Many people have tried a famous Big Mac at McDonald’s fast food restaurants at least once in their lives (even though it’s not quite healthy food).
This hamburger is probably the most famous in the product line of the American fast food industry. However, few people know that it gave rise to the so-called Big Mac Index, which is used to compare the value of currencies of different countries.
What is the Big Mac Index?
The Big Mac Index is the price of the burger in various countries that are converted to one currency (such as the US dollar) and used to measure purchasing power parity.
It all started in 1986 when The Economist magazine decided to estimate the currencies’ value by countries based on the prices of Big Mac at McDonald’s fast-food restaurants.
Thus, The Economist introduced a simple indicator of the fundamental value of currencies globally.
Why exactly was the Big Mac taken as an indicator?
The reason is very simple. Big Mac is the most well-known product in McDonalds’ fast-food chain. Besides, the same ingredients are used for Big Mac in any country: meat, bread, cheese, lettuce, onions, etc. Therefore, The Economist experts use Big Mac alone instead of determining the cost of a consumer basket (more complex method) for each country.
Big Mac Index Table as of Q2 2020
The most relevant Big Mac Index so far (as of July 2020) is presented in the table below.
Let's analyze these data a bit.
The South African Rand exchange rate expressed in terms of the Big Mac Index in 2020 is 5.43 rand per dollar.
Considering that the current market rate of the South African currency is about 16.67 rand, rather than 5.43 per US dollar, the rand is undervalued by approximately 67.44%.
Thus, the South African Rand is the world’s most undervalued (cheapest) currency according to the Big Mac Index.
In 2019, the Russian ruble was the most undervalued (by 64.5%) currency worldwide.
Now, Big Mac costs $1.91 in Russia. While the price of the burger in the United States is $5.71, the Russian currency exchange rate is 23.64 ruble per dollar in terms of the Big Mac Index.
However, the ruble is much cheaper in Forex – about 70.59 ruble per US dollar (as of July 2020). Therefore, we can conclude that the Russian currency is undervalued by the market by almost 66.51%.
In the list of world’s most undervalued currencies, Russian ruble and the south african rand are accompanied by the turkish lira (undervalued by 64.28%), the ukrainian hryvnia (by 61.28%), and the mexican peso (by 60.97%). Notably, the currencies of India, Pakistan, Philippines, and other low-income countries are not in the top five most undervalued currencies in 2020.
As for the most highly valued currencies, the statistics by countries shows that the world’s most overvalued (expensive) currency is the Swiss franc.
Considering that Big Mac costs 6.91 francs in Switzerland, the USD/CHF rate expressed in the Big Mac Index terms should be 1.14 francs per dollar. However, the value of this pair is currently quoted around 0.94 in Forex, which makes the Swiss currency overvalued by the market by 20.94%.
Lebanese pound overvalued by the market by 4.25%. Swedish krona overvalued by the market by 0.80%. Besides the lebanese pound and swedish krona, The Economist’s experts identified other overvalued currency in their previous rating – Norwegian krone. However, today, things are not the same for these currency as well – they have also become undervalued, although not as much as the rand and ruble.
According to the Big Mac Index authors, Euro is also undervalued by the market. The average price of Big Mac in the Eurozone is 4.79 euros, meaning the currency is undervalued by 16.18%.
Notably, according to the Big Mac Index, all major currency pairs, except the Swiss franc, Swedish krona and Lebanese pound, are undervalued against the US dollar.
Can We Use This Knowledge in Trading?
We can hardly do it in the short and medium terms, but the Big Mac Index can serve as a useful assistant while long-term trading.
For example, it can be used as a filter when opening positions in the Forex market. After all, if the Japanese yen is significantly oversold against the US dollar, traders are better to refrain from opening long positions on USD/JPY.
Similar conclusions can be drawn for other Forex currency pairs.
The key thing to remember is that the Big Mac Index is a true indicator of the fundamental value of currencies, and it can be used by traders in trading.