By Kathy Lien
There have been a lot of big swings in the currency market over the past year. Eight months ago, the EUR/USD was trading at a record high of 1.60 and now it is only few cents away from its 3 year low. In the past 6 months alone, the British pound, Australian and New Zealand dollars have fallen more than 20 percent against the US dollar. Currencies that were once overvalued have now become undervalued. Although currencies do not always trade at fair value, the valuation of currencies is important for context. Let’s take a look at the current valuation of currencies based upon Purchasing Power Parity.
What is Purchasing Power Parity?
Purchasing power parity is based on the idea that foreign exchange rates are determined by the relative prices of a similar basket of goods between 2 countries. In other words, a Big Mac in the US should cost the same as a Big Mac in the UK once exchange rates are accounted for. PPP has its faults as it assumes that goods can be traded easily without regard to such things as tariffs, quotas and taxes. It is also a long term way of valuing exchange rates and does not take into consider shorter term factors.
Nonetheless, PPP gives us context when looking at the current valuation of various currencies against the US dollar. There are 3 publicly available sources for purchasing power parities – Bloomberg’s PPP calculation using consumer prices, the Economists’ PPP calculation that compares the price of Big Macs around the world and the OECD’s PPP data. The reason why the PPP values are not consistent is because different methods of calculation and different baskets of goods used to comare prices will arrive at different PPP rates.
This is why we need to look at the valuation of the currencies from a broader perspective.
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