By Carl Paraskevas - Chief Economist
Next time you bite into a Big Mac, think about the Big Mac Index and how it could affect your forex trading.
Rooted in the law of one price and purchasing price parity, which says that goods in one country should equal another after forex adjustment, the Big Mac Index, produced by the Economist Newspaper, compares the prices of the famous Big Mac hamburger around the world to determine whether currency pairs are overvalued or undervalued.
Big Mac Index: % overvaluation/undervaluation vs USD
NZD/USD, AUD/USD and JPY/USD are most likely to be undervalued says the latest cut of the Big Mac Index. In fact, on an unadjusted basis, the price of a Big Mac in every country aside from Norway and Switzerland look under-priced versus the United States after adjusting for forex rates. Or, to phrase it differently, every major currency aside from the Norwegian kroner and Swiss Franc look undervalued against the US dollar.
Adjusted Big Mac Index: % overvaluation/undervaluation vs USD
Still, one big argument against using purchasing price parity valuations, amongst others, is that higher or lower income levels in specific countries can leave the price of goods like Big Macs higher or lower without influencing forex rates. To account for that differential, the Big Mac Index adjusts valuation metrics to account for income levels. On that basis, NZD/USD, AUD/USD, and USD/JPY still look significantly undervalued by -6%, -16%, -31%, respectively.
Be warned, however, that the law of one price and purchasing price parity has all kinds of pitfalls, and many argue it never really holds true. So, alone it should never be relied upon. The deficits of purchasing price parity aside, the Big Max Index still one good and easy tool of many to have in your toolkit to get some sense of bias in the forex pairs you trade.
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