How to determine the real value of the national currency?

5 мая 2022 г.

The National Regulator openly manipulates the exchange rate to the benefit of the economy, undervaluing it when there is a trade deficit, thereby helping exports, and overvaluing it when there is a surplus, so that citizens and businesses can buy more imported goods.

The real exchange rate of a nation's currency is determined by its purchasing power abroad. In theory, it is calculated through a sample of identical goods. It is enough to estimate how much a certain conditional consumer basket costs in the home country, and compare the amount spent in another country.
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Why do we need to know the exchange rate regime and the real value of the national currencies?

• If a country has a fixed or transitional exchange rate, a currency trader can determine the entry points with a guaranteed profit.
  
  
• For example, the yuan is strictly "locked" in the corridor of 2% on the stock exchange, which allows you to enter at the maximum deviations, knowing exactly what intervention of the People's Bank will soon follow. The peculiarities of such trading are described in our article about USDCNH trading.
  
  
• Knowing the pricing mode, you can determine the entry strategy on the border of the basket value. Examples of trading such currency pairs using currency corridors are presented below.
  
  
• Trading on the Boundaries of the Nominal Value of National Currencies in Fixed and Transition Modes
  

UAE Dirham (AED)

The USDAED currency pair is the easiest to trade because of its strongest peg to the dollar - the national central bank kept the exchange rate at 3.6725 dirham even during the 2008 crisis.

As a result the UAE national currency chart looks like a series of candles with long tails, above and below which pending orders should be placed.

The figure shows a weekly candlestick chart, where you can see the possible deal levels at a glance, but there are some subtleties in this kind of trading. Firstly, there are only two brokers who are ready to provide access to the USDAED pair; secondly, they ask for a minimum deposit of $10,000; thirdly, the maximum leverage for this currency is 1 to 5.

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Models for determining the real exchange rate
There is no single ideal model in the Forex market that works out 100% of the signals for the differences between the nominal value of the currency. Just like any indicators, the presented formulas need a historical check, they are suitable for certain currency pairs with different accuracy and work in combination with each other. This is why we will try to examine the basic models and theories of exchange rates.

The purchasing power of the national currency against any other currency is determined in four ways, which we will talk about below.
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The law of one price - comparing the cost of the same good in different countries

The current price of a commodity in national currency units = The exchange rate of the currency pair* The current price of a commodity in a foreign currency.
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Absolute Purchasing Power Parity

In the formula of absolute parity instead of the price of one product, the average price level of the same basket of goods for different countries is used as expressed in national currencies or minimum subsistence values.

For example, in Australia the living wage was 600 AUD for 2017, while in the European Union it is equal to: in Germany - 1240 euros, in France - 1254, in Italy - 855.

The euro is a common currency for 26 states, so the three largest EU economies were chosen to use the average value of (1240+1255+855)/3= 1117 in the formula.

If 1117 is the average EU living wage and 600 is Australia's living wage, then solving this expression, we get 1117/600 = 1.86.

In 2017, the EURAUD exchange rate was 1.38. As you can see from the graph of the currency pair, the arbitrage correctly predicted the trend of strengthening of the euro.
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Relative trade parity.

Economists in their calculations use economic indicators that show the relative change in consumer prices. The difference between the current indicator value from the economic calendar and previous data is substituted into the formula.

For example, the U.S. Consumer Price Index was 119.4 in 2012 and rose to 121 by 2013. During this period, the EU CPI showed values of 118.3 and 120.1. The EURUSD exchange rate changed from 1.30 to 1.36.

Using the formula, let's calculate the real euro exchange rate by taking the 2012 value of 1.30, successively multiplying it by a fraction of the relative values of the U.S. CPI 121/119.4 and the European CPI 120.1/118.3:

1,3* (121/119,4) *(120,1/118,3) = 1,3374.

As you can see from the formula, the euro was undervalued, which led to the collapse in 2014, where parity was equalized due to monetary measures taken by the ECB and the Fed.

The consumer price index is essentially an indicator of inflation, which is the primary focus of central banks when making decisions on the size of the discount rate. In economic statistics, it is rare to see this indicator published in relative units; everywhere there is a percentage change, which can also be used in another model.
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Relative Inflation Parity

When calculating the real value of national money relative to the currency of another country, a slightly modified formula is used.

The current rate of a currency pair can be represented as equal to (1 + annual inflation of one country/1 + annual inflation of another country) * the current rate of the pair at the Forex market.

Let's calculate the EURUSD exchange rate in 2015. At the end of that period, U.S. inflation was 0.73%, while in the Eurozone it was 0.08%.

The real EURUSD exchange rate at the end of 2015 = (1 +0.0083)/(1+0.073)*1.0565= 0.992.

EURUSD quotes at the beginning of 2016 were undervalued, and the rate hike policy adopted by the Fed did not immediately save the situation - the market saw values close to 1.02 before the value of the European currency began to rise.

This formula can be used to forecast the exchange rate by fitting it with the future inflation that central banks calculate in the reports they publish at every monthly meeting.
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Sincerely R. Linda!