CFM7012 - Understanding foreign exchange: exchange rates
Why exchange rates matter
British holidaymakers travelling to the US hope that sterling
strengthens against the US dollar. They will then get more dollars
for each pound sterling they exchange, and will be able to buy more
goods in the US.
On the other hand, someone seeking to sell dollars and buy
sterling will hope that sterling weakens against the dollar. The US
dollars that he or she holds will then become more valuable in
sterling terms. For example in 1999 the dollar strengthened against
sterling. At 1 January 1999 the exchange rate was $1.6638 =
£1. At 31 December 1999 the rate was $1.6117 = £1. $1,000
could be exchanged for £601 at the beginning of the year but
the same amount of dollars could be exchanged for £620 at the
year end.
Exactly the same principle applies to companies. If sterling
strengthens against a particular foreign currency – say the
US dollar – the company will get more foreign currency for
each pound sterling, in other words each £1 sterling is worth
more in US dollar terms.
Suppose that the company is exporting mackintoshes to the US.
It sells the mackintoshes to a US retailer for £75 each. But
if sterling strengthens against the US dollar, that £75 is
worth more in terms of US dollars. The retailer may increase the
price charged to the end customer, so that fewer mackintoshes are
sold; or they may pressure the UK company to lower its price, thus
squeezing the UK supplier’s profit margin; or they may cancel
the order entirely. In any event, the UK company’s
competitiveness in the US market is reduced.
Moreover, if sterling strengthens against the dollar, any
mackintoshes imported from the US into the UK will be cheaper in
sterling terms. So the UK company is also likely to face increased
competition in the domestic market.
If sterling weakens against the US dollar, the effects are
reversed. The competitiveness of exports to the US increases, while
imports from countries using the US dollar become less attractive.
The diagram below illustrates this:
