Using Purchasing Power Parity to Compare Currency Valuations

Summary

The document explains how the price of the same product in different countries can be used to form a purchasing-power-parity comparison. The suggested procedure is to infer an exchange rate from the product prices, then compare that implied rate with the observed market exchange rate. The gap gives an indication of whether one currency appears relatively overvalued or undervalued against another under this approach.

A quoted burger-price example compares Britain and the United States and reports an implied rate, a market rate, and a calculated undervaluation for sterling. The answer connects the approach to the Big Mac Index and also points to inflation as relevant context for exchange rates. This is a single-product illustration of a relative valuation concept, not evidence that currencies will converge to the implied rate or a trading signal. The document supplies no broader basket, sampling method, adjustment for local costs, or treatment of uncertainty.

Key ideas

• Purchasing power parity can be illustrated by comparing the same product’s prices across countries.
• The product prices imply a benchmark exchange rate.
• Comparing the implied rate with the market rate indicates relative currency valuation under the method.
• The burger example is an illustration rather than proof of fair value or a convergence forecast.
• Inflation is identified as relevant context for exchange rates.

Tags

# Simple cross-rate table question


# Simple cross-rate table question












I am trying to self-study and came across this question, I am not sure how to answer this.

I think I should transform all of the product's quoted prices to USD then compare them, is that correct?

> The table below shows retail prices of a single product in three countries. Use the cross-rate table and state which country’s currency is relatively (i) under-valued, and (ii) over-valued.

## Answer by AKdemy (score 1, accepted)

https://quant.stackexchange.com/a/68078

That is the idea of the Big Mac Index. You have one product, and would like to figure out what the “fair” exchange rate is based on the theory (application) of purchasing-power parity (PPP). The link to the economist above shows a computation for the relative over- / under- valuation:

```
A Big Mac costs £3.49 in Britain and US$5.65 in the United States. The implied exchange rate is 0.62. The difference between this and the actual exchange rate, 0.73, suggests the British pound is 15.9% undervalued.
```

You can look here to get an idea how inflation impacts exchange rates.

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