Become a Global Currency Trader Using the “Big Mac Method”

by Nicholas Vardy
McDonalds_Sign

Global currency markets are the largest and most liquid financial markets in the world.

Today, the volume of foreign exchange trading exceeds an astonishing $5 trillion a day.

That averages to $220 billion per hour - equal to the entire market cap of AT&T (NYSE: T).

Yet I bet you never thought of investing in this exotic asset class.

But thanks to the advent of currency exchange-traded funds (ETFs), you can assemble your personal trading portfolio of global currencies at the click of a mouse.

The "Big Mac Method" of Currency Trading

Compared with stocks and bonds, currencies are an exotic asset class.

So before you go up against the likes of George Soros in the global currency markets...

You'll need the proper framework for understanding currencies.

Enter the "Big Mac method."

Back in 1986, Britain's The Economist first published its Big Mac Index - an irreverent way of measuring purchasing power parity (PPP) - that is, the relative overvaluation and undervaluation of the world's currencies.

According to the theory of PPP, a dollar should buy you the same amount of the same good across all countries.

In the long run, the exchange rate between two countries should converge to a rate that equalizes the prices of an identical basket of goods and services in each country.

By comparing the cost of Big Macs - a good produced in about 120 countries - the Big Mac Index calculates the exchange rate (the Big Mac PPP) at which Big Macs would cost the same in the United States as they do abroad.

Compare the Big Mac PPP with the market exchange rates, and voilà... you see which currencies are overvalued or undervalued.

With this information, you can construct - and profit from - your very own global currency portfolio.

The Big Mac Index Makes It Big

Although it started out as a tongue-in-cheek indicator, the Big Mac Index has gained a lot of credibility.

Economic textbooks discuss the measure, and it has been the subject of at least 20 academic studies.

Even governments take the Big Mac Index seriously.

The Argentine government once subsidized the price of the Big Mac to suppress its reported rates of inflation.

But you don't need to go to Latin America to unearth suspect government statistics.

Here's one I found, right from the good old U.S. of A...

In 2010, the average price of a Big Mac in the United States was $3.73.

Today, the average price is $5.28 - a whopping 42% higher.

That's triple the 14% cumulative inflation rate calculated by the U.S. Consumer Price Index over the same period.

How the Big Mac Index Works

As I noted, the average price of a Big Mac in the U.S. is $5.28.

In contrast, a Big Mac will set you back $6.76 in Geneva, Switzerland.

So according to the Big Mac Index, the Swiss franc is overvalued by 28.1%.

That makes the "swissie" the most overvalued currency in the world.

By way of comparison, in China, the average cost of a Big Mac is only $3.17.

So the Chinese yuan is undervalued by about 40%.

Where are the cheapest Big Macs in the world?

According to the The Economist's most recent data, in Kiev, Ukraine, a Big Mac will cost you a mere $1.64 (69% undervalued).

In Cairo, Egypt, you can pick up a Big Mac for $1.93 (63% undervalued). And in Kuala Lumpur, Malaysia, you can grab one for $2.28 (57% undervalued).

Over the years, you can see some surprisingly big swings in currency valuations.

Today, a Big Mac in the European Union will cost you an average of $4.84.

That means the euro is undervalued by a modest 8.4% compared with the U.S. dollar.

But that's a far cry from July of 2008 when the euro was overvalued by a whopping 50%.

Going short the euro back then would have netted you a tidy profit.

Your Big Mac Currency Hedge Fund

So if you were running a currency hedge fund, how would you trade according to the Big Mac Index?

Applying the principal of buying undervalued currencies - and selling the overvalued ones - here are some trades you could put on...

Among the big six currencies traded by foreign exchange traders, you'd sell the Swiss franc through the CurrencyShares Swiss Franc Trust (NYSE: FXF) - an ETF tracking the only major currency that is substantially overvalued (28%).

You'd buy ETFs for the Japanese yen with the CurrencyShares Japanese Yen Trust (NYSE: FXY) and the CurrencyShares British Pound Sterling Trust (NYSE: FXB), undervalued by 35% and 16.8%, respectively.

You'd avoid betting on the CurrencyShares Canadian Dollar Trust (NYSE: FXC) and the CurrencyShares Euro Trust (NYSE: FXE), as both are within 10% of their PPP values.

And thanks to the bevy of new currency ETF offerings, you could also bet on some of the more exotic currencies using the Market Vectors Indian Rupee/USD ETF (NYSE: INR), which is 47% undervalued, and the WisdomTree Chinese Yuan Fund (NYSE: CYB), which is 40% undervalued.

So there you have it...

Currency ETFs offer yet another example of how ETFs (and the Big Mac Index) can broaden your investment horizons.

By buying and selling the wide range of currency ETFs available today, you too can become a global currency trader active in the $5 trillion a day foreign exchange markets.

Good investing,

Nicholas

Thoughts on this article? Leave a comment below.

This article contains Plus content.

To access it, sign in or click here for more information on Investment U Plus+.

Live Twitter Feed