How to value currencies

Ever since the UK voted to leave the European Union, the pound has been skating on thin ice. This week, it fell through. In less than four months, sterling has plunged from a high of just over $1.50 to the US dollar to a low of below $1.20 (it has rallied a little since). It is by far the worst-performing major currency this year, with even the Mexican peso – which traders are using to bet on the likelihood of a Donald Trump presidency – outperforming it. We look at the impact of the plunge in sterling on the wider economy on page 24. But has the rout in the pound been overdone? One way to check is by using The Economist’s “Big Mac index”.

The Big Mac index is derived from an economics theory called “the law of one price”. Simply put, this claims that in a modern global economy, the cost of any given goods should be the same around the world, once you take the exchange rate into account. So if a product costs £5 in London and $10 in New York, the exchange rate should be £1 to $2. The argument is that any serious price differential would result in people buying a product where it is cheap and selling where it is expensive (arbitrage).

As the name suggests, the Big Mac index uses the price of the famous McDonald’s hamburger – a simple, standardised product that is sold in 119 countries around the world – to calculate whether a currency is cheap or overpriced. According to The Economist, as of July, a Big Mac sells for an average of $5.06 in the US, compared with £2.99 for the UK. This implies that the exchange rate should be £1 to $1.69, which would make the pound relatively cheap.

Of course, the Big Mac index is a very rough, somewhat light-hearted guide to currency valuation. Using other goods produces entirely different results. For instance, the latest iPhone costs £599 in the UK and $649 in the US, implying an exchange rate of £1 to $1.08, suggesting that you should be buying dollars. However, you can take a wider measure – purchasing power parity (PPP) data, which looks at the price of all goods and services in an economy. This suggests that £1 should be worth around $1.45. And several studies suggest that over the long run, currencies do tend to revert to the exchange rates predicted by the PPP and even the Big Mac index.

However, they don’t work terribly well to make short-term predictions. Indeed, Ahmad Raza of the University of Otago found that currency trading strategies based around these measures underperformed. The main reason for this is that in the real world there are often barriers to trade, such as tariffs and simple physical distance, which prevent the theoretical arbitrage described above. Indeed, some services are almost completely non-tradable. Global brands also have sufficient market power to vary their prices by region. So while PPP and Big Mac prices can provide useful pointers to a currency’s fundamental value, they are only part of the picture. And as Brexit has shown, in the short term there are plenty of surprises that can derail even the most considered currency forecast.

Curzon Note: At the date this article was posted £1.00 = $1.22 /€1.10

Source: Mathew Partridge, MoneyWeek