The real exchange rate (and how you can get it)

There are many reasons why you might be wondering about the real exchange rate. Maybe you’re looking to send money overseas, to a friend or family member, or perhaps you’re an entrepreneur making a payment, or being paid in a currency other than your own. Or maybe you’re just looking for answers to your economics homework.

Either way, you want to make sure you know what the real exchange rate is. And, if you’re sending money overseas, then Wise might be able to help you make sure you get the fairest deal, with the real exchange rate and no nasty hidden fees. More on that later.

Here’s what you’ll find covered:

• The definition of exchange rate (buy, sell, and spread, too)
• Defining the real exchange rate (in real life)
• How you can get the real exchange rate when you transfer money
• The factors that play a role in a nation’s currency price
• How you can calculate the real exchange rate yourself
• RER vs REER vs NEER for those of you doing your homework

Let’s start at the beginning. What exactly is the real exchange rate, anyway?

Exchange rate definitions: what you should know

If you’re looking at a currency conversion chart at your local bank, or online, you’ll notice there are 2 or more different rates shown for each currency pairing. The most common — and useful — exchange rates are usually marked up as the buy rate and the sell rate.

Sell rates

The sell rate is the rate that the bank or exchange bureau will sell you a foreign currency. You might also see it marked as the tourist rate because it’s the exchange rate that a bank will give an individual — like a traveller — to convert their cash for that trip abroad. So if you’re in the US and want to get some euros for your upcoming getaway to Paris, you need to look at the sell rate.

Buy rates

The buy rate is the exchange rate that the bank will use to buy the foreign currency and give you back local currency. So if you come back with a pocket full of euros after that holiday to France, the buy rate is what you’ll be offered to convert them back to dollars.

Spreads

You’ll also notice that there’s a difference between the buy and sell rates. This difference is known as the spread. It basically represents a part of the profit that the bank makes on the exchange rate for every conversion they carry out.

Real exchange rate (RER) vs real effective exchange rate (REER) vs nominal effective exchange rate (NEER)

If you’re an amateur trader or a student of economics and you’ve heard the terms real exchange rate (RER), real effective exchange rate (REER), and nominal effective exchange rate (NEER), then you’re probably wondering what the difference is. Of the three, the real exchange rate is probably the most useful to you.

Many are familiar with how currency exchange rates are written. The price of one currency is expressed in terms of another. For example, the value of the dollar can be expressed in euros:

1 USD = 1.13990 EUR

The above it shows that a dollar is roughly worth €1.14. But this doesn’t quite tell us enough. If I earn in both euros and dollars and I want to buy a phone, what currency should I buy in? Which saves me money?

This is where real exchange rate, or RER, comes in. RER measures the value of a country's goods against those of another country at the prevailing exchange rate.

Imagine a world where only one product is available: a particular kind of strawberry candy. If the real exchange rate between USA and France is 1, this means that this candy costs same in both USA and France. In the US it would cost a dollar and in France it would cost about 1.14 euros. Economics arrive at RER using a formula. RER between two currencies is the product of exchange rate — where the value of one currency is expressed in the terms of another — and the ratio of prices between the two countries.1

The other two terms, Real Effective exchange rate (REER) and Nominal Effective exchange rate (NEER), are primarily used by economists. Both REER and NEER are used mainly to work out the strength of a currency.2 The 2 look at the value of one nation’s currency against a selection of other currencies — usually chosen to reflect the main trading partners of the country in order to show the general trends and changes in currency markets from a macroeconomic perspective. s

REER , just like the real exchange rate (RER), is expressed in terms of the price of goods that the currency can buy at the exchange rate between 2 countries. NEER, however, is expressed in terms of value of currency of another country.2, 3

Defining the real exchange rate (in real life)

Apart from the technical definition of real exchange rate if you were doing your economic homework, there’s another sense in which we use that termfor general financial purposes. There are lots of different exchange rates that are used when you buy or sell currency. But what you should be on the lookout for is which one of these is the real exchange rate.

In that case, the one that really matters is the real exchange rate — known as the mid-market rate, or sometimes the spot rate or inter-bank rate.

It’s called the inter-bank rate because it’s the exchange rate that banks use when they trade currencies on the global markets — the same rate you’d find when you Google a currency pair. It’s also the best, and the fairest rate out there. The only downside is that it’s usually only available for banks and large international institutions buying huge volumes of a currency in a single transaction.

Or at least that was the case until Wise came up with a new way to offer the real exchange rate to regular people, too. More on that in a second.

How can I get the real exchange rate when I make an international money transfer or trade money?

Meet Wise. Wise believes it isn’t fair that only large institutions get access to great exchange rates. By offering a poor exchange rate to their customers, many banks and traditional money exchange services take a cut every time people exchange their currency — but don’t call it a fee. That doesn’t feel transparent, and typically costs customers more. Much more.

Wise is working towards a world where there are no borders, and where everyone can access the best exchange rates — no matter how much or how little money they have. International money transfers from Wise are carried out using the real exchange rate — the one usually only available to banks and big institutions. Wise only charges a small, upfront fee for each transaction, so you know exactly what you’re paying, and with no hidden costs.

Another solution is the Wise borderless multi-currency account that allows you to hold, manage and send cash to others in dozens of currencies. It’s free to sign up, and there are no monthly fees or minimum average balance to keep the account open. Check your balance across currencies at a glance, using the handy app. And switch between currencies easily, using the real exchange rate. You can even receive domestic bank transfers in regions like the UK, the US, the EU, and Australia with your own local bank details.

See how Wise works and find out if they might pose a better solution for your international transfer needs today.

Which factors play a role in establishing the price of a country’s currency? How are exchange rates determined?

Currency exchange rates can be floating, or pegged — also described as fixed. Floating exchange rates change freely depending on market forces. Pegged currencies also move according to the market, but are pegged to the movement of another currency — usually the US dollar or euro.

This means that the value of any currency is constantly changing. The main factor that determines the value of a currency is supply and demand based on volume trades. Demand goes up or down mostly due to big investors buying or selling large currency volumes. If lots of traders and institutional investors want to buy a particular currency, its value compared to other currencies will rise. On the flip side, if more traders want to sell the currency, the value will drop.

But what makes traders and institutional investors want to buy or sell a currency? It’s a mix of art and science, based largely on whether they think a particular country is stable and economically successful. If investors believe a country is doing well, they’ll be happy to leave their money there. They could also buy up more of that particular currency, causing the exchange rate to rise. On the flip side, if they think a country is politically or economically unstable they’re more likely to sell the currency, causing the value to drop, and thus reinvest somewhere else.

How do I calculate the real exchange rate myself?

The good news is that, although the real exchange rate moves up and down all the time, it’s easy to find out what the current rate is.

You can just google a currency pair using the correct three-letter currency codes — so to check the rate to switch dollars to euros, you’d google USD/EUR, for example.

Or simply use an online currency converter, so you can find out what the real exchange rate is and compare it to what you’re offered by your bank or money exchange service.

Exchange rates change all the time, so to make sure you’re getting a fair rate for your currency conversion, you need to know how to get the latest real exchange rates for your currency pairing.

Now that you know both the economic definition and the real-world definition of what the real exchange rate is, you have the tools and knowledge to make sure you get the best deal available — so you’ll never get ripped off again.

Sources:

1. http://www.imf.org/external/pubs/ft/fandd/basics/realex.htm (July 4, 2018)

2. https://www.economicshelp.org/blog/11422/economics/real-effective-exchange-rate (July 4, 2018)

3. http://datahelp.imf.org/knowledgebase/articles/537469-what-is-nominal-effective-exchange-rate-neer (July 4, 2018)

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