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Why forex traders need to understand the Big Mac Index

US Dollar Index, index, Why forex traders need to understand the Big Mac Index

What thought comes to mind when you read the "Big Mac Index"? Most people will probably think of the McDonald's logo. But for those who are interested in finance, this index can be much more important than just a hamburger.

What is the Big Mac Index?

The Big Mac index really directly refers to the "Big Mac" of McDonald's. McDonald's is a huge global network of fast food enterprises, covering more than 70-80% of the globe. The Big Mac is used as a reference point for the economy, based on how much the Big Mac costs in each of the countries, which reflects the cost and value of different currencies. The Big Mac burger is used because it is sold in every existing store.

Big Mac Index in 2020

Country - Price, USD

Australia - 4,13

Brazil - 3,63

Canada - 4,81

Germany - 4, 52

Russia - 1,79

Spain - 4,52

USA - 5,67

The famous annual review of The Economist magazine

When The Economist magazine first introduced the Big Mac Index in 1986, it was conceived as a fun and entertaining way to calculate purchasing power parity. Thirty-four years later, this index has become one of the most quoted and reliable in the world standard, which traders rely on and which is also taught in many economic textbooks.

What is purchasing power parity?

Purchasing power parity is an economic theory known as a "basket of goods". Purchasing power parity is used as a benchmark to calculate whether the two currencies being compared are in equilibrium.

Read more: What is a Benchmark in investment and trading

The levels are tested through the prism of a fixed set of consumer goods and commodities. The two currencies must be in balance when both are placed in the basket, and must have the same value in each country.

In the case of the Big Mac Index, the price of the famous McDonald's Big Mac is the benchmark used to determine purchasing power parity. The theory states that fluctuations in the exchange rate between currencies affect the price that consumers will eventually pay for a hamburger.

Why you might be interested in using purchasing power parity for forex trading

For traders who do not know, purchasing power parity (PPP) is an indicator that is used to compare economic variables, since they differ in different countries. One of the key attributes of the model is that it is formed without taking into account changes in exchange rates and possible distortions.

This is the problem of forex traders who want to use this model in their daily trading. Forex traders need data on exchange rates to make informed investment decisions.

Unlike purchasing power parity, the Big Mac index is based on differences in exchange rates and directly reflects the value and devaluation of currencies. This makes it a much more effective indicator for forex traders. The Big Mac is also a material object, and not a concept, like purchasing power parity.

Read more: What is the devaluation of currency

Why the Big Mac Index can be a great tool for forecasting the forex market

Since its creation in 1986, the Big Mac index has been a valuable tool for forex traders who wanted to find a connection between the long-term forecast of a currency and its exchange rate. Traders who use the index to predict the market perceive discrepancies between the index and the real exchange rate as a measure of potential future correction of exchange rates. In other words, the index connects the Forex market with commodities and shows the direction where the market can go.

As is the case with most theories, this correlation only works until it stops working. Since the cost of a hamburger can be influenced by various factors, the exchange rate is not always an accurate indicator of the strength and direction of the market.

But the main reason why the Big Mac is not a reliable indicator is that it does not take into account small short-term fluctuations in the foreign exchange market.

It only works for the long term and, therefore, will not help those traders who need to understand the short term. In combination with other indicators, the Big Mac index is an excellent tool that you should be able to use.

Example of the Big Mac index in action

Let's look at the following example:

If the cost of a Big Mac from McDonald's is $3.75 in the US and 2 pounds sterling in the UK, the exchange rate is expected to be 1.875 (3.75 USD/2 GBP). When the dollar exchange rate rises, the Big Mac index tells us that the pound is overvalued. If the dollar is declining, the index tells us that the pound is undervalued.

Why the Big Mac Index can be misleading

Initially, the index was supposed to be more entertaining, since it was far from perfect. McDonald's can influence the index because they make a decision about the cost of their Big Mac burger. Another big disadvantage is that the Big Mac burger does not have any rigid characteristics. Each country has its own type of Big Mac burger, which differs in size, ingredients, and type of bun.

Traders can use the Big Mac index as an indicator of commodities.

Conclusions about the Big Mac Index

The Economist came up with the Big Mac Index in 1986 to use it to determine whether currencies are at their "exact" level.

Over the past years, this index has become a world standard, many scientific studies have been devoted to it, and it is included in textbooks on economics.

Read more: About the Big Mac Index and its competitors


 

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