almost 2 years ago • 2 mins
The Big Mac Index is based on the idea that identical goods (like, say, a Big Mac) should have the same price – adjusted for the exchange rate – in any country. When they don’t, that suggests that one country’s currency is perhaps out of whack with its fundamentals – and that may imply an investment opportunity.
Say a Big Mac costs 24.4 yuan in China and $5.80 in the US. If they were selling at roughly proportional prices in both countries, you could assume a theoretical exchange rate of 4.2 yuan (or renminbi) per US dollar (24.4 divided by 5.80). The thing is, the actual currency exchange rate is 6.37. So since you can get more yuan per USD than you should in theory, the yuan is considered undervalued. By comparing every currency to the US dollar, we can then quickly see which currencies are over- or undervalued versus the dollar – that’s the Big Mac Index.
The results are interesting: the Russian ruble and Turkish lira were the most undervalued currencies in January when the latest index was released, with exchange rates trading around 70% below their “Big Mac” levels. Switzerland’s franc and Norway’s krone, on the other hand, were the benchmark’s most (and only) overvalued currencies versus the US dollar. Other notably undervalued currencies were the Japanese yen (-41%), the Mexican peso (-42%), the Chinese yuan (-34%) and the Australian dollar (-22%). It Oh and it also shows that the US dollar is pretty overvalued.
Of course, the Big Mac Index isn’t aimed at providing an exact measure of a currency’s fair value (there are too many limiting assumptions, after all). But it remains a quick and easy way to judge whether a currency has deviated by too much from its fair value. You can see, for instance, that the Turkish lira is likely undervalued versus the Swiss franc. And the Japanese yen is likely undervalued versus the Norwegian krone, or even versus the US Dollar. For those with a long-term horizon, those pairs might present some interesting currency value trades. One way to profit is to buy the currencies that you think are undervalued, or invest in assets (stocks or bonds, for example) that are denominated in those currencies. Another is to use contracts-for-differences to bet on certain currency pairs that you think are poised to shift.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.