Understanding exchange rates can be frustrating, and knowing when you’ve got a good rate even more so, with rates changing on a dime. The reality is that there are multiple calculations taking place, and the real effective exchange rate (REER) is calculated as the weighted average value of a basket of goods compared to what that same basket would cost in another country.
The real exchange rate calculation looks like this:
- REER = CERn x CERn x CERn x 100
But there is much more to understand when it comes to exchange rates than just looking at a formula, so we’ll dive deeper into the details.
If you spend any amount of time transferring money overseas or investing in high-yield savings, knowing how exchange rates are worked out can be a powerful way to make sound judgments about your investment portfolio.
In this article, we’ll run through the alternative calculation methods, what they mean, and how you can harness that information to make better choices when transferring currencies across borders.
Why are There Different Currency Exchange Rate Calculations?
The topic of exchange rates can be as complex or as simple as we want to make it. You might come across multiple different methods:
- Nominal exchange rates: The currency you can purchase in one denomination in exchange for another.
- Real exchange rates: The actual purchasing power of that currency, concerning other exchange rates and pricing.This is known as the REER or Real Effective Exchange Rate.
- Multilateral exchange rates: The value of a currency against multiple others, which is achieved through indexing the variations in the average value of a basket of goods.
- Trade weighted exchange rates: A tool used by countries to measure their Real Effective Exchange Rate (REER).
- Spot exchange rates: The price quoted to buy one currency and sell another at a fixed date, or on an “as soon as possible” basis.
While the factors impacting currency valuations are based on high-level macroeconomics, knowing how to calculate real exchange rate values is the most relevant, given that this is the only reliable way to evaluate how a currency is performing against many others.
What is the Exact Calculation to Find the Real Exchange Rate?
As we’ve seen, there are several calculations used to assess the performance of a currency. The real exchange rate calculation works like this:
- REER = CERn x CERn x CERn x 100
CER stands for the Country Exchange Rate, and the way you find it is:
- Take the average bilateral exchange rates between the currency you wish to calculate the REER for and weigh it against the respective trade allocation with that trading partner.
- Each exchange rate must be weighted; for example, a rating to the power of 0.60 applies to a currency with a 60% weighting. This applies to each CER in the calculation.
- Multiply each weighted exchange rate by the next, and then multiply that final total by 100 to create your index.
You can use either bilateral exchange rates or real exchange rates, which will reflect adjustments for inflation.
Another calculation method takes the nominal exchange rate and compares it to foreign prices over domestic prices to arrive at a similar result, i.e.:
Real Exchange Rate = Nominal Exchange Rate x (Foreign Prices/Domestic Prices).
Using averages and weightings ensures that either method creates a fair basis.
How are Real Exchange Rates Used in the Foregin Exchange Market?
Every time you transfer a currency, request an FX trade, or purchase stocks in a different country, you’re quoted an exchange rate. That won’t be a “market” rate or the rate at which the transfer provider is buying or selling the currency, but the exchange rate they will apply to your transaction.
It’s normal for this to be bumped up a little, but it’s equally important to know if you’re paying a reasonable rate or whether the provider is pitching it too high. Conversely, they could be offering a rate that looks too good to be true, and making up for it with excessive processing fees or account management costs.
REER tells us the value of the currency we’re analyzing in respect of an average of the other major currencies in circulation. These figures are vital for serious traders, who will be able to use the REER, and how it is changing, to look at factors such as:
- How stable the currency is or whether severe fluctuations are expected.
- The underlying trade factors and whether forthcoming changes in trade volumes, exports, or tariffs are likely to impact the exchange rates.
- Underlying circumstances contributing to currency values, such as competition and technological advances.
For example, if you were to analyze the US dollar rate and see it weaken against the Euro, you would know that US exports to the region are about to become cheaper — meaning a trade opportunity has opened up.
EU businesses buying dollars to invest in exports would find that they can purchase more dollars per Euro due to the changes in the rates. That means their purchasing power instantly increases, making US products cheaper on the consumer market. This brief example illustrates the power of the REER and why it’s such a vital factor in assessing international trade capabilities and market performance.
Who Needs to Be Able to Calculate the Real Exchange Rate?
Understanding the science behind exchange rates is a compelling asset to have when trading on the currency markets, investing in currencies, or practicing trading strategies to test the waters. Exchange rates quoted for transfers are based on calculations, estimates, and speculation as to economic performance and demand for the country’s currency, goods, and services. So while economics relies on indexes and formulas, this remains an inexact science, vulnerable to unexpected circumstances.
Nominal exchange rates are helpful in buying products in a foreign currency or budgeting for an expense. Still, they can’t provide more in-depth analyses such as a comparison of living standards or a forecasting and indexing tool to track a currency’s performance. The REER can help to measure:
- Consumer and production prices
- Export prices
- GDP fluctuations
Increases in the REER result generally increase net imports, and they are a vital indicator of ongoing growth or contraction and essential information for investors and foreign currency traders.
Can I Use the Real Exchange Rate to Improve Currency Investment Performance?
You can indeed! Exchange rates impact economies profoundly and can be a prime piece of data that influence global trading decisions. Exchange rates directly impact investment performance and factors such as interest rates and national inflation, reach every sector of the economy – from property values, to export rates, the volume of imports, and even employment opportunities. Knowing how the REER works and what it means can make a substantial difference to currency trading opportunities and moving quickly when it counts. If you’re looking to exchange currencies with Cashero, you will have all the information you need to decide whether that exchange is right for you (and likely it will be).
Content Disclaimer:
As of the date of publication, the information contained on this page is deemed to be factually accurate for all terms of conditions, features, and fees. Changes made to Cashero’s terms of conditions, features, or fees after the publication of this content may not be accounted for.
App Disclaimer:
The Cashero App is now available for download in both the Apple App Store and Google Play Store, though not all features are currently functional. Cashero has not yet officially launched.
