Exchange Rates and Global Competitiveness (9BS0 4.2.5)
Exchange rate movements change prices, costs and profits for any business trading across borders. You must be able to calculate currency conversions, apply SPICED, and assess how appreciation and depreciation affect exporters, importers and multinationals.
How exchange rates work
An exchange rate is the price of one currency in another. If £1 = $1.27, a UK exporter's £250 product costs an American buyer 250 x 1.27 = $317.50.
The mnemonic SPICED — Strong Pound, Imports Cheaper, Exports Dearer — summarises the effects. If the pound strengthens to £1 = $1.35, the same product now costs 250 x 1.35 = $337.50, a rise of $20 with no change in the UK price. American demand will likely fall, especially where rivals offer substitutes.
Depreciation reverses this: a weaker pound makes UK exports cheaper abroad and imports dearer at home. Rates float with interest rates, inflation differences, trade flows and market confidence, which is why they move daily and why internationally trading firms watch them constantly.
Winners and losers from currency movements
Effects depend on a firm's trading position.
| Situation | Strong pound | Weak pound |
|---|---|---|
| UK exporter | Loses price competitiveness abroad | Gains competitiveness or margin |
| UK importer of materials | Input costs fall | Input costs rise |
| UK firm with US revenues | Dollar earnings convert to fewer pounds | Dollar earnings worth more in pounds |
Real examples: easyJet buys aircraft fuel priced in dollars, so a weak pound inflates its costs. JD Sports, after its 2024 Hibbett takeover, earns a large share of revenue in dollars — those earnings translate into more pounds when sterling is weak and fewer when it is strong. Many exporters both import inputs and export outputs, so the net effect depends on which side dominates; a car plant importing components and exporting vehicles may find the effects partially cancel.
Managing exchange-rate risk
Businesses cannot control rates but can manage exposure. Hedging with forward contracts locks in today's rate for future transactions, buying certainty at the cost of missing favourable moves. Natural hedging matches currency inflows and outflows — earning dollars and paying dollar costs — so movements offset internally, one reason firms produce inside their major markets. Pricing strategies help too: invoicing in sterling shifts risk to the customer, while premium differentiation reduces price sensitivity, insulating demand when a strong pound raises foreign prices.
For evaluation, weigh significance against other factors. Exchange-rate effects are often temporary and two-directional, while quality, brand and productivity determine competitiveness durably. A firm like Dyson competing on technology suffers less from a strong pound than a commodity exporter competing purely on price. The elasticity of demand for the product is the analytical key: the more price-sensitive the market, the more exchange rates matter.
Key terms
Practice questions
Using the data, calculate the change in the dollar price of a £250 UK export if the exchange rate moves from £1 = $1.27 to £1 = $1.35. You are advised to show your working. [4 marks]
Model answer guidance: At £1 = $1.27: 250 x 1.27 = $317.50. At £1 = $1.35: 250 x 1.35 = $337.50. The dollar price rises by $20.00, about 6.3%, even though the sterling price is unchanged. The stronger pound makes the export dearer for American buyers, which is likely to reduce demand where substitutes exist.
Explain one benefit to a UK importer of an appreciation of the pound. [4 marks]
Model answer guidance: A stronger pound buys more foreign currency, so imported goods and materials cost less in sterling. An importer of US-priced components sees input costs fall without any negotiation, widening margins or allowing lower prices. For example, at $1.35 rather than $1.27 per pound, every dollar of imports costs about 6% less in sterling. This benefit is immediate, though it lasts only while the pound stays strong.
Discuss the possible effects of a sustained depreciation of the pound on a UK retailer that imports most of its stock. [8 marks]
Model answer guidance: A weaker pound raises the sterling cost of imported stock, squeezing gross margins. The retailer must absorb the cost, cutting profit; raise prices, risking volume in a price-sensitive market; or switch to domestic suppliers, who may be dearer or lack capacity. Hedging can delay but not permanently avoid the impact once contracts roll over. On the other hand, if the retailer also sells online to overseas customers, its prices become more attractive abroad. The overall effect is negative for import-heavy retailers, with severity depending on elasticity and competitor exposure.
Assess whether hedging is worthwhile for a medium-sized UK exporter that invoices customers in dollars. [10 marks]
Model answer guidance: Hedging with forward contracts converts unpredictable dollar receipts into known sterling amounts, protecting margins on contracts often signed months before payment. For a medium-sized firm without deep reserves, one adverse swing could wipe out a year's profit, so certainty has real value for planning and pricing. However, hedging has costs: fees, management time, and the loss of gains when the pound falls; badly judged hedges can even lock in poor rates. Hedging most of the exposure while leaving some unhedged balances protection and opportunity. For a firm whose margins are thin and dollar revenues large, hedging is clearly worthwhile; the case weakens as exposure shrinks.
Evaluate the importance of exchange rates compared with other factors in determining the global competitiveness of UK businesses. (20) [20 marks]
Model answer guidance: Exchange rates matter visibly: a move from $1.27 to $1.35 raises a £250 export's price by $20, and for price-sensitive commodity products such swings decide orders — while import-cost effects hit margins across retail and manufacturing, as dollar fuel costs do for airlines. However, rates move in both directions and firms can hedge, price in sterling or build natural hedges, so currency is a manageable, often temporary influence. Durable competitiveness rests on productivity, innovation, quality and brand: Dyson and premium drinks brands hold global positions through differentiation that a strong pound dents but does not destroy, whereas no favourable rate rescues an uncompetitive product for long. The judgement therefore depends on the product's price elasticity: for undifferentiated exporters, rates rank among the top determinants; for differentiated firms they are a second-order factor. Overall, exchange rates shape short-run performance, but sustained competitiveness is earned through factors firms control.
Examiner tips
- Write SPICED at the top of your plan for any currency question, then state which side of it applies to the firm in the case.
- Show conversion working in full: amount x rate, both scenarios, then the difference — each step can carry a mark.
- Link exchange-rate impact to price elasticity of demand for top-band analysis: elastic demand makes currency moves matter more.
In The Business School simulation your students make these exact decisions in a live market against rival firms — every choice mapped to the specification. Free teacher demo, no installs, students join with a PIN.