Many names can be subscribed to the Economist”s introduction of the Big Mac Index since its invention in 1986, lighthearted, tongue in cheek and half hearted. How serious they were with this index is questionable but since 1986 whole cottage industries have developed by economist, 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 United States Dollar through the Federal Reserve’s trade weighted average as its base since Big Mac Hamburgers are sold in almost 120 nations of the world. 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.
To determine purchasing power parity, factor the price of a Big Mac in nation A 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 A divided by the price of a Big Mac in U.S. Dollars. Take this figure and divide by the Federal Reserve’s trade weighted average, the exchange rate.
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 formula is prices will eventually equalize over time. While this simple formula may serve as a theoretical guide to determine under and overvaluations of currencies, practicality says many limitations exist in the short and long term for measuring evaluations and achieving successful trades.
Prior research suggests short term duration will never achieve parity because the short length of time will never equalize prices while longer terms may see deviations in prices last for many years without a guaranteed means of achieving real parity. One reason for this is 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 world competitive. Another conundrum for the long term is the measure of the trade weighted average which can remain a constant for many years compared to the prices of a Big Mac which is market driven.Prices of Big Mac’s are not even constant within nations.So the comparison of the Big Mac Index is apples to oranges where prices may never equalize and parity may never be achieved. Factor 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, a tax on goods at the border. This tax must be valued with any transportation costs. Inflation is never the same between nations. This can have an effect of eroding prices where high inflation may exist in one nation and lower in another. The cost of goods and commodity prices may be quite different in many nations which may skew not only the Big Mac Index but the original cost of the Big Mac in any particular nation. 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, 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 skewed 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
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 trade able instrument on the New York Board of Trade.Whole cottage industries, web sites, college lectures have devoted themselves to this concept of purchasing power parity based on the cost of the Big Mac hamburger, a parity that may never exist.
Brian Twomey is a currency trader and an adjunct professor of Political Science at Gardner-Webb University