The Economist has once again posted its Big Mac Index, a measure of the strength of foreign exchange rates, based on the purchasing-power parity (PPP) of a McDonald burger. The Big Mac uses a single point of reference (the Mac) to calculate the over or under valuation of a currency , the theory being that prices and exchange rates should adjust over the long run, so that identical baskets of tradable goods cost the same across countries.
Using the PPP of the Mac for measuring the strength of a currency as opposed to a basket of goods does have distinct advantages, in that the noise and deflections which may exist in selecting a broad spectrum of goods, is removed. However, there is another factor which will intrinsically effect PPP.
The PPP of a currency, will always reflect the fundamental political and economic attributes of a region, which serve to skew it's value. For example in Switzerland, the Swiss franc is used by investors as a safe haven. Consequently, it is priced in at a premium. Conversely, South Africa is considered an economically and politically high risk region, hence the discount at which the rand trades.
Similarly, currencies of other emerging markets or volatile regions also tend to trade at a discount, with the exception of Brazil 's real. Brazil's price enigma can be attributed to the capital controls which the country maintains and to the fact that many traders use the Brazilian real, as a point of reference and security to price in other currencies in the region.
A similar pattern can be observed with the pricing of options. When implied volatility of specific equities experience a spike, relative to their historical volatility, thus reflecting an apparent overvaluation, some traders view this as an opportunity to sell the option and profit from the anomaly. Invariably, the incongruousness is a function of weakness within the equity or the underlying company. Without the appropriate hedge, many a trader has been wrong-footed.
The Mac Index is a good exercise to measure currency valuations, but to trade on the apparent anomaly, can be dangerous.
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