Japanese Yen is Cheapest and Swiss Franc the Most Expensive Currencies says 'Big Mac Index'

- Valuation metrics rank relative value of G10 currencies.

- Yen is cheapest on all metrics - Swiss Franc most expensive.

- Currency valuations may explain recent moves in FX market.

Image © Leonid Andronov, Adobe Stock

The market value of something may not be its 'true' value and it is the job of analysts to try to determine the latter so as to better identify whether an asset is a bargain, or piece of 'old rope'.

There are many methods of evaluating asset prices but in the currency market two important ones are the "Real Effective Exchange Rate (REER) and Purchasing Power Parity (PPO) valuation methods.

REER is a measure of how fairly a currency is priced against a basket of its most highly traded peers. PPP uses the difference in cost of a basket of similar goods in two different currencies to determine currency valuation.

A useful proxy for the basket of comparable goods is the Big Mac Index, which evaluates an exchange rate according to the difference in the price of a McDonalds Big Mac hamburger in two countries. Although it may sound like a joke, the Big Mac Index is actually quite a serious tool for evaluating currencies. 

The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. If a currency is overvalued the assumption is that it will drift back to fair value and therefore depreciate over time. Vice versa if a currency is undervalued.

Below are the G10 currencies from both a REER perspective and PPP,  based on up-to-date information from the Bank of International Settlements (BIS) (for REER), and the Economist website (for PPP). The Big Mac Index uses slightly out of date info from July 2018 but the BIS REER data is from August 8, 2018.

The Yen is the most undervalued and the Swiss Franc the most overvalued currency in the G10 based on an average of several valuation methods. These include both REER and PPP using the Big Mac Index, and a GDP-adjusted variation of the Big Mac Index. Valuations versus both GBP and USD are included in the PPP calculations.

Above: PPP currency valuations.

As can be seen from the chart above the Yen is the most undervalued currency, by just under 20%, and the Swiss Franc is overvalued by more than 20%. This suggests that over the long-term, the Yen will probably rise and the Franc may fall.

Looked at purely on a REER basis, as of August 08 2018, the currency valuations are as shown in the chart below:

Above: REER currency valuations.

Purely on a REER basis, the Canadian Dollar is actually the most undervalued currency, by around 18%. The most overvalued is still the Swiss Franc, also by around 18%. 

The Big Mac Index for Pound Sterling as the base currency for comparison shows its value relative to other G10 currencies below.

Above: GBP Big Mac Index valuations.

Again the Yen is the most undervalued currency and Swiss Franc the most overvalued. Finally, the Big Mac Index using the Dollar as the base currency for comparison, shows G10 currencies are valued as follows.

Above: USD Big Mac Index.

Once again there is no change in the conclusion - the Yen is still cheap and Franc most expensive. Interestingly, relative valuations may explain why the Yen and Canadian Dollar have been rising so strongly recently, because they are the two most undervalued of the G10 currencies.

Valuations may also explain why analysts have been so keen to call a top in USD/JPY despite the pair being in a strong uptrend. If the pair went much higher then the Yen would become even more undervalued.

Above: Currency valuation data from various models.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here