Exchange Rates or Foreign Exchange work on the basis of pairs; showing the value of one currency in relation to another currency. You will often hear the pound is getting stronger or getting weaker. The strength of it is meant in relation to its purchasing power.
Let’s say last year the £1 enabled you to buy $1.50. This year £1 enables you to buy $1.80 – the pound has clearly gained in strength as it is enabling you to buy more of a different currency.
Impact of Exchange rates on investing
When it comes to Investing, the Exchange Rate is important. Should the pound depreciate, it could mean that businesses will struggle with increased costs when it come to importing materials from abroad that are priced in other currencies such as the Euro or US Dollar. This will impact their bottom-line or profits and potentially the Share Price.
With the Brexit vote, the FTSE 100 was initially very volatile, but soon settled down as it was realised that many of the firms on the London Stock Exchange would actually benefit from a weaking of the Pound. This is because many of the firms were actually global, generating more revenues in countries such as the US – when US earnings were converted into pounds, they actually got more for their money (as the pound was weak).
Besides the impact Exchange Rates have on the costs of a business and its earnings, it can also have a more direct impact on you if you are investing in US shares. If you are buying US shares as a UK investor, your Online Broker will subject you to a Foreign Exchange fee as you will need to pay for the shares in US Dollars. If the pound is weak, you will get less shares for your money in a US company than if the pound was strong.
Numerous factors affect the strength of a currency – however entities such as the Bank of England can try to influence it (although they do not control it). For example if they increase the Bank Rate of interest, it is logical that the demand for pounds will increase, thus boosting the value of the currency. Likewise, by ensuring a healthy and stable Economy is usually associated with a strong currency.