Currencies and Purchasing Power

This week we are looking at the fluctuation of currency exchange rates, as well as the effects of exchange rates on investors and consumers. The exchange rate between two currencies indicates the relative worth of one currency against the other. As I write this article, the Euro-to-US dollar (EUR/USD) exchange rate is 1.36 – one Euro has the equivalent value to $1.36 USD. The American dollar-to-British Pound (USD/GBP) exchange rate is 0.66, so an American dollar in England can purchase £0.66 worth of goods. In efficient markets, equivalent items should cost the same in all countries; this is known as “the law of one price.” But since prices cannot adjust to rapidly fluctuating exchange rates, the purchasing power of one currency against another is constantly changing.

Purchasing power parity (PPP), based on the law of one price, attempts to find the appropriate exchange rate so that an identical good in two different countries has the same price in terms of purchasing power. In theory, PPP should determine exchange rates; in the real world, currencies fluctuate for all sorts of other reasons, while the prices of goods and services remain constant over short periods of time. (A notable exception is The Trader Bar in Melbourne, Australia, where the price of each drink fluctuates based on the current demand. A lighthearted, though effective, illustration of PPP is The Economist’s Big Mac Index, which compares the price of a McDonald’s Big Mac in different countries against the country’s exchange rate to show how relatively expensive or cheap each currency is.

The market exchange rate determines the purchasing power of one currency relative to another, but what determines market exchange rates? Let’s look at the recent situation in Europe and how it has affected the purchasing power of the Euro. Currencies fluctuate similarly to bonds in that a rise in interest rates results in a decrease in the currency value, which happened recently as a Greece, Spain and other European nations issued a large amount of debt. Uncertainty over these governments’ ability to repay loans to their investors forced them to issue debt at a higher interest rate than previously; as expected, the Euro declined sharply. For example, relative to the US dollar, Australian dollar and Yen, the Euro has fallen -4.90%, -5.63% and -7.66% respectively since January 1, 2010. These are drastic declines over such a short period.

Investing in the foreign exchange market is unique in that it operates 24/7 and produces small profit margins in comparison to other markets. As a rule, I do not attempt to use currencies as long-term investments. I do, however, occasionally hedge against large fluctuations in exchange rates that may affect my foreign investments by using various techniques. Currency fluctuations don’t usually affect investment returns that much over the long term, but exchange rates can be highly volatile over short periods of time.

In the long run, purchasing power parity should determine the relative value of currencies. But in the short term, currencies can be substantially over or undervalued, such as the Yuan which the Big Mac Index estimated to be almost 50% cheaper than the US dollar. So if you are looking for the best price on Big Mac’s, look no further than Beijing!