Purchasing Power Parity Trading Strategies
Have you ever asked yourself why your 5 pound can barely buy you a Big Mac in the UK but...
In a different country it could buy you a whole farm to grow all the ingredients necessary to create your very own Big Mac?
Yeah... me neither... but today we are going to be talking about how much power your 5 pound not has, and why other currencies are weaker...
We are going to discuss:
What is Purchasing Power Parity in simple terms?
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 any two countries.
Simply put, Purchasing Power Parity is comparing the difference in price of the same product in different currencies.
Doing this allows us to see how much Purchasing Power one currency has against another, for example, if I could buy 1 Big Mac for $5 In the US but in India that same $5 could buy me 5 Big Macs due to the different economic conditions!!
How is PPP calculated?
Purchasing Power Parity may seem like a complex economic theory; however, it is pretty simple to understand, and you can even calculate it by yourself if you want…
Here’s how!
PPP is calculated by dividing the average price of a product in one country, for example the UK, with the price of the same product in another country, for example, the US in their own respective currencies…
The resulting number is the Purchasing Power Parity!
Once you have the PPP value you compare this with the current exchange rate.
If the PPP value is lower then the exchange rate, this would mean your base currency (the currency on the left of your forex pair) is undervalued, and vice versa!
Why is PPP important?
Jamal Ibrahim Haidar in the research paper titled ‘Currency Valuation and Purchasing Power Parity’ states that...
“PPP helps determine whether the foreign exchange market precisely prices a currency because a currency, typically, reverts to its PPP value over time.”
Purchasing Power Parity is not just a tool used by Traders and investors to make money.
It is also widely used by economists and public officials to identify weaknesses in their own and other economies.
Identifying if their prices for essential goods such as Water supply, heating and electricity are firm and fair, allowing them to make Fiscal Policy decisions.
Purchasing Power appears in our everyday lives, if you have ever wondered why in the UK your £2 can buy you a chocolate bar but in Brazil that same £2 could buy you a 3-course meal then you have experienced PPP.
PPP allows us to see the gaps in currency, it is based on the theory that a product should have the ‘same price no matter where its sold in the world’, you can see that this is not always the case. Once we have seen this, we can then explore why they do not cost the same…
In the Big Mac examples Beef might be cheaper in the US than in Switzerland and therefore your $4.99 Big Mac may cost something closer to $8.99 if you took your money to a Swiss Maccies!!
PPP gives us a gateway to understanding different economies and currencies by giving us a level playing field to compare all currencies on, and then exposing the gaps for us to fill.
How does PPP affect exchange rates?
PPP and exchange rates have a very close relationship, as I showed you earlier, we can use the Purchasing Power Parity between two currencies to actually figure out what the target (optimal) exchange rate should be between two countries.
This can help us make trading decisions by helping us build a good strong bias on a currency or currency pair which is key for the Global Macro Investing method used by Logikfx traders.
If we know that a currency is undervalued thanks to our own PPP workings or an indicator like the Big Mac Index, we can then explore why it is undervalued by exploring different fundamental indicators like import and export data or Interest Rate differentials to help us build a good picture around an economy.
Haidar (2011) sets out in his research paper that the big Mac Index alone “cannot provide a ‘true’ value of currency” and that...
“While the BMI is not perfect, it provides hints about the operation of foreign exchange markets”.
Like most Fundamental indicators if used by itself the Big Mac Index cannot provide you with enough solid data to accurately predict movement on exchange rates, which is inevitably how traders make money, but it does act as a platform, to build a bigger picture on an economy.
What is the Big Mac Index?
You have probably noticed me using Big Macs and referencing the Big Mac Index Multiple times in this article, and no I’m not hungry, so let me explain why…
The Big Mac Index was invented by The Economist in 1986 as a guide to whether currencies are at their “correct” level.
It is based on the theory of purchasing-power parity (PPP), the notion 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, a burger) in any two countries.
To give you an example of how it tells us this as of January 2021 a Big Mac costs £3.29 in Britain and US$5.66 in the United States. The implied exchange rate is 0.58.
The difference between this and the actual exchange rate, 0.74, suggests the British pound is 21.6% undervalued!
If you are as intrigued by the BMI as most other traders, then make sure you read Logikfx’s guide to the Big Mac Index and how to use it in your strategy!
Why does currency strength matter?
Most Traders use technical chart patterns and short-term news events to gain biases on the currency and economy that they are trading with, and while this information is relevant, it is not concrete enough to gain actual big picture view of how strong a countries economy actually is.
Determining currency strength involve many different factors, below is a chart where you can see how much information goes into determining currency strength...
That may seem like unnecessary and long-winded information but gathering all that is worth it when you see the results of trader that use currency strength as part of their trading strategy…
The benefit of determining currency strength is that it provides you with reliable long-term information, and as factors like money supply and interest rates take time to implement the bias moves slowly, giving you ample waring if there is likely to be an uptick in strength.
I know what you’re thinking though…
At Logikfx we are lazy! If something can be simplified without sacrificing credibility, we get it done!!!
We are all about saving time, that’s why we created the currency strength meter, our flagship piece of tech.
This tool condenses everything you saw in the chart above into a simple number, if you want to learn more about the details of this then read this article!
Purchasing Power Parity is just one piece of the puzzle when it comes to currency strength, it gives Global Macro investors and insight into different economies and exposes the gaps in currency that can be filed with other Fundamental indicators such as IR% differentials and GDP differentials.
Purchasing Power Parity vs GDP
PPP and GDP also share a very similar relationship, they both indicate the health/strength of economies however they draw on very different data to do so.
This then allows us to asses the strength of a currency More effectively.
GDP is defined as the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health. - Investopedia
In simple terms GDP looks at all the services and goods produced in a specific country, no matter who makes it, if it was made within that countries borders then it counts towards GDP.
Remember earlier I told you that GDP and PPP have a special relationship?
Many people criticize the Big Mac Index (the PPP indicator) because you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate.
Taking this criticism on board the economist came up with the GDP-adjusted Big Mac index, and it works like so...
Varying labour costs and barriers to migration and trade may undermine purchasing-power parity...
To control for this, the adjusted index predicts what Big Mac prices should be given a country’s GDP per person...
The difference between the predicted and the market price is an alternative measure of currency valuation.
to illustrate what this looks like lets look at the GDP-adjusted BMI:
As we can see from the new indicator, a Big Mac costs 22% less in Britain (US$4.44) than in the United States (US$5.66) at market exchange rates. Based on differences in GDP per person, a Big Mac should cost 17% less. This suggests the pound is 5.8% undervalued.
How strong is the Dollar in 2021?
In this section we will be looking at the Economists Big Mac Index and comparing 5 of the major currencies with the US Dollar, to help us gain insight into what PPP can tell us...
We will be comparing USD against: GBP, AUD, NZD, CAD and JPY; using the GDP adjusted Index for more accurate results.
USD vs GBP
The British pound is 6% undervalued against the US dollar.
USD vs AUD
The Australian dollar is 4% undervalued against the US dollar.
USD vs NZD
The New Zealand dollar is 4% overvalued against the US dollar.
USD vs CAD
The Canadian dollar is 9% overvalued against the US dollar.
USD vs JPY
The Japanese yen is 19% undervalued against the US dollar.
Here's a link to the BMI so you can check any currencies strength against the USD: https://www.economist.com/big-mac-index
What are the drawbacks of PPP?
With any fundamental or technical indicator there are always shortcomings when it comes to it’s respective abilities and no indicator or tool is 100% perfect.
It is hard to find specific products that are sold the same over lots of different countries, even the Big Mac is different in India than it is in the USA, this makes PPP hard to spot and a difficult measurement to make.
PPP doesn’t consider other factors that affect currency strength; this would not be an issue if every trader had similar education to the education provided at companies like Logikfx but unfortunately that isn’t true.
PPP cannot be trusted by itself as there is always more context to a currency underperforming or being undervalues than just the price of a Big Mac.
Many people mistake the fact that PPP is an old and established economic theory that it can always be trusted to give you an accurate idea of currency strength, this is not true.
Just like I have said before, in trading context is always key, understanding why currencies are moving Bearish or Bullish is much more helpful for you as a trader in the long term than just entering trades blind.
PPP is a long term, big picture kind of fundamental indicator.
It will give you an idea on a currency, but price won’t normally start to move for a while, and plus there may be other forces keeping the currency undervalued.
This can catch traders who do not know how to time their trades properly as they wait for weeks while their position is hovering in the RED!!
The issue here is not necessarily the fact that it is a long term indicator, as that’s actually what we prefer at logikfx, the problem is that as PPP and PPP tools like the BMI state that currency is under or over-valued, there will be months before you might start to see a reaction into where you want to go.
Because PPP isn’t as powerful an indicator as Money Supply or GDP differentials a currency can stay in that under or overvalued area for much longer than a couple of months.
These points are the two main drawbacks of PPP, it’s difficulty to actually analyse affectively and also its lack of context.
These two points illustrate how academics such as ‘Jamal Ibrahim Haidar’ (Haidar, 2011) from the International Finance Corporation of the World Bank feel about using PPP and more specifically the Big Mac Index.
How to use PPP in your Trading Strategy
Purchasing Power Parity is unique, it’s not often that traders can see economic theory make it’s way into trading currency, we are used to seeing Macro and Microeconomics affect our trades.
Tangible things like interest rates or GDP, but, whether its being taught at universities or talked about on Bloomberg PPP remains relevant…
Purchasing Power Parity is most affective when It is combined with other fundamental indicators, as it gives us an idea of what currencies may be under or over-valued, then using other indicators we can add context to this PPP or Big Mac Index value.
This allows you to gain big picture biases and opinions on currency and as we just learned, trying to use the Big Mac Index or PPP in general for short term trades isn’t very affective.
Conclusion
Purchasing Power Parity seems complex, it’s not.
It seems like you would need a degree to be able to properly understand it, that may help to be honest but really you don’t need an econ-degree.
This article has explained to you what PPP is, how to calculate it for yourself or read it on the Big Mac Index, how to trade using PPP and also what to look out for when implementing it into your strategy.
Still learning how to trade? Learn through Logikfx Investment and Trading Academy (LITA) and take the first steps into growing your value as a trader with our free online courses, webinars, seminars. All from a small team of highly skilled traders with over 15 years’ experience in the financial markets. Learn how to make money trading forex, alongside the best ways to manage your risk through a proper trading journal, and sensible approaches to setting a stop loss (that doesn't get hit)!
Already know how to trade? Save hundreds of hours each month on trading technology, analysis and research using Logikfx's Macro Technology in the LITA Portal. Computing thousands of fundamental reports for over 23 economic regions, you'll know accurate currency strength at the click of a button.
References:
Haidar, J.I. (2011). Currency Valuation and Purchasing Power Parity. SSRN Electronic Journal, 12(3).
