Is This Currency Overvalued? Purchasing Power Parity (PPP) and Long-Term FX Valuation

We all know that a coffee costs more in New York than in Bangkok. And that in Australia, your morning espresso requires you to take out a second mortgage.

I remember the first time I really got hit with this concept. I was travelling in Central Asia years ago, living like a king on what would be a modest budget back home. Everything seemed absurdly cheap. My brain kept doing mental calculations: “This amazing meal costs what I’d pay for a coffee in Sydney!”

What I was experiencing firsthand was a massive deviation from what economists call “purchasing power parity” – and it’s a useful concept for thinking about whether a currency is fundamentally over- or undervalued.

These price differences aren’t entirely random. They reflect something fundamental about currencies and their relative values.

Understanding this concept probably won’t help you with your systematic trading on any time scale you care about, but it’s one of those ideas that deepens your background knowledge. In my opinion, your breadth and depth of market knowledge are correlated with the number of good ideas you’re likely to have – so from that perspective, let’s dive into PPP.

What the Hell is Purchasing Power Parity (PPP)?

PPP is based on a simple idea: in theory, identical goods should cost the same everywhere once you convert the prices using exchange rates.

If a pair of Nike shoes costs $120 in New York and €100 in Paris, PPP would suggest the “fair” exchange rate should be $1.20 per euro. That’s because in an efficient market, if the shoes were much cheaper in one location, people would buy there and sell elsewhere until prices converged.

However, as my trip to Asia showed me, the real world doesn’t work that way. Prices for the same goods vary wildly across countries, even after converting currencies.

This happens for all sorts of reasons – different tax systems, labour costs, transportation expenses, trade barriers, and so on. But the core insight remains: these price differences suggest that some currencies are overvalued relative to others.

So when we talk about a currency being “overvalued” or “undervalued” according to PPP, we’re saying it buys more or less stuff than it theoretically should compared to another currency.

This matters because, over time, currencies should tend to move toward their PPP-implied values. If you can identify a currency that’s significantly mispriced, you might find an edge – but you’ll likely need a whole lot of patience to actually realise it.

The Big Mac Index: Fast Food Economics

The most famous simplified version of PPP is The Economist’s Big Mac Index. It compares the price of a Big Mac across countries to determine if currencies are over- or undervalued against the USD.

The logic is beautiful in its simplicity: a Big Mac is nearly identical worldwide and contains a mix of traded and non-traded inputs (beef, lettuce, labour, rent), making it a decent proxy for a basket of goods.

For example, if a Big Mac costs $5.81 in the US but only $3.64 in Japan (when converted from yen to dollars), this suggests the yen might be undervalued by about 37% against the dollar.

But there’s a catch: these misalignments can persist for years or even decades. The market doesn’t immediately correct them, and there are good reasons for that.

The Real Effective Exchange Rate (REER) – A Broader View

While PPP typically compares a currency to the USD, a more comprehensive view is sometimes useful. This is where the Real Effective Exchange Rate (REER) comes in.

The REER measures a currency’s value against a basket of other currencies, weighted by trade importance and adjusted for inflation differentials.

It’s “effective” because it uses trade-weighted averages and “real” because it accounts for inflation.

Why is this useful? Because it gives you a better picture of a country’s overall international competitiveness.

REER Index (2010=100). Image: World Bank

If a country’s REER rises, it means its currency has strengthened relative to its trading partners in real terms. This typically makes its exports more expensive (less competitive) and imports cheaper.

REER can be thought of as a country’s economic “temperature” – when it gets too high (currency too strong), exports suffer and the economy might cool; when it’s too low (currency too weak), inflation might heat up as imports become expensive.

Central banks and some institutional traders track REER closely. When a currency’s REER deviates significantly from historical averages or estimated equilibrium levels, it signals potential misalignment that might eventually correct.

The Critical Distinction: Mispricing ≠ Timing

Here’s an important practical take.

Just because a currency is undervalued doesn’t mean it’s going to strengthen tomorrow, next week, or even next year. Markets can remain “irrational” far longer than you can remain solvent, as Keynes supposedly said.

Studies on PPP deviations show a typical “half-life” of currency misalignments ranging from 3 to 5 years. That means it takes that long for just half of a valuation gap to close. Some estimates for certain currencies like the Chinese yuan put the half-life anywhere from 19 months to 26 years!

Let me emphasize this: being fundamentally right too early feels exactly like being wrong.

You might view PPP as a long-term compass rather than a short-term map. It tells you where things should eventually go, not what will happen tomorrow. The truth is, it’s not likely to be of much direct benefit over the time scales systematic traders care about.

Valuation Metrics

It would be extremely sub-optimal to rely on valuation metrics alone. These represent one tiny bit of signal in an ocean of noise.

Instead, you might incorporate various valuation metrics (which might include PPP) as one component of a more comprehensive analysis. You might blend valuation with market flows, positioning data, and other fundamentals.

Bigger players active in this space would maintain sophisticated internal models of “fair value” for currencies. These models might start with PPP or REER as a baseline, but then adjust for factors like:

• Productivity differences
• Terms of trade shifts
• Current account balances
• Capital flows
• Interest rate differentials

This data is freely available from the OECD, World Bank, FRED, and BIS.

Productivity metrics. Source: OECD

Even with these refined models, institutions know that valuation alone rarely drives short-term moves. They might monitor capital flows and positioning as well, for example:

• Order flow (net buying/selling pressure)
• Portfolio inflows/outflows
• CFTC’s Commitment of Traders (COT) data
• Central bank interventions
• Trade balance shifts

The magic happens when valuation aligns with shifting flows or positioning extremes. If a currency is deeply undervalued and the COT data shows extreme short positioning, that could signal a potential reversal – but whether you can realistically act on it is another matter.

Think of it this way: valuation tells you what should eventually happen; flow and positioning hint at what might happen next.

How to Track Misalignments

Look, there are easier ways to get an edge in the markets, but if this sort of global macro investing is your bag, here’s how you might track currency misalignments without needing a Goldman Sachs research team.

Here are some straightforward approaches that won’t make your brain explode:

1. Follow the Big Mac Index

The Economist publishes this index at least annually. It gives you a quick percentage over/undervaluation for dozens of currencies.

Just remember it’s a rough guide. Some currencies (like those of developing nations) will always look undervalued due to structural factors like lower wages and rents. Some countries are missing from the index altogether.

2. Use OECD or World Bank PPP Data

Organisations like the OECD publish PPP exchange rates for many currencies. Compare these to market rates to spot potential misalignments.

For example, if the OECD says 1 USD = 4.0 Brazilian real in PPP terms, but the market rate is 5.0, the real might be ~20% undervalued against the dollar.

You can also create a simple model by:

1. Starting with a base PPP value
2. Adjusting it monthly using inflation differentials
3. Comparing this updated fair value to the actual rate

This gives you a running estimate of misalignment.

3. Track REER Indices

The Bank for International Settlements (BIS), World Bank (WB), Federal Reserve Economic Data (FRED), and many central banks publish REER data.

Currencies trading far above or below their historical averages are interesting. You may need to transform some series to make them more comparable with their earlier histories (a simple rolling z-score is useful). A currency with a REER 20% above its 10-year average might be overvalued for example.

4. Monitor Analyst Estimates

IMF External Sector Reports and research from major banks often include currency valuation assessments. Media coverage typically highlights significant findings from these reports.

When you see commentary like “Based on our model, the yen is 15% undervalued versus the dollar,” that’s usually based on a PPP or fundamental model.

5. DIY with Inflation Data

You can do a quick PPP calculation yourself:

1. Choose a base year when you think a currency pair was fairly valued
2. Compile inflation rates for both countries since then
3. Apply the cumulative inflation differential to estimate the current fair value
4. Compare to the actual market rate

This method uses real CPI data and can be done in a simple spreadsheet.

US (blue) and Japan (maroon) inflation rates. Image: TradingView

PPP for Systematic Traders: A Real-World Perspective

As someone who approaches trading systematically, I’m always looking for edges that can be quantified and exploited methodically. PPP offers some interesting possibilities here, but with important caveats.

In quantitative investing, PPP forms the basis of the “value” factor in FX portfolios (alongside other factors like carry and momentum). The simplest systematic approach would be:

1. Rank currencies by degree of PPP misalignment
2. Go long the most undervalued currencies
3. Short the most overvalued currencies
4. Rebalance periodically (monthly or quarterly)

Research suggests this type of strategy can indeed be profitable over the long term. Currencies that are very cheap by PPP standards tend to appreciate eventually, while expensive ones tend to depreciate.

But there’s a catch (isn’t there always?): the slow mean-reversion we discussed earlier. A pure value strategy in FX often requires longer holding periods and can suffer extended drawdowns while waiting for the turn.

The historical performance of value strategies in FX has been more erratic compared to carry or momentum. There have been long periods where a PPP value strategy produced weak or even negative returns.

Making PPP Work in Practice

The most effective way to use PPP in systematic trading is to combine it with other factors. Here are some approaches that work better than pure PPP:

1. Adjust carry trades for value

The classic carry trade (buy high-interest-rate currencies, sell low-rate ones) can blow up when those high-yield currencies are grossly overvalued.

Research shows that modifying carry trades by PPP valuation – avoiding or down-weighting currencies that are richly valued even if they have high interest rates – can improve risk-adjusted returns.

2. Create composite signals

Blend PPP with other factors to create a more robust model. For example, assign each currency a score based on:

• Valuation (PPP deviation)
• Carry (interest rate differential)
• Momentum (price trend)
• Maybe even volatility or other factors

Then trade based on the combined score.

Here’s a plot from Deutsche Bank of returns to three individual currency factors (valuation, carry and momentum), and the blended factor (DBCR):

Source: Deutsche Bank

You can see that the blended factor is a smoother ride than any of the individual factors.

3. Use PPP as an extreme filter

Maybe you could use extremes of PPP to filter or reduce certain positions. For example, you might choose not to short a currency (or short it less) that’s already 30% undervalued by PPP measures, even if other signals suggest doing so.

This very much depends on what you’re doing, but it might be worth considering.

Why This All Matters: The Big Picture

At this point, you might be wondering: if PPP takes so long to play out and requires so much patience, why bother with it at all?

Personally, I’m not tracking PPP as it has almost no impact on the sorts of things I’m trading at time scales I care about. That’s probably true for most indie traders – unless you’re doing long-term macro stuff.

Still, knowing things is preferable to not knowing them. Many of the best ideas come from connecting disjointed pieces of information. If you don’t have the information in the first place, you can’t make the connection.

What I’m saying is that while PPP isn’t where you’d first reach for edge as an indie trader, understanding the concept is more generally useful.

One practical application could be as an input to an existing FX model. For example, I used to do the FX carry trade, but I lost interest during the era of super-low interest rates. I would be willing to wager that a PPP deviation input would improve the performance of that carry strategy – perhaps I should go look.

How I Think About Valuation

Here’s how I think about valuation generally, and currency valuation specifically:

1. Valuation is real, but timing is everything. Currencies do eventually move toward fair value, but “eventually” can be a very long time. The time scale over which this plays out likely renders it unimportant for systematic traders.
2. Extremes can be interesting. Like many factors, the action is often in the tails. If you do use PPP as an input to your trading, I would pay special attention to extremes.
3. Combine with other factors. Research suggests that PPP can be useful as part of a multi-factor approach, for example, blended with momentum, carry, or other signals.
4. A long game. If you’re going to trade based on valuation, be prepared to hold positions for months or even years, not days or weeks.

The Bottom Line on PPP and Currency Valuation

PPP and related valuation metrics are tools for understanding the fundamental forces driving currencies in the long run. They won’t tell you what will happen tomorrow, but they provide context for interpreting market movements and identifying potential long-term opportunities.

For systematic traders, PPP may be interesting as one component of a diversified strategy – a value factor that complements other approaches like momentum and carry. If you’re not doing that sort of trading, then PPP is useful background information, but likely won’t give you much edge in the short term.

Remember that markets can deviate from fundamental value for extended periods, but they don’t defy economic gravity forever. Currencies that are significantly misaligned will probably eventually correct. But our trading careers may be in their twilight by the time that happens..