Browne
Digital Producer: Nicola Davies
Web Production: iCG
Film Production: Brick and Pin
Director: Richard Topping
Exposure: Online

£100,000 – the real cost of going to university

nature x2
Creative Commons License photo: B a m s h a d

As a student currently embarking on a university degree, I’m looking forward to the freedom university will offer and meeting a whole bunch of new people from across the world. But one major worry is the finance: the cost of going to university.

Many people only look at tuition fees when they think about going to university. In the UK, university tuition is roughly £3,000 a year. For a 4 year masters degree course, this adds up to £12,000.

Tuition Fees: £12,000


But there’s the cost of accommodation, which is typically at least as large as the tuition costs. The cost of accommodation varies. In some of the larger cities, a room will typically cost £120/week. In some smaller town universities, £80/week might be closer to the norm. A 40-week let on university accommodation will set you back £4,000 a year. However, in later years of university, most students will live outside of university halls and this will be more expensive. Assuming an average accommodation cost of £4,500 per year, this adds up to £18,000 over a 4 year degree course.

Accommodation Cost: £18,000


sheffield, hidden sunrise
Creative Commons License photo: paolo màrgari

There is a much bigger cost which most people don’t even think about. Because studying at university and getting a full-time job are mutually exclusive options, by choosing to go to university you are actually saying “I will not be going to work” as well as “I will be going to university”. Economists call this the opportunity cost.

By choosing to study at university, you are foregoing 4 years of salary which you would have earnt otherwise. The typical starting salary for somebody leaving school with A-Levels but no university degree is £15,000 a year. By working, you’d potentially have earnt £60,000.

Opportunity Cost: £60,000


The other significant cost which needs to be considered is housing. Over the last few years, house prices in the UK have been rising by about 10% a year. What this means is that a house which will cost £100,000 today will cost £110,000 this time next year. Leaving university with £30,000 of debt and without £60,000 of salary means that university graduates must wait even longer before they can put together a deposit and get a foot on the housing ladder. On top of that, graduates may have to take out a larger mortgage on their first home because they cannot make a large upfront payment. Obviously, the appreciation in housing value depends on market conditions, but I think £10,000 is a reasonable ballpark estimate.

Housing Appreciation Cost: £10,000


So to sum it all up, when we take in all the costs of university:

£3,000 a year for tuition X 4 years = £12,000
£4,500 a year for accommodation X 4 years = £18,000
Direct Financial Costs: £30,000

£15,000 a year could have earnt in basic non-graduate job X 4 years = £60,000
Opportunity Cost: £60,000

House price rise in the additional time you must wait before buying = £10,000 (obviously this depends on whether house prices are rising)
Housing Appreciation Cost: £10,000

Total Cost of going to university: £100,000

It’s pretty depressing reading. University is a very, very expensive enterprise. It’s easy to see from these calculations why so many lower income families find it very difficult to send their children to university.

Flying Caps
Creative Commons License photo: Thiru Murugan

But I think it also calls into question whether it’s worth going to university to study certain degrees. According to the government’s graduate prospects website, graduates in humanities earn £51,549 more in their lifetime and graduates in arts earn £34,949 more. Are the real costs of going to university greater than the benefits?

On average for all degree courses, those who graduate from university earn on average £160,000 more over their lifetime. This would still seem to indicate that going to university is good value for money. But the net benefit is probably less than people would think.

I really don’t want to put anybody off studying at university and I don’t think money should ever stop anybody from pursuing their dreams. But what is true is that going to university is an extremely expensive enterprise these days and students may be getting a bit of a raw deal.

The Problem with Fuel Taxes and Road Pricing

8th Ave .....Midtown Manhattan
Creative Commons License photo: 708718

Congestion and pollution are two “external costs to society” which are associated with driving. When you take your car out of the garage and take a trip down to the local supermarket or pick up the kids from school, you are imposing costs on other people: exhaust fumes which others must breathe and you take up space on the road contributing to traffic jams.

To correct for social costs, governments use taxes to make sure the individual pays for the costs they impose on society or to “internalise the external costs”. There are three taxes which are used to try and discourage driving:

  • VAT on Buying a Car
  • Road Tax
  • Fuel Tax

People hate taxes. People remark that death and taxes are the only two certain things in life and I think that fuel tax is one of the most hated (in the UK, fuel tax is 64p for every litre). The government argue that this fuel tax is to correct for “external costs” but I will argue that the fuel taxes is unfair and are targeting the wrong people.

The Costs of Driving

Comings & Goings
Creative Commons License photo: Pro-Zak

Urban motorists impose greater external costs on society. City roads are full to their capacity and that means traffic jams everywhere. An extra car on the road is only going to make it worse. Congestion wastes everybody’s time. Secondly, population density is so much higher in cities meaning that the exhaust fumes produced will affect a lot more people. And not to mention noise pollution…

In contrast, rural roads are much quieter and less congested. Because there is so much spare capacity on the roads, an extra car on a rural road isn’t really going to add to congestion or effect anybody else. And although exhaust fumes are still emitted and noise pollution is still produced, it effects a lot less people: there are less people for it to affect.

So the external costs imposed by drivers in cities are greater than the external costs imposed by drivers in the country.

The effects of taxes

Beijing smog
Creative Commons License photo: kevindooley

When you buy a car, you pay value added tax on the vehicle. To keep the car on the road, you must also pay road tax. Both of these taxes will discourage people to own a car because they increase the cost of owning one. But once you own a car and it’s licensed to drive on the road, these taxes will play no part in your decision about whether to use the car to drive to work or not: whether you use it or not you’ve already paid the tax. And whether you live in the city or the country you pay the same amount of VAT and road tax.

The other tax is fuel tax. This affects people’s decision on whether to drive to work or school. If it costs £2 to drive to work you might choose to do it every day but if it cost £8 you’d probably only drive if it was raining or for some reason the trains weren’t operating.

As I’ve mentioned, the external costs of urban driving are greater. So a fair tax which “internalises external costs” should penalise urban drivers more. But the taxes on urban driving are actually lower than taxes on rural driving. Places in the city are situated much closer to each another and so less fuel is needed to drive between them. As the amount of tax paid is directly linked to the amount of petrol used, this means urban motorists are paying less tax than rural motorists. This is unfair.

Is it essential to drive?

Il terzo occhio
Creative Commons License photo: fabbio

Another factor that economists must consider is “how necessary is it to drive?”

In the city, there are a huge range of alternatives to driving. In London, there is a flat rate 90p charge on all bus journeys, where ever in London you go. Buses are also very frequent: you shouldn’t have to wait any more than 10 minutes. I’ve found that I rarely have to wait more than a few minutes.

When I’m in the country, it often costs £3 for a single bus journey and the bus only comes once an hour or sometimes even every 2 hours. And there is about a 20 minute window for the time that the bus arrives.

In the city, everything is also much closer to each another. That makes cycling or walking a much more viable option.

So in the country there is often no choice except from to drive because everything is so far away from each another and there are no viable public transport options. In these areas, motorists must pay extortionate amount of taxes. Meanwhile urban city drivers, with the luxury of viable alternatives such as the bus, escape with lower amounts of tax. I think this is the fundamental unfairness of fuel tax.

Solving the problem

Sam Houston Tollway
Creative Commons License photo: billjacobus1

The problem is that fuel tax penalises the wrong people. The solution is to tax urban drivers more to account for the greater amount of “external costs” they impose by driving.

In London we also have the congestion charge zone (£8 to enter Central London per day) and the low emission zone (£200 per day for heavy polluting vehicles to enter London). I think this somewhat solves the issue but it’s only restricted to London.

A few years ago the Labour government floated plans for a national road charging scheme.

Motorists will receive regular bills, possibly monthly, charged at variable rates by time and geography: rural country lanes would likely be charged at the bottom of the range, around 2p a mile, with inner city rush hour roads attracting the top £1.30 rate. The government hopes motorists will change their driving habits – by staggering journeys, sharing cars or switching to public transport – to the extent that there could be a 50% cut in congestion.

From a point of view of an economist, I feel that this is the perfect solution to the problem. It would reduce congestion which would lead to time savings for everybody and stop country motorists from being unfairly penalised.

In 2007, 1.7 million people signed a petition against the national road charging scheme. The idea seems to have fallen from the agenda. Because of the inherent unfairness in fuel taxation, I hope the government will reconsider a national road charging scheme.

Gordon Brown wants Apprentice-style TV reality show

Gordon Brown - World Economic Forum Annual Meeting Davos 2007
Creative Commons License photo: World Economic Forum

In what must be the strangest news I’ve heard in a while, British Prime Minister Gordon Brown wants to star in his own Apprentice-style TV reality show

The email from producer Margaret McCabe pitched the show, which would feature aspiring politicians as contestants, as being targeted for the “Apprentice meets Maria/Strictly Come Dancing audience”.

The memo added that the show was “not stunt TV” and as a judge, Brown could become “more popular than Alan Sugar”.

A spokesman for Blears confirmed that a reality show was in the works: “It is a very worthy programme idea. These young people would engage and have some kind of competition, and then there would be a way of electing a young prime minister for a day.

“The idea is to get more young people interested in politics. But it hasn’t been commissioned yet. It is very early days.”

It has been documented before that Gordon Brown is a big fan of the X Factor.

I think it’s interesting how Gordon Brown is such an unpopular prime minister that he now feels like he needs to be a judge in a television reality show. There will of course be worries that this show could cheapen politics. I can’t remember whether it was just an idea which was floated or an idea which actually happened in some country, but people talked about having a reality show to determine a candidate who would stand for Member of Parliament. Of course, the problem is the winner of the show has had an unfair amount of publicity and would probably easily win election based on the fact they were once on TV, regardless of whether their politics were actually any good.

Anyway, the “Junior PM” project is still in the very early days so it’ll be interesting to see whether it gets any further.