Always consider hidden risks
The Big Mac Index And the New iMac Index ?
Sep 25 ( From Pragmatic Capitalism, WSJ, The Economist,
Econfix,Wiki, University of BC )
Big Mac Index
The Big Mac Index is published by The Economist as an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. The Economist’s Big Mac Index provides us with a glimpse at relative values in the currency markets. It seeks to make exchange-rate being able to make comparison...
The Big Mac index is The Economist’s lighthearted analysis of foreign-exchange rates. Its secret sauce is the theory of purchasing-power parity (PPP), according to which prices and exchange rates should adjust over the long run, so that identical baskets of tradable goods cost the same across countries. Our basket contains only a Big Mac, and relies on the efforts of McDonald’s to produce identical products from the same ingredients everywhere (or almost everywhere: for India we use the Maharaja Mac, which contains chicken rather than beef).
The Purchasing Power Parity
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large.
Does PPP determine exchange rates in the short term?
No. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would be typical.
How is PPP calculated?
The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries.
According to PPP, by how much are currencies overvalued or undervalued?
OECD comparative price levels
Each month, the Organisation for Economic Co-operation and Development measures the difference in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed, as of November 2012, in each of the countries listed to buy the same representative basket of consumer goods and services that would cost 100 USD in the United States. According to the table, an American living or travelling in Norway on an income denominated in US dollars would find that country (in November 2012) to be the most expensive of the group, having to spend 71% more US dollars to maintain a standard of living comparable to the USA in terms of consumption. At that time it could be said the price of a Big Mac in Norway was fairly representative of Norway's price level (as measured by a broader basket) since the Big Mac Index implied that Norway's currency was 80% overvalued, not far off 71%.
At market exchange rates, the Canadian version of the burger costs $5.26 ($485 for an iMac), compared with an average price of $4.56 in America ($499for an iMac). By our reckoning, then, the Canadian dollar is roughly 15% overvalued relative to its American counterpart. In Mexico, by contrast, a Big Mac is just $2.86 ($592for an iMac) at market exchange rates, suggesting the peso is 37% below its long-run value relative to the dollar. The greenback buys much more Big Mac south of the border than north of it.
The Big Mac index suggests that currencies are particularly overvalued in Norway, Venezuala and Switzerland ( see graph above ).
Currencies in much of the emerging world, including Russia, China, and India, are too cheap relative to the dollar on our gauge.
Japan is the country that caused the most recent talk of currency battles. The new government’s plan to reflate the economy with fiscal and monetary stimulus has helped drive the value of the yen down in recent months. The Big Mac index put the yen close to fair value against the dollar in July; it is more than 29% undervalued now. That’s a tasty development for Japanese exporters but indigestible news for rivals.
So one of the bet arbitrage is to buy an for an iMac in Canada and to sell a Big Mac!
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The New iMac Index : Argentina Most Expensive Place to Buy iPad, Malaysia Cheapest
( From Wall Street Journal )
Consumers in Argentina pay the most globally for an iPad, more than double the cost in Malaysia, the world’s cheapest place to buy the Apple Inc. product.
A 16-gigabyte iPad with Wi-Fi and a retina display sells for $1,094.11 in Argentina, compared with $473.77 in Malaysia, according to CommSec, a unit of Australia’s Commonwealth Bank.
Other expensive places to buy an iPad include northern Europe and Latin America. (Brazil: $791.40; and Denmark: $725.32.)
CommSec has been keeping an iPod index since 2007 (it later added the iPad) as a way of monitoring whether currencies are valued appropriately.
The index is a way of exploring the economic concept of purchasing power parity. That is, a good should trade at the same price in different countries when expressed in the same currency given free markets.
In theory, price differentials between countries are not sustainable in the long run because of market forces that will prompt consumers and businesses to shop overseas for cheaper products.
The index takes its name from the Big Mac, a hamburger sold at McDonald's restaurants.
The Economist first compared the price of a McDonald’s Big Mac in a number of countries in 1986. It regarded the long-established Big Mac as the perfect universal commodity now produced locally in sixty-six countries. If the prices of a Big Mac in several countries in local currencies were expressed in dollars using the exchange rate, then it would be possible to see whether exchange rates do equalize the prices of an identical commodity such as a Big Mac. It is evident that a dollar does not buy the same amount in each of these nine countries. The question arises as to whether the exchange rate between the dollar and the currency of each of the countries shown below moves in the long run to equalize prices of an identical product such as a Big Mac. Some economists think this is the case.
One suggested method of predicting exchange rate movements is that the rate between two currencies should naturally adjust so that a sample basket of goods and services should cost the same in both currencies (PPP). In the Big Mac index, the basket in question is a single Big Mac burger as sold by the McDonald's fast food restaurant chain. The Big Mac was chosen because it is available to a common specification in many countries around the world as local McDonald's franchisees at least in theory have significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies.
The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued. ( See graph below )
IPad Index Big Mac Index
The Big Mac Index And the New iMac Index ? $MACRO, $STUDY
, $MCD, $AAPL