Why Should Forex Traders Need to Understand the Big Mac Index?

Burgers as a Benchmark for Trading

What idea comes to mind when you read The Big Mac Index? For most, you would think of McDonald’s’ insignificant index list of boring burgers, or perhaps, the binary of the friendly and scary looking clown, Ronald McDonald.

After all, I guess this shows that McDonald’s’ advertising and PR may be way more catchy and ‘addictive’ than their food. Though, for those interested in finance, this index may be more important than just a mere burger.

What is the Big Mac Index

The Big Mac Index does indeed refer directly to the McDonalds‘ “Big Mac”. McDonald’s is a huge worldwide chain making its mark over 70 – 80% of the globe. The McDonald’s Big Mac is used as a benchmark for economics, based on how much a McDonald’s Big Mac costs in each country, which reflects on different currency’s worth and value. They were able to use the Big Mac burger because it sells in every store that exists.

The Economist’s Infamous Annual Survey

When The Economist magazine first introduced The Big Mac Index in 1986, it was intended to be an amusing and entertaining way to calculate Purchasing Power Parity.  Thirty-four years later and this index has become one of the most cited and reliable sites in global standard, which is relied upon by traders and taught in many economic textbooks too.

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 guide to calculate whether two compared currencies are in equilibrium. The levels are tested through the lens of a fixed set of consumer products and goods. Two currencies are to be in balance when both placed in the basket and should have the same worth 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 the exchange rate fluctuations between currencies ultimately affect the price that consumers will end up paying for a hamburger.

Why You Might Want to Reconsider Using the PPP Guide to Trade Forex

For traders who don’t know, the Purchasing Power Parity (PPP) is a measurement which is used to compare economic variables as they differ from one country to another. One of the key attributes of the model is that it is formed without taking into account changes in exchange rates and the distortions that would cause.

Herein lies the problem for forex traders who wish to use this model in their everyday trading. Forex traders need exchange rate data in order to make informed investment decisions. After all, it’s right there in the title of the profession.

In contrast to the PPP, the Big Mac Index relies on discrepancies in the exchange rate and directly reflects currency valuations and devaluations. This makes it a much more effective indicator for forex traders to trade with. The Big Mac is also a tangible item, rather than a concept, as the PPP is.

Why the Big Mac Index Can be a Great Forex Market Forecasting Tool

Since its inception in 1986, the Big Mac Index has been a valuable tool for forex traders wanting to find a connection between the long term forecast of a currency and the value of its exchange rate. Traders who use the index to forecast the market look for disparities between the index and the real exchange rate as a measure of potential future correction in foreign exchange rates. In short, it connects foreign exchange to goods and establishes a potential road map for where the market may be heading.

As with most theories, this correlation only works until it doesn’t. Since there are many factors that can influence the price of a hamburger, exchange rates are not always a sure fire indicator of the strength and direction of the market.

However, the big reason why the Big Mac is not a fool proof indicator is that it doesn’t address the small, near term fluctuations of the forex market. Instead, it only looks at the long term and therefore cannot prepare those traders who need to see what’s directly in front of them. Paired with other indicators, the Big Mac Index is a great tool to add to your arsenal. Like with all indicators, use this one with caution and always back it up with other data sets.

Example to the Big Mac Index in Action

To illustrate the theory, let’s consider the following example:

If the cost of a McDonald’s Big Mac is $3.75 in the United States and £2.00 in Great Britain, the exchange rate is expected to be 1.875 ($3.75 /£ 2). When the exchange rate of the dollar rises, The Big Mac Index tells us that the GBP is overvalued. If the exchange rate of the Dollar lowers, the index tells us that the GBP is undervalued.

Why the Big Mac Index Might be Misleading

At first, the index was intended to be lighthearted and fun because as it was far from perfect. McDonald’s can influence the index because they decide on the cost of their Big Mac burger. Another glaring imperfection is that the Big Mac burger does not have the same specifications. Each country has its type of Big Mac burger, from its size to ingredients and also to the type of bun.

For traders, The Big Mac Index can be used as a commodity indicator in currency investments.

For an indication of this Index and to see how it is calculated, click on this link to read, which is from MarketWatch, 

The Big Mac Index Summary

The Economist invented the Big Mac index in 1986 as a guide to whether currencies are at their “accurate” level.

Over the years this index has become a worldwide standard, today there are quite a few academic studies on the subject, and it is included in economic textbooks.

If you want to receive an invitation to our weekly forex analysis live webinars, trading ideas, trading strategy, and high-quality forex articles, sign up for our Newsletter.

Subscribe to our youtube channel.

Click here to check how to get qualified.

Click here to check our funding programs.

Share: