by Jason Jenkins, Investment U Research
Tuesday, February 26, 2013
“Fun” and “a loose gauge” are just some of the descriptions given to The
Economist’s Big Mac Index.
However, since its invention in 1986, you can see on the internet that a whole cottage industry has sprung up from this concept. At first, it was to find that ideal arbitrage trade.
But investors should take the Big Mac Index for what it was intended to be – a talking point.
Currency Trading 101
Here’s a little economic talk for you so you can an idea of what’s going on. The perfect arbitrage trade is the synchronized buy and sell of an asset so you can make some money from the difference in price. What you are attempting to do is take advantage of price differences in similar investment vehicles. Arbitrage comes about due to market inefficiencies. It helps makes sure that there aren’t large price variations for fair value over the long term.
Now enter technology.
As advanced and fast as trading systems are now, its hard to take advantage of mispriced assets. A lot of traders have systems to check on currency fluctuations. But if they do occur, it’s usually gone within moments. Given the advancement in technology it has become extremely difficult to profit from mispricing in the market.
So the purpose of the Big Mac Index was to gauge the percentage of overvaluation and/or undervaluation between two currencies in two different countries by using the price of an actual Big Mac. Why a Big Mac? You have to love the world’s appetite for fast food. Big Macs are sold in nearly 120 countries becoming a standard consumer good. Then, take the U.S. dollar through the Federal Reserve’s trade-weighted average and use that as your base. Now you can use the formula of purchasing power parity to determine if currencies are over or undervalued.
So What is Purchasing Power Parity (PPP)?
Please bare with me. Only a little more of all this academic economic currency talk.
Think of PPP as a simple equation. Let’s look at it step by step:
- First of all find the price of a Big Mac in the country you are attempting to value in its local currency.
- Next, find the price of a Big Mac in U.S. dollars.
- PPP is the price of the Big Mac in the initial country divided by the price of a Big Mac in U.S. dollars.
If you take this number and divide it by the Federal Reserve’s trade-weighted average, you get the exchange rate. In essence, the exchange rate gives you the percentage of under- or overvaluation of a currency. The exchange rate adjusts so that the same good in two different countries will be the same price when put in the same currency.
As we all know, just because its in a book or taught in a classroom, it doesn’t mean that it will happen in real life. Research shows that in the short-term you’ll never reach a parity because of an insufficient time duration. Over the long-term, parity may never be reached because of things like Central Banks purposefully undervaluing their currency. Think of China. Its an export dependent nation and undervaluing the currency also allows them to earn more in foreign reserves.
With more emerging markets increasing prominence on the world scene, you’ll see more of this so they may be more competitive in the world market.
And there are so many other differences that go into prices
If only it was this simple to figure out what’s going on in different currencies. And that’s why the Big Mac Index is always talked about in a tongue-in-cheek manner. Look at all the different factors that could go into pricing that would differ from country to country:
- The trade-weighted average can remain constant over a long period of time. The prices of a Big Mac are market driven. If this is the case, then the Index becomes severely flawed.
- The prices of Big Macs may fluctuate throughout individual countries.
- Different taxation systems could affect how the same product is priced. This would especially be the case in countries that have implemented value-added taxation systems.
- Inflation varies between countries.
- Different countries will pay different costs for goods and commodities. This will skew the Index.
- The price of labor and possible trade restrictions between countries will also skew the Big Mac Index over the long-term.
- Cultural or religious reasons will affect how Big Macs are received in different countries. Along those lines, there may be sharp differences in countries dependent upon its make-up of rural and urban areas.
- And finally, we could discuss countries experiencing financial crisis or in the midst of military conflict.
So What Can We Take Out of The Big Mac Index?
Well, a hamburger may be able to tell you a little about the global economy. Better yet, it’s a way to look at similar countries with similar economies.
I just mentioned all the differences that can affect the Index. Yet it may tell you some things if you compare countries with similar make-up and development.
It can be a means to gauge changes in worker wages/productivity globally and to see if currencies are where they should be.
Ryan Avent, chief economist at The Economist, explains how they use it:
“When you look at a country like India or Mexico, labor there is much cheaper than it is in the U.S. or in Europe. And that really has to do with productivity differences…so one thing we’re measuring is productivity gaps between different countries and how far along these places are in terms of development and growth with the richest countries.”
And in turn, you could measure the difference between Big Macs in the U.S. and Switzerland. An inflated price for Big Macs in Switzerland may indicate that the franc is overvalued and will need to adjust.
But above all remember, this was created in fun and is still used in that manner by The Economist. But there is some value in being able to identify issues that could be explained with more due diligence in the currency world.
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