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Feb. 14, 2014, 12:01 p.m. EST

How to trade the ‘Big Mac Index’

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About Nicholas A. Vardy, CFA

Nicholas A. Vardy is Chief Investment Officer at Global Guru Capital, a fee-only, SEC-registered investment-advisory firm where he manages money for high-net-worth clients. Vardy is also the editor of three investing and trading services at NicholasVardy.com. He appears regularly on the Fox Business Network and CNBC Asia, and is a highly-rated speaker at investment conferences around the globe.

Nicholas regularly contributes his market views on his company blog. You can also follow Nicholas on Twitter @NickVardy or email him at nvardy@globalgurucapital.com.

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By Nicholas A. Vardy, CFA

It's now been 28 years running that Britain's Economist magazine has published its annual "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.

According to the theory of purchasing power parity, a dollar should buy the same amount of the same goods across all countries.

The subject of over 20 academic studies since its launch in 1986, the "Big Mac Index" compares the cost of Big Macs — an identical item sold in about 120 countries — and 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 you see instantly which currencies are under- or overvalued.

Global currencies: The current state of play

Over the past few years, I've been struck by how many formerly overvalued currencies have gotten back in line with what the Big Mac's PPP would suggest.

Five years ago, the euro was overvalued by a massive 50%, compared to the U.S. dollar. Today, the average Big Mac in the euro zone will set you back only 7.8% more than in the U.S.

A few years ago, the "Big Mac Index" had the United Kingdom pegged as one of the most expensive places on the planet. Just prior to the financial meltdown of 2008, the British pound hit 2.10 GBP to the U.S. dollar. Afterward, the GBP tumbled to about $1.35. Today, a Big Mac actually costs the same in the United Kingdom — $4.63 — as it does in the United States, where a Big Mac sells for $4.62. (The cost of a Big Mac in the United States has risen 5.72% over the past year — higher than the headline CPI would suggest.)

The Big Mac Index: Overvalued currencies

The Scandinavian currencies have always been the most overvalued in the world. A Big Mac in Oslo today is 68.6% more expensive than in the United States. In Sweden and Denmark, Big Macs are 36% and 12% overvalued, respectively. The safe-haven Swiss franc is overvalued by 54.5%. Most of these figures are actually down compared to a few years ago.

Brazil's currency — the real — has suffered a huge fall from grace. Three years ago, the Brazilian real was 52% overvalued according to the Big Mac Index. Today, it's a mere 13% overvalued compared to the U.S. dollar.

The Big Mac Index: Undervalued currencies

The biggest changes in the past year have been the devaluation in emerging-markets' currencies.

For as long as I can recall, the Chinese yuan has been consistently the most undervalued currency in the world. But the 2014 "Big Mac Index" marks the first year that Russia, Hong Kong, Indonesia, South Africa and India all have currencies that are cheaper than the Chinese yuan, when measured by PPP.

The Mexican peso and Chinese yuan are now valued roughly equally. That explains why U.S. companies are "re-shoring" from China to Mexico, and why you'll be seeing a lot fewer "Made in China" labels in your local Wal-Mart over the coming years.

The Big Mac Index: What you'd trade today

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

Among the "big six" currencies traded by foreign-exchange traders, you'd sell the Swiss franc /zigman2/quotes/202079537/composite FXF +0.68%  — the only major currency that is massively overvalued. You'd ignore the British pound sterling /zigman2/quotes/205988498/composite FXB -0.24% , euro /zigman2/quotes/208198139/composite FXE +0.36%  and the Canadian dollar /zigman2/quotes/202089315/composite FXC -0.60%  , which are roughly within 10% of their PPP values. The Japanese yen /zigman2/quotes/200725153/composite FXY +0.51%  is undervalued by 35.7%. But with the Japanese central bank committed to driving the yen down further, only a serious contrarian would go long the yen.

You could also bet on some less mainstream currencies. Based solely on the Big Mac Index, you'd sell the Swedish Krona Trust  and the Brazilian Real . You'd buy the Chinese yuan /zigman2/quotes/203125516/composite CYB +0.20%  (40.7% undervalued), the Russian ruble (43.3% undervalued), the South African rand (53.3% undervalued), the Mexican peso (40% undervalued) and the Indian Rupee  (66.8% undervalued).

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