Being a good investor means that you have understood more than just stocks, companies and what makes a good investment. One of the following most important things to consider is currencies, these are particularly important when you are investing in foreign assets (which is a good idea for diversification).
Investors are constantly searching for resources that will enable them to make well-informed investing choices. One such tool that gives a quick and simple way to calculate purchasing power parity (PPP) between two currencies is The Economist’s Big Mac Index, which is released yearly. We will go over the Big Mac Index’s definition, methodology, and significance for investors in this article.
What is the Big Mac Index?
This is something that was explained to me during my undergraduate years at University and the concept is pretty interesting. The Big Mac Index is a price index that compares the relative price of a Big Mac burger in different countries. The index was introduced in 1986 by The Economist as a semi-humorous illustration of PPP, but it has since become a widely recognised tool for comparing currency values. The idea behind the index is that a Big Mac burger is a standardised product (although many will disagree with this!) that is sold in almost every country around the world (in fact in some countries, McDonald’s has been banned, Bermuda, Bolivia, Iceland, Iran, Macedonia, Yemen and Zimbabwe, among others). As it is sold and consumed in many countries, its price can be used as a benchmark for comparing the cost of living and currency values between countries.
How does the Big Mac Index work?
To calculate the Big Mac Index, the price of a Big Mac burger in a foreign country is divided by the price of a Big Mac burger in a base country (usually the United States). This gives an implied exchange rate between the two currencies, which can be compared to the actual exchange rate to determine if a currency is overvalued or undervalued.
Let’s use GBP to USD as an example. Suppose the price of a Big Mac in the UK is £3.39, while the price of a Big Mac in the US is $5.66. The implied exchange rate between the pound sterling and the US dollar is 1.67 (£3.39/$5.66). If the actual exchange rate is lower than 1.67, then the pound sterling is undervalued against the US dollar. If the actual exchange rate is higher than 1.67, then the pound sterling is overvalued against the US dollar.
As of January 2022, the exchange rate between GBP and USD was 1.35, which is lower than the implied exchange rate of 1.67. This means that the pound sterling is undervalued against the US dollar according to the Big Mac index.
Why is the Big Mac Index important for investors?
For a number of reasons, the Big Mac Index can be a valuable tool for investors. First off, it offers a quick and simple method for comparing the cost of living and exchange rates between nations. This can be helpful for investors seeking investment opportunities in nations with undervalued currencies or who are thinking about investing in international markets.
Second, the Big Mac Index can be used to spot nations that might be going through an inflation or deflationary period. A country may be suffering inflation if the cost of a Big Mac there is rising more quickly than in the base country. The cost of a Big Mac may be a sign of deflation if it is getting cheaper.
Third, the Big Mac Index can be used to identify potential trade opportunities. For example, if a country’s currency is undervalued according to the Big Mac Index, it may be cheaper for investors to import goods from that country. This can be risky though and should be thought about with extreme caution!
Last but not least, the Big Mac Index can be a useful tool for investors who are looking to hedge their currency risk. By comparing the implied exchange rate with the actual exchange rate, investors can determine whether a currency is overvalued or undervalued and adjust their investment strategies accordingly.
To wrap things up, investors can analyse the purchasing power of various currencies and seek potential arbitrage possibilities using the Big Mac Index. The index has some drawbacks, but it is a convenient and approachable way to learn about the relative worth of differing currencies. The Big Mac Index will likely remain a crucial tool for investors and economists as the world grows more globally integrated.