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CFM12030 | Understanding corporate finance: foreign exchange: why exchange rates matter

From HM Revenue & Customs · Corporate Finance Manual

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.