GROUP CURRENCIES BY PURCHASING POWER PARITY (PPP) (BIG MAC INDEX)

Ranking currency pairs for the PPP is a valid use of fundamental data to detect if a currency pair is overvalued. The theory of PPP basically asserts that a good way to detect if a currency is overvalued or undervalued is to compare prices of similar products across countries. A well-known version is the Big Mac index. The idea is that a product like a McDonald’s hamburger should have the same cost in different countries. If one compared a global product such as Coca-Cola, the differences in prices in one country compared to another would demonstrate an imbalance in the currency value. To learn more about PPPs, visit the Organisation for Economic Co-operation and Development’s web site to read this article: www.oecd.org/dataoecd/61/54/18598754.pdf. (Source: Main Economic Indicators, pp. 280–81, March 2008, _C OECD 2008.)

Here is how the OEC defines PPP:
PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are simply price relatives which show the ratio of the prices in national currencies of the same good or service in different countries. For example, if the price of a hamburger in France is 2.84 Euros and in the United States it is 2.2 dollars, then the PPP for hamburger between France and the United States is 2.84 Euros to 2.2 dollars or 1.29 Euros to the dollar. This means that for every dollar spent on hamburger in the United States, 1.29 Euros would have to be spent in France to obtain the same quantity and quality—or, in other words, the same volume—of hamburger.

Economists predict that currency prices will revert to toward the level of purchasing power parity. The task of the forex trader is to access the PPP information in a timely way and use it to determine a potential direction for the trade. Since the process of reverting back to a mean PPP takes time, it is a perfect application of longer-term option trades. Let’s look at some recent PPP data that is easily accessible. The most overvalued currency was the Swiss franc, and the most undervalued was the Chinese yuan. The euro appears overvalued by 23 percent and the British pound by 18 percent. Based on the Big Mac theory, one would buy out of the money puts on the EURUSD, GBPUSD, and the USDCHF. In contrast, the Mexican peso, The British pound, the yen, and the yuan were undervalued, suggesting purchasing longer-term calls on these currency pairs. Where the strike prices should be can be suggested by the prediction that these currencies will retrace by at least 50 percent of the amount they are calibrated to be overvalued or undervalued. The duration of the options should be longer term than most, six months to a year! Of course, variations such as put and call spreads can be applied as well as combinations such as shorting the spot underlying and buying protective hedges.

1. The Big Mac Index, July 5, 2007, www.oanda.com/products/bigmac/bigmac.shtml

2. The OECD PPP data. Detecting very overvalued currencies based on OECD PPP parity measures can lead to longer-term option trades. Figure 4.5 depicts OECD data in a very accessible and understandable format and is available to anyone from the Pacific Forex Service. (Source http://fx.sauder.ubc.ca/PPP.html.) Figure 4.5 shows which currency pairs are overvalued and undervalued on December 27, 2007, based on OECD data. As a result, the forex trader can play a long-term reversion to the PPP equilibrium by buying puts and put spreads on the overvalued
pairs and calls and call spreads on the undervalued pairs. It is worthy to note that the yen and the New Zealand dollar are the closest to their equilibrium point. This suggests trades of a shorter-term nature.

3. UBS Data on PPPs. The UBS Bank also provides frequent updates on PPP values.
Their data showed that the GBPUSD and AUDUSD were overvalued and that the USDNOK were undervalued. (Source: www.ubs.com/1/e/ubs ch/wealth mgmt ch/research/rates.html.)