Mechanical Forex

In forex trading there are many ways in which a person can estimate a currency’s value over another and determine if that currency is over or under valued against a partner. Amongst these ways to assess value we have the trade balance, the central bank interest rate and purchasing power parity. This last item, which measure the difference in price between similar goods in two countries is based on the presumption that a good purchased in a country has the same value in every country and therefore differences in price suggest differences in the fundamental value of the currencies evaluated. For example, if a pencil in the US costs 1 USD and in the European Union that same pencil costs 0.5 Euro, then the “fair” exchange rate of the EUR/USD would be 2, since this rate gives you the value of the pencil.

One of the most interesting concepts to evaluate price parity was introduced in 1986 by Pam Woodall in The Economist, this concept, the use of the BigMac to evaluate the differences in value between two currencies has gained a lot of support since McDonalds is widely distributed in more than 100 countries and its food is “standarized” to a certain extent.

It is absolutely true that the BigMac Index has been right in the past and will probably be right in the future about the fundamental over or underbrought situation of different currencies. For example the price of a BigMac in the US in July 2008 was 3.57 USD and in Great Britain the price was 2.29 GBP. If you calculate the “fair” exchange rate, you would get a value of 1.55 when at the time the GBP/USD was trading at more than 2, being overvalued by more than 20%. If you calculate the prices now with a BigMac in the US costing 3.58 USD and 2.49 GBP in London, you would get an exchange rate of 1.43, implying that the current value of the GBP/USD is overvalued by nearly 10%.

Of course, the BigMac index is not perfect in the sense that all the BigMacs are not equal. For example, the BigMac in Dubai doesn’t have beef, but lamb and BigMacs in India have no meat at all. There is also the concern of taxes and import/export of commodities to make the burgers which are not taken into account by the Index itself. This overhead costs could add artificially to the purchasing power of a currency since the BigMac could be more expensive merely due to these additional costs which do not reflect the purchasing power of the currency when compared with a country where these costs are non existant.

However, I would have to say that with all its flaws, the BigMac Index remains an important tool to compare purchasing power parity amongst different countries since its is one of the most “standarized” consumer goods which has a measurable price amongst a wide variety of countries. If you are interested in comparing the BigMac index with your current long term views about currency exchange rates you can take a look at the 2010 BigMac index table for several countries here . How expensive is a BigMac in your city ? Leave a comment and we’ll get to make some comparisons :o).

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