Big Mac Index - McDonalds Index of Purchasing Power
'Burgernomics.'
Ever heard of it?
This term was coined alongside the invention of the big mac index by The Economist in 1986.
Created as a light-hearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP) in any two countries.
In this article we will cover...
How much does a Big Mac Cost in 2021?
This may seem like a slightly odd question, but it holds very significant meaning in what we are going to be discussing in this article, you see, assessing the price of big Macs worldwide can give us a good idea of what may happen in the currency market in the future…
And its extremely fun for me 😊
Below is the BIG MAC INDEX from the economists live feed, that maps out the different prices of big macs in over 100 countries. Differences in local prices – in this case, for Big Macs – can suggest what the exchange rate should be…
We will get to what this means later in the article…
This may all seem confusing now but it will all become clearer the further down your read!!
What the Big Mac Index Tells Us
Simply put, the Big Mac index tells us what the exchange rates of two different countries should be in the future.
But why Big Macs?
McDonald’s are a huge multinational company with restaurants in around 120 different countries worldwide, one consistent staple of their menu is…
This well-known burger is pretty much the same in terms of ingredients and size all over the world, with a few exceptions, and according to economics this means it should cost relatively the same wherever it is sold, as it is effectively the same product.
But, it is not the same price everywhere, there are sometimes big differences between the relative prices of big macs in two different countries which can indicate that one of the currencies in the pair may be overvalued or undervalued.
The Economists ‘Burgernomics’ team exposes these over or under-valued currencies in the form of the Big Mac Index…
It does this through comparing the purchasing power parity of two different countries, giving the user a good idea of the current conditions of the exchange rate…
But what is PPP?
Purchasing Power Parity (PPP)
Purchasing-power parity implies that exchange rates are determined by the value of goods that currencies can buy.
Economists theorise that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, The Big Mac) in any two countries.
How to read the Big Mac index
Many people know about the Big Mac index, but they don't know how to read it...
Below, I will go step by step through all the important features and how to use them
The first aspect to take not of is the date and base currency, highlighted in the red box. This is where you can either scroll so see past data or change the base currency, most users would recommend to stick with the USD as the base currency as the base as it is the most used currency in the world.
However for forex Traders you can change the base currency depending on the currency at the base of the pair you want to trade.
The next key aspect is the index of currencies, found on the left side of the indicator here you can mix and match the different currencies that you want to analyse.
It also gives you a snapshot view of each currency and its relationship to the base currency in terms of the BMI.
The next and last section is the information centre, this is where the economist breaks down the verdict on the currencies you are analysing with graphs and historical data!
How do you calculate Big Mac Index?
You may think that this economic indicator would be extremely technical and complicated to create, but I am going to show you an extremely simple method that you can use to create your OWN big mac index!
The Big Mac Index is calculated by dividing the average price of a big mac in one country, for example the UK, with the price of a Big Mac in another country, for example, the US in their own respective currencies…
The resulting number is the big mac index for the countries!!
Then you compare this value with the current exchange rate…
If a Big Mac in the UK where to cost £5.00 and in the US it where to cost $7.00 then that would imply that the exchange rate for the two countries should be $1.4 for every £1…
However, if the actual exchange rate were $2.8 for every £1 that would mean that the USD is undervalued by 100%!!!
As you can see from above when you compare the Big Mac Index number to the exchange rate you can tell whether the currency is above or below its target exchange rate.
What does the McDonalds index really measure?
The Big Mac index effectively gives us a tool to determine whether the market is right, It doesn’t just measure the prices of your favourite food.
If the Big Mac index is telling you a currency is overvalued, it is not because Maccies are charging too much for their burgers, it could be for a whole number of reasons to do with that country’s economy, maybe low public sending or too many unsustainable imports.
The big mac index is like a test for a currency, it will not tell you why it is over or under-valued, but it will allow you to go and confirm it for yourself with research.
For example, A burger in Thailand costs 25% less than in America when its price is converted to dollars at prevailing exchange rates, suggesting that the Thai baht is undervalued.
Once we have this information, we would conduct more fundamental analysis to help s determine why the Thai baht is undervalued and assess whether this is worth adding to our portfolio.
Why is the Big Mac Index useful?
Traders are always looking for new and innovative ways to gain an edge on the market, as if (as a trader) you can form a reliable idea of future movement in price then you can position your portfolio to meet this bias.
Indexes and indictors that can be found all over the place normally look at very specific sets of data and certain aspects of a currency.
The Big Mac Index on the other hand gives you a big picture or ‘fundamental’ look at a currency comparison.
Opportunity is another big thing that traders struggle to find, finding currencies with potential for growth is effectively the name of the ‘macro investing game’. This is because finding a currency that is undervalued represents an opportunity to get in on the market early.
Getting in on a market with big potential for growth is what yields the highest returns, being able to get in at the start of a trend is way more valuable than turning u a few weeks late…
The Big mac index and fundamental analysis in general is a comprehensive way to spot market trends before they happen, therefore giving you the best shot at getting in at the start of a movement.
How do I know if a currency is Undervalued or Overvalued?
Currency value is a hard thing to analyse, there are so many ways to do it that it can become complicated…
Some traders decide to solely rely on price action and chart patterns to tell them where to enter their trades.
Naturally this small-minded approach to trading can produce inconsistent and sometimes even no returns.
Professional Forex traders know that currency value cannot be accurately determined using technical analysis, there needs to be a bigger picture approach to the currency and the economy that the currency is a part of.
This is called fundamental analysis.
The Big Mac Index is one tool that traders can use to gain a big picture view on what the value of a certain currency is other examples such as, interest rate decisions and consumer confidence surveys.
Some different tools that traders use as well as the Big Mac Index will be…
- The difference between Interest rates between countries.
- The difference between GDP in two different countries.
- Import and Export data
- Employment numbers
And a whole variety of tools laid out in this article!
How do Forex Traders Use Big Mac Index?
As previously stated, traders use the Big Mac Index to give them insight into whether a currency is under or over-valued, this will then lead to the respective trader planning on whether to long or go short (buy or sell) the currency.
With the most successful traders the Big Mac Index falls under the value section of their strategies, this value section is part of a three-step system to gain a big picture bias on a currency…
Value
The first step is value, this is the most important and probably the most complex step, we use fundamental analysis (including the Big Mac Index) to determine whether trade idea is good or bad and equate its value.
If the fundamentals look good that means the trade is of a high value and there is huge potential for our bias to be confirmed.
If the fundamentals are not so positive or maybe even just neutral the value of that trade decreases and we put those trades on a watch list to see how the fundamentals change over time.
As LITA traders we have access to all sorts of analysis tools and education to help with this step...
Non LITA traders and professionals who use fundamental analysis will find all this info and more such as interest rate decisions and consumer confidence surveys themselves through hours of research.
Optimise
The second Step is optimise, using indicators and chart patterns as a timing tool we determine a viable point of entry for any trade.
This is where the technical analysis comes to the forefront of professional analysis as it provides a door into the market to allow us to enter safely and be able to move on to step 3 with confidence in our bias.
One example of these tools is the COT reports mapped over time telling us the bias of hedge funds, effectively allowing ourselves to trade with them, and therefor emulate their success.
Risk Management
Step 3 is where we control our risk, using professional risk management methods we can protect our capital and ensure safe and well managed trades where we are able to enter the market with complete confidence and security no matter what way the trade goes.
At Logikfx we use our own software and tools such as the basis point calculator and the position size calculator to determine stop loss and take profit and our exposure limit calculator to manage our deposits and our exposure to gain complete confidence in our trade.
Professional traders also pay close attention to their risk to reward ratio, if the risk is significant and the reward is not then we do not place a trade and we go back to step 2 to try and find a better place to enter.
Is the Big Mac index misleading?
The issue with the raw Big mac index (you will understand why I called it ‘raw’ in a second) is that it does not consider the current conditions of the country it is assessing, for example labour costs in poorer countries will be much lower than in the UK or the US.
In the Economist’s own words…
“Varying labour costs and barriers to migration and trade may undermine purchasing-power parity”.
However, they did find a solution to this problem, They released an adjusted index which predicts what Big Mac prices should be given a country’s GDP per person.
Above is the GDP adjusted Index
Gross domestic product or GDP is a measure of the size and health of a country’s economy over a period (usually one quarter or one year).
It is also used to compare the size of different economies at a different point in time.
By using what is called the GDP adjusted Big mac index they can form a much more reliable outlook on what Prices and exchange rates should be, this includes looking at the difference between the predicted and the market price as an alternative measure of currency valuation.
Conclusion
The big mac index is a very useful tool for a lot of traders, it helps massively when trying to value currency, however, it cannot be used as the be all and end all of your currency valuation.
As explained in the “How do Forex Traders Use Big Mac Index?” section this index should be used as part of a comprehensive and tested fundamental strategy.
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