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Which Currencies are Overvalued and Undervalued?

Last updated 2/26/2009 7:33 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

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.

Based upon all 3 PPP calculations, the Swiss Franc is the most overvalued currency followed by the Euro.   This is not much of a surprise since the Swiss Franc has fallen the least against the US dollar over the past 6 months.  

The most undervalued currencies are the Australian and New Zealand dollars.   The British pound and Canadian dollars are also undervalued but only marginally.  

What does this tell us about exchange rates going forward?   On a short term basis, nothing much.   However from a longer term perspective, the weakness of the Australian dollar could make it an attractive value play while further strength in the CHF and EUR could be limited.  

More on Purchasing Power Parity

PPP’s Basket of Goods

The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by gross domestic product (GDP). It includes consumer goods and services, government services, equipment goods, and construction projects. More specifically, consumer items include food, beverages, tobacco, clothing, footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishings, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, goods and services for personal care and household operation, and repair and maintenance services.

Big Mac Index

One of the most famous examples of PPP is the Economist’s Big Mac Index. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere, comparing these with actual rates signals if a currency is under or overvalued. For example, consider that the exchange rate between the United States and Canada is 1.57. In the United States a Big Mac cost $2.49. In Canada, a Big Mac cost $3.33 in local Canadian dollars (CAD), which works out to only $2.12 in U.S. dollars. Therefore, in the case the exchange rate for USD/CAD is overvalued by 15 percent using this theory and should be only 1.34.

OECD Purchasing Power Parity Index

A more formal index is put out by the Organization for Economic Cooperation and Development. Under a joint OECD-Eurostat PPP program, the OECD and Eurostat share the responsibility for calculating PPPs. This latest information on which currencies are under- or overvalued against the U.S. dollar can be found on the OECD’s web site at www.oecd.org. The OECD publishes a table that shows the price levels for the major industrialized countries. Each column states the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case the representative basket costs 100 units in the country whose currency is specified. The chart that is then created compares the PPP of a currency with its actual exchange rate. The chart is updated weekly to reflect the current exchange rate. It is also updated about twice a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the OECD; however, they should not be taken as definitive. Different methods of calculation will arrive at different PPP rates.

Limitations to Using Purchasing Power Parity

PPP theory should be used only for long-term fundamental analysis. The economic forces behind PPP will eventually equalize the purchasing power of currencies. However, this can take many years. A time horizon of 5 to 10 years is typical. PPP’s major weakness is that it assumes goods can be traded easily, without regard to such things as tariffs, quotas, or taxes. For example, when the United States announces new tariffs on imports the cost of domestic manufactured goods goes up; but those increases will not be reflected in the U.S. PPP tables.

There are other factors that must also be considered when weighing PPP: inflation, interest rate differentials, economic releases/reports, asset markets, trade flows, and political developments. Indeed, PPP is just one of several theories traders should use when determining exchange rates

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.