There are two concepts that many investors often mix up: nominal exchange rate vs. real exchange rate. What’s the difference? While both measure how currencies compare, they can actually tell you very different things.
For modern investors, knowing which metric to use — and when — can make a huge difference when trying to find undervalued opportunities.
In this guide, we’ll look at what each rate measures, why they both matter, and how you can use them to make smarter investment choices.
What Is the Nominal Exchange Rate?
The nominal exchange rate is the straightforward price of one currency in terms of another (like seeing $1 = €0.90 on a currency converter.) It’s the number you’ll find on news apps or trading platforms, showing how much of another currency you can buy right now.
This rate can be increased or decreased based on supply and demand. For example, suppose that there are more people who want euros than there are euros available (maybe because the EU economy is booming). In this case, the euro’s nominal rate will rise. Similarly, central banks or large investors can influence rates by purchasing or selling large amounts of currencies.
There’s a limitation, though. This rate does not take into account inflation or differences in prices across countries. If the euro increases 5% against the dollar but prices in Europe go up 7% faster than in the U.S., then in real terms, the euro has actually lost value — even as the nominal rate is indicating it’s stronger.
Here’s another example to show how this works in the real world. Suppose that an item costs $3 in the U.S. and €3 in Europe. If the nominal rate is $1 = €0.90, the item seems cheaper in Europe. But if inflation in Europe pushes the price to €3.21 (while U.S. prices stay at $3), the euro’s higher nominal rate no longer makes it a better deal.
Keep in mind that the nominal rate is just a starting point. It doesn’t tell the full story. Relying on it alone could lead investors to wrong conclusions about currency valuation or a country’s economic health.
What Is the Real Exchange Rate?
In simple terms, the real exchange rate shows what your money can actually purchase. It accounts for inflation differentials across countries — a key difference between the nominal exchange rate vs. real exchange rate.
Think of it this way: if a book costs $5 in the U.S. and €4 in France, the real exchange rate tells you how many books your dollars can buy in France compared to the U.S. — not just how many euros you’d get for your bucks.
This adjustment helps you get a better sense of your true purchasing power. As long as the real exchange rate is stable, this suggests that prices of goods in the two countries are fairly comparable, even if the nominal rate fluctuates every day.
The real exchange rate can also reveal undervalued currencies or markets to investors.
Suppose that the real rate shows that goods in Japan are 20% cheaper than in the U.S. That could signal that it’s a great time to invest in Japan. While nominal rates often jump around based on news and speculation, real rates offer a steadier, long-term picture of economic reality.
Now that you know what each rate means, here’s how to use formulas to calculate nominal exchange rate vs. real exchange rate.
Nominal Exchange Rate Formula
You can calculate the nominal exchange rate by dividing the foreign currency amount you receive by the domestic currency you trade. Here’s how it works:
Nominal Exchange Rate = Domestic Currency / Foreign Currency
So for example, if $1 USD = €0.85 EUR, the formula is:
Nominal Exchange Rate = 1 / 0.85 ≈ 1.176 USD/EUR
This means 1 euro buys approximately $1.176 based on the current rate.
You can use this rate to:
- Calculate how much foreign cash you’ll get for your home currency
- Figure out how many foreign stocks or assets you can buy with your savings
- Determine the cost of imports/exports before adjusting for inflation
However, remember that this rate shows only the surface value; you’ll need to pair it with real-world price checks to understand the true value.
Real Exchange Rate Formula
The real exchange rate is a more practical measure of purchasing power parity than the nominal exchange rate. Here is its formula:
Real Exchange Rate = Nominal Rate × (Domestic Price / Foreign Price)
It’s helpful to break it down with an example:
- Nominal Rate: 1.2 USD/EUR (1 euro buys $1.20)
- Domestic Price: $3 for a book in the U.S.
- Foreign Price: €2 for the same book in France
Real Exchange Rate = 1.2 × (3 / 2) = 1.8
So what does this mean? For every $1 you spend on a book at home, you’d only get 1.8 books abroad. In this case, €2 equals $2.40 — less expensive than the $3 you’d spend at home.
Companies can use this rate to decide where to manufacture goods. For instance, if real rates show foreign labor is cheaper, they might outsource.
On the other hand, as an investor, you can use it to check real rates to spot undervalued markets. A low real rate (e.g., 0.5) means foreign goods are cheaper, signaling that it’s a good time to invest there.
Nominal Exchange Rate vs. Real Exchange Rate: Why They Matter for Investors
Exchange rates can shape your investment returns, corporate earnings, and global opportunities. Here’s how to use the nominal exchange rate vs. real exchange rate to your advantage:
Portfolio Diversification
Currency shifts can pump up or drag down your international investments. For example, if you have European stocks and the euro strengthens against the dollar, your returns can get a boost when you convert your profits back to USD.
But when global markets tank, “safe-haven” currencies like the dollar or yen often surge — which can wipe out gains from international stocks. This can make diversification less effective when you need it most.
Smarter Investment Decisions
One of the best ways to use real exchange rates is to find undervalued markets. For example:
If the real exchange rate shows that Mexican pesos are weaker compared to the dollar, it might indicate a good time to invest in Mexican stocks — your profits could surge when converting back to USD. Watching how currencies behave in the forex market can also help you spot when those gains could multiply or when it’s time to pull back.
Impact on International Stocks & ETFs
Strong domestic currency can shrink your foreign investment returns. Suppose that a Japanese ETF climbs 10%, but the yen falls 5% against the dollar. Your actual gain drops to just 5%. Real exchange rates help you see if currency shifts are hiding (or inflating) a stock’s real performance.
Corporate Earnings
Global companies report earnings in their home currency — and exchange rates can distort the numbers. Real exchange rates can help you see whether growth comes from strong business fundamentals or just favorable currency swaps.
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