March 31, 2023
Foreign exchange in inflationary times
For an introduction to foreign exchange, check the Big Mac index.
Investors who plan to add an international component to their portfolios need to understand something about exchange rates. An investment in foreign stocks or bonds offers an extra path for risk and for reward. In addition to the economic fundamentals that will drive the value of the investment, there is the possibility that changes in relative currency values will have an important effect on the bottom line. Logically, exchange rates should not affect purchasing power around the world. When something costs $100 in Chicago or New York, a traveler ought to be able to exchange $100 for enough yen or euros to buy a similar item in Tokyo or Paris. Economists call this idea "purchasing power parity."
In real life, logic doesn't always prevail. Each year since 1986 The Economist magazine has constructed an index of purchasing power using a single commodity: the Big Mac. What started as a light-hearted guide for making exchange-rate theory more digestible has evolved over the years, and is now included in economics textbooks.
McDonald's hamburgers are sold around the world; their quality is consistent, but the prices are not, as shown in the table below. All prices have been converted to dollars for easy comparison. Where the local price is above the U.S. price, the local currency is overvalued according to the theory of purchasing power parity. When the price is below ours, the currency is undervalued.
The first column gives the local prices of the Big Mac converted to dollars. Comparing these provides a measure of how overvalued or undervalued a foreign currency is relative to the dollar, in the second column.
Although the Big Mac index is subject to some distortions by local sales taxes, trade barriers and other factors, The Economist reports that its PPP estimates are remarkably close to those derived by more sophisticated methods. The data show that the dollar has been strengthening against other world currencies in recent years.
Inflation has caused the median price of a Big Mac in the U.S. to rise by 6% in the last two years, according to the article. Other countries have experienced even more inflation than we have, but the effect has been offset by the changing currency relationships. For example, two years ago the Big Mac was 26% cheaper in Japan, and now it is 41% cheaper.
Caution for investors.
The volatility in currency exchange rates is just another difficult fact of life for investors, one that adds both risk and reward to the international component of an investment portfolio. Although it may be important for investors to have a global perspective, it's also important to stay well diversified, not concentrated in a single country or region.