Financial instruments are often described as being undervalued or overvalued. Many investors , and traders, justify their actions on just such distinctions. In theory it is a sound concept. It certainly makes a lot of sense to purchase a security, or an asset class, if it is undervalued. At the opposite end of this spectrum, same logic would apply when selling an overvalued instrument. Problem is, how do we know when price of an asset is at a fair value and  when does it move into one of the extremes?  Formulas have been developed for all financial markets that help participants answer this important question. For currencies it is Purchasing Power Parity.

Currencies are probably the most difficult of major asset classes to have a reliable fair value measurement. For stocks one could use a ratio of liabilities to assets, projected earnings or book value and be reasonably satisfied with the results. Valuations for commodities can be done in similar manner, using existing inventories, current and future supply-demand ratios, etc;. It doesn’t mean that these calculations are fool proof but they satisfy a lot market players and justify their activity. Currencies more complex. They are not commodities, since they can be produced at will(printing money), nor should they be valued as stocks. After all, countries are not run like corporations, even if some think they should be.

Given these limitations, Purchasing Power Parity(PPP) concept was developed.  This assumption states that exchange rates of currencies should be in equilibrium if they have same purchasing power in their respective countries. For that a fixed basket of tradable goods and services is compared and PPP relationship is derived. Most people following markets are familiar with this concept in its simplest form, known as the “Big Mac Index”, which was introduced by “The Economist” magazine and uses the price of a hamburger around the world. It reasons that since product is virtually identical, it should have the same price everywhere. Price disparity from location to location implies an over- or undervaluation of host currency against US Dollar.

Purchasing Power Parity is a much more complex tool, which uses many more variables. It even includes inflation into formulas, but excludes “non movable” goods that can not be traded between countries, like houses. Number of international organizations calculate PPP, one of them is the Organization of Economic Cooperation and Development. University of British Columbia Sauder School of Business publishes PPP values in handy graphic form, which easily shows valuations against base currency. Here is the chart for US Dollar.

Similar graph for Euro.

These charts are up to date. More details can be found at http://fx.sauder.ubc.ca/PPP.html.  As we can see, in relation to US Dollar, many currencies are over valued, making USD undervalued against virtually all major currencies. Not so Euro, which, using PPP is inexpensive only against a handful of currencies. Most emerging markets seem to have their respective currencies severely undervalued in relation to both USD and EUR, situation which should correct itself over time. 

Purchasing Power Parity is intended to be a long term fundamental indicator for future currency moves, and not a guide for short term market swings. Theory states that exchange rates should gravitate towards parity, with economic forces gradually equalizing purchasing power between countries and their respective currencies. This process can be truly long term, measured in terms of months and even years. Some currencies can remain out of equilibrium for much longer.

 
Chart of Japanese Yen against US Dollar is overlaid with PPP for these currencies going back to mid 1980′s. As we can see JPY has been overvalued against USD for vast majority of this time. Only once, for a brief period couple of years ago, they were at “fair value”, during the height of the carry trade, before it imploded. What is changing, however, is the magnitude of this imbalance. The difference is getting smaller and smaller. It could be compared to a chart of any financial instrument plotted with a long term moving average. Price, bounced from the MA in is going for new high. This could have a making of double top, which would indicate pending reversal of this trend. This means that over coming months and years Japanese Yen should weaken significantly in relation to US Dollar, and likely other currencies, too.

Purchasing Power Parity is useful long term indicator. Unfortunately, it is difficult to use for active, short term trader. It reflects very long, fundamental forces. Not everybody has the patience and deep pockets necessary for trading this indicator. Nonetheless, it helps to clarify this illusive quantity for every currency- its value. And, of course, it is always helpful in deciding where to go on vacation. At this time Turkey and Mexico are a good value as measured by PPP.

Mike K.