Definition
The modern day business dynamic has enabled globalization across the world on a number of fronts. Therefore, international trade now takes place more than ever, and this has enabled companies to operate in more than one country.
However, when dealing with international trade, the concept of the exchange rate is really important, and it can greatly impact the overall profitability of the company.
However, when companies are working with exchange rate, the actual returns are often subject to volatility, because of which companies are often unable to estimate the real returns of a particular transaction that involves exchange rate calculations.
Therefore, in this regard, companies often use the ‘real’ metric, which is defined as the real exchange rate.
The real effective exchange rate is a metric that is designed in order to compare the nation’s currency value against the weighted average of the basket that constitutes of the major currencies that the company normally trades in.
In this regard, it can also be seen that countries that have larger trading relationships with other countries mostly have the largest weighting in the comparative index.
On the other hand, countries that do not have a lot of international trade with other companies mostly smaller weightage in the existing basket of currencies.
In this regard, a real effective exchange rate is used in order to gauge the fluctuation of one currency in comparison to other currencies. Subsequently, it is also used in other international trade assessments.
Explanation
As mentioned earlier, it can be seen that the Real Exchange Rate is used as a metric to compare the value of a specific currency in relation to the other existing currencies.
Hence, Real Effective Exchange Rate is used in order to measure the underlying trading capabilities of the given company. It becomes highly important for trading partners to conduct this assessment so that they have an inherent idea about the volatility in the financial transactions occurring as a result.
Furthermore, Real Effective Exchange Rate is termed to measure the equilibrium point of a particular currency. Additionally, it also gives useful insights regarding the underlying factors within the country’s trade flow, which can eventually help them to analyze their standing in the international market, pertaining to competition and technological changes.
Formula
Real Effective Exchange Rate is calculated using the following formula:
Real Effective Exchange Rate: (Country’s Exchange Rate) weight 1 x (Country’s Exchange Rate) weight 2 x (Country’s Exchange Rate) weight 3 x 100
The calculation involves the following steps that need to be undertaken:
- Country’s Real Effective Exchange Rate is calculated by taking the average of the bilateral exchange rates between the country, and the trading partners. Subsequently, weightage is assigned to these trades using the allocation of each partner that is involved in this regard.
- Additionally, it must also be noted that the average of the exchange rates is calculated using the assigned weightages for the respective rate.
- Subsequently, after all averages, as well as weights have been incorporated, it is multiplied by 100 in order to arrive at the respective scale.
When calculating real effective exchange rate, it also gets important to consider the fact that there is a need to use REAL exchange rates, so that they incorporate all the underlying factors of inflation.
This is to get a clear idea regarding the standing of the local currency versus other respective currencies. Regardless of this being incorporated or not, it can be seen that the currency will be overvalued in terms of one trading partner, and undervalued in terms of another.
Example
The concept of real effective exchange rate can further be explained using the following illustration:
Country A has United States Dollar as their major trading currency. They have trading relationships with other countries, including the United Kingdom, India, and Africa.
Around 60% of the trade is conducted in the United Kingdom, whereas 30% is conducted with India, and 10% of the total trade value is conducted with Africa. Therefore, when calculating the real effective exchange rate, United Kingdom would hold the most value in the basket of goods. This would be followed by India, and then Africa.
This implies that in the case where the UK Pound sees volatility, it would greatly impact the real effective exchange rate of Country A, because their basket has the most weightage for the United Kingdom.
In comparison, if there is a change in African Currency, it would not greatly impact Country A’s Real Exchange Rate as much, because their weightage is considerably low.
