Exchange Rates

An exchange rate is the value of one currency in terms of another currency. For example, if the exchange rate is £1 = $1.25, this means one pound can be exchanged for one dollar and twenty-five cents.

Exchange rates matter to businesses because many firms trade internationally. A business may import raw materials, buy components from overseas suppliers, export finished goods, own overseas stores or receive revenue in a foreign currency. Exchange-rate changes can therefore affect costs, prices, revenue, profit margins and competitiveness.

Appreciation means a currency rises in value against another currency. If the pound appreciates, one pound buys more foreign currency than before. For example, if the exchange rate changes from £1 = $1.20 to £1 = $1.35, the pound has strengthened against the dollar.

Depreciation means a currency falls in value against another currency. If the pound depreciates, one pound buys less foreign currency than before. For example, if the exchange rate changes from £1 = $1.20 to £1 = $1.10, the pound has weakened against the dollar.

A useful exam rule is SPICED: Strong Pound Imports Cheaper, Exports Dearer. If the pound appreciates, UK businesses may find imported materials, components or finished goods cheaper. This can reduce costs for importers. However, UK exports become more expensive for overseas customers if prices are kept in pounds, which may reduce demand.

The opposite is WPIDEC: Weak Pound Imports Dearer, Exports Cheaper. If the pound depreciates, UK exports become cheaper for overseas customers if prices are kept in pounds. This may increase export demand and improve competitiveness. However, imported materials, components and finished goods become more expensive, which can raise costs.

Exchange-rate changes affect exporters and importers differently. An exporter may benefit from a weaker pound because overseas customers can buy the product more cheaply in their own currency. This could increase sales volume, revenue and market share. However, if the exporter relies on imported components, the benefit may be reduced because its costs also rise.

An importer may benefit from a stronger pound because imported goods or materials become cheaper in sterling terms. This can reduce costs and may allow the business to lower prices or improve profit margins. However, a weaker pound can increase import costs and put pressure on margins.

The impact of exchange-rate changes depends on price elasticity of demand. If demand is price elastic, a price change caused by exchange rates may have a large effect on sales volume. If demand is price inelastic, customers may continue buying even if prices rise, meaning the effect on sales may be smaller.

The impact also depends on contracts. Some businesses agree fixed prices with suppliers or customers months in advance. This may delay the effect of exchange-rate changes. Other businesses may use hedging, such as forward contracts, to reduce uncertainty by agreeing an exchange rate in advance.

Exchange rates can also affect multinational corporations. A multinational may earn revenue in one currency but report profit in another. Currency movements can therefore affect reported revenue and profit when overseas earnings are converted back into the home currency.

Businesses can respond to exchange-rate changes in several ways. They may adjust prices, change suppliers, source more locally, use forward contracts, invoice in their own currency, hold foreign currency accounts or move production closer to major overseas markets.

Overall, exchange-rate changes create winners and losers. The same currency movement can benefit one business and harm another. Strong exam answers should always identify whether the business is mainly an importer, exporter or multinational, then judge how exchange-rate changes affect costs, prices, demand, margins and competitiveness.