How a burger became a Purchasing Power Parity index
Even those not familiar with financial terms have definitely heard about the Big Mac Index. However, hearing about something doesn’t equal understanding it. Let’s make a quick dive into the history behind this.
Back in September 1986, The Economist created the Big Mac Index named after a hamburger sold in McDonald’s restaurants. It was a partially humorous illustration of PPP – purchasing power parity. The PPP theory suggests that currency exchange rates should be the same as a basket of goods and services in different countries.
The Big Mac was the perfect choice for this, because of identical ingredients and franchise’s control around the world. Consequently, it makes the comparison possible between various currencies.
What is the recipe then? We obtain the Big Mac Index by dividing the price of a Big Mac in one country by the price of a Big Mac in another country in their local currencies. The result is compared then with the actual exchange rate between two currencies. If the value is lower, then the first currency is considered under-valued in contrast with the second. And vice versa, if the number is higher, then the first currency is over-valued. For instance, in April 2009, the Big Mac was sold in Germany for €2.99 (US$3.96), which points to the euro being traded above the PPP with a relatively big difference of 10.9%. As of July 2018, the most expensive places to buy the hamburger were Switzerland, Sweden and the US and the cheapest were Egypt, Ukraine and Russia.
What is interesting to know is that there are many more variations of the Big Mac index, which investors deem to be helpful. UBS Wealth Management expanded the index to include the number of hours an average person has to work to afford a Big Mac. For example, in 2015 it would take you 8.6 minutes in Hong Kong to earn a Big Mac, while in Kenya the number goes up to 172.6 minutes. Furthermore, you can even find similar indexes regarding Apple devices, Starbucks items, Ikea Billy bookshelf, and so on.
How can investors benefit from it? You don’t have to eat junk food to use the BM index for your own good. As a matter of fact, you can easily calculate for yourself the real economy situation of the country before starting a business there. For example, there were rumors between 2010 and 2012 that Argentina had been altering its official consumer price data to understate its actual inflation rate. The Economist found out with the help of its Big Mac Index that the average annual rate of burger inflation was 19%, whereas Argentina claimed it be 10%. Due to these calculations numerous investors were informed of the growing inflation. Thus, it helped them in valuing bonds and other inflation-sensitive securities, because such mistakes would come at a price bigger than Big Mac’s.
Besides, the data from the Big Mac Index is useful for investors in other ways. You can use the values to make sure whether the currency is overvalued or undervalued in comparison with others. Sometimes, the official numbers from the foreign exchange market sure can lie. Moreover, investors can monitor changes in the numbers by themselves to be aware of inflation rates.
Overall, it might seem like just another humorous unit of measurement, but you can never be overly informed. I would advise you to keep an eye on all changes in the currency market in all the ways possible. Only this way will you be able to earn a million of Big Macs in no time.