Nicholas A. Vardy, CFA

Jan. 30, 2015, 12:53 p.m. EST

How to make money from the "Big Mac" index

By Nicholas A. Vardy, CFA

The last six months have been a tumultuous time in the $5 trillion dollar a day world of global currency trading. The moves in both developed-market and emerging-market currencies have been sharper than any time since 2009.

A stronger economy and falling oil prices has pushed the U.S. Dollar Index 15% higher in the past six months. The euro went the other way, tumbling 17% in anticipation of the European Central Bank's recent entry into the quantitative-easing game. The steep 14% fall in the value of the Japanese yen offered continued evidence of Japan's commitment to Abenomics and its easy money policy.

Then there was the dramatic jump of 13% in one day in the Swiss franc when, on Jan. 15, the Swiss National Bank abandoned its currency's peg to the euro.

Not to be outdone, Vladimir Putin's shenanigans and tumbling oil prices gave the Russian ruble a shellacking, beating the Russian currency down by roughly 50% since mid-summer.

Enter the Big Mac Index

One way to get your head around currencies is to look at what the same goods cost in different cities across the world.

Since 1986, Britain's Economist magazine has done exactly that with its now-famous Big Mac Index — a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP) — that is, the relative over- and undervaluation of the world's currencies compared to the U.S. dollar.

By comparing the cost of Big Macs — an identical item sold in about 120 countries — the Big Mac Index calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad.

Compare the Big Mac PPP to the market exchange rates, and voilà, you get an instant insight into which currencies are under- or overvalued.

The current state of play

I have been writing about the Big Mac index for close to a decade. Yet, I've seen the most dramatic movements only in the past year.

Take the example of the European currency. Seven years ago, the euro was overvalued by a massive 50% compared to the U.S. dollar. Last year, the European currency had fallen to being 7.8% overvalued. Today, the euro is 11% undervalued.

So if you're looking to splurge on that trip to Paris to see the Mona Lisa in person, this is the best time to go in the past 10 years.

Back in 2007, the United Kingdom was one of the most expensive places on the planet as the British currency hit a high of $2.10 U.S. dollars to the Great British Pound (GBP). After the Great Recession in 2008, the GBP tumbled to about $1.35. Today, it's back to $1.50.

In the current Economist survey, a Big Mac actually costs 8.8% less in the United Kingdom — $4.37 — than it does in the United States, where a Big Mac sells for $4.62.

By the way, the cost of a Big Mac in the United States rose 3.7% in 2014 on top of a 5.72% rise over the previous year. Both of these increases are substantially higher than the headline U.S. CPI numbers.

Few overvalued currencies

Not surprisingly, the Swiss franc is the most overvalued currency in the world — though at 57.5% overvalued, it's just 3% higher than last year.

As a group, the Scandinavian currencies have always occupied the top of the charts. A Big Mac in Norway today is 31.5% more expensive than in the United States. But that is down from 68.6% more last year. Sweden and Denmark come in this year at a mere 2.7% and 12.2% undervalued, respectively. Once again, this is a far cry from the 36% and 12% overvalued levels, respectively, you saw last year at this time in the currencies for each of those countries.

Brazil's currency — the real — rounds out the ranks of overvalued currencies. Four years ago, the Brazilian real was 52% overvalued on the Big Mac Index. Today, the real is 8.7% overvalued compared to the U.S. dollar.

A slew of undervalued currencies

I've already touched on the dramatic drop in the euro and the yen.

But perhaps the biggest changes in the past year have been the widespread devaluation in emerging-markets' currencies. For most of the past decade, the Chinese Yuan has been the most undervalued currency in the world. Today, it trades 42.2% below its PPP rate, pretty much where it has stood for many years.

Yet, a whole slew of emerging markets' currencies are now cheaper than the Chinese yuan, as competitive devaluations spread across the global economy. Russia, India, Hong Kong, Indonesia, South Africa and India are all top emerging markets that are more undervalued than the Yuan.

What you would trade today

So, if you were running a currency hedge fund and using the principle of buying undervalued currencies — and selling the overvalued ones — here is what you'd do.

Among the "big six" currencies favored by foreign-exchange traders, you'd sell the Swiss franc (PSE:FXF)  — the only major currency that is massively overvalued. You'd ignore the British pound sterling (PSE:FXB)   and the Canadian dollar (PSE:FXC)  , both of which are roughly within 10% of their PPP values. The euro (PSE:FXE)  and the Japanese yen (PSE:FXY)  would be long bets based on their current undervaluation of 11% and 34.4%, respectively . But with both the European Central Bank and the Bank of Japan committed to driving the euro and yen down further, you'd have to be a real contrarian to bet on the European and Japanese currencies.

Looking at less mainstream currencies, you'd buy the Chinese Yuan (PSE:CYB)  (42.2% undervalued), the South African rand (SZR) (53.6% undervalued), the Mexican peso (FXM) (30.1% undervalued) and the Indian Rupee   (60.6% undervalued).

My top recommendation to my subscribers is to continue betting on the greenback's rise against the broad U.S. Dollar Index through the PowerShares DB US Dollar Bullish ETF (PSE:UUP) .

After all, the U.S. Dollar Index is only back to where it was in March 2009, right when global stock markets bottomed.

But that also means the U.S. dollar is still 25% below its 2001 peak — and 50% below its peak in the 1980s.

Fashionable predictions about the "demise of the dollar" notwithstanding, the Greenback has a way to go.

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