Lighthearted, tongue-in-cheek and half-hearted are just a few descriptions attributed to the Economist's introduction of the Big Mac Index since its invention in 1986. How serious they were with this index is questionable, but since it was devised, whole cottage industries have been developed by economists, traders and teachers devoted to the concept of finding the perfect arbitrage trade.
The idea behind the Big Mac Index was to measure the percentage of overvaluation and undervaluation between two currencies in each nation by comparing prices of a Big Mac hamburger, using the U.S. dollar through the Federal Reserve's trade-weighted average as its base. This is effective because Big Macs are sold in almost 120 nations. Since the Big Mac became the standard consumer good common to all nations, devising a method for determining overvaluation and undervaluation of currency pairs would be based on the formula of purchasing power parity.
Purchasing Power What?
To determine purchasing power parity, factor the price of a Big Mac in nation X in the local currency. Next, determine the price of a Big Mac in U.S. dollars. Purchasing power parity is the price of a Big Mac in nation X divided by the price of a Big Mac in U.S. dollars. Take this figure and divide it by the Federal Reserve's trade-weighted average, the exchange rate. Essentially, the exchange rate is the percentage of under- or overvaluation of a currency. A lower price means the first currency is undervalued compared to the second currency, while a higher price means the second currency is overvalued in percentage terms against the dollar.
The concept behind this is that prices will eventually equalize over time. While this simple formula may serve as a theoretical guide to determine under- and overvalued currencies, practicality says many limitations exist in the short and long term for measuring evaluations and achieving successful trades.
Prior research suggests short-term durations will never achieve parity because the short length of time will never equalize prices. Longer terms may see deviations in prices last for many years without a guaranteed means of achieving real parity. One reason for this is that some nations undervalue their currency purposefully, especially if they are export-dependent, to aid their exporters and earn more in foreign reserves. This is a constant revenue stream and a means for emerging market nations to become competitive in the world market.
SEE: Forex Walkthrough
Apples to Oranges
Another conundrum for the long term is the measure of the trade-weighted average, which can remain a constant for many years. Compare this to the prices of a Big Mac, which is market driven, and you can see how flawed the Big Mac Index can be. Prices of Big Macs may not even remain constant within nations. Therefore, the comparison of the Big Mac Index is apples to oranges where prices may never equalize and parity may never be achieved. Factor in the hidden costs involved between nations and the index can remain skewed for many, many years.
For example, many nations institute a value-added tax, or a tax on goods at the border. This tax must be valued with any transportation costs. Also, inflation is never the same between nations. This can erode prices where high inflation exists. The cost of goods and commodity prices may be quite different depending on the nation, which may skew not only the Big Mac Index but also the original cost of the Big Mac in a given location.
Wage costs and further trade restrictions between nations can also skew the longer-term implications for the Big Mac Index as well as the cost of the Big Mac. Factor a possible war among or between nations and a possible financial crisis, and the Big Mac Index may never achieve parity.
Not to mention the fact that the index can't predict impending crisis yet prices of a Big Mac may be altered due to a supply and demand problem. Various people in many nations accept and reject eating a Big Mac based on cultural and religious reasons. More differences may exist between populations of the countryside and the more populous cities.
The Bottom Line
Implementing a trade based on trade-weighted exchange rates may turn out to be unprofitable compared to a normal trade based on current market driven spot prices and current market driven Big Mac prices. Spot prices move based on the dollar index, a tradable instrument on the New York Board of Trade. Whole cottage industries, websites and college lectures have devoted themselves to this concept of purchasing power parity based on the cost of the Big Mac hamburger, but that parity may never exist.