Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.
Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.
Abstract: In this article, we introduce another method for evaluating the ‘fair’ value of a currency: the Behavioural Equilibrium Exchange Rate (BEER), a model which is widely used in practice. The BEER model was developed by Clark and MacDonald (1999) and estimates the fair value of currencies according to short, medium and long-run determinants. An important concept is that there is no prior theory for the choice of economic variables; hence, the choice of variables is based on economic intuition and data simplicity and availability.
We also do an application of the BEER and run a Fixed-Effect panel regression on the G10 currencies, using the US Dollar as the base currency, and three widely used macroeconomic variables – inflation, terms-of-trade and interest rates – for our regression. We conclude by commenting the results and making a brief analysis on the Euro (Spot rate versus BEER value).
Abstract: In this article, we introduce the two effective (i.e. multilateral) exchange rates that measure the value of a specific currency in relation to an average group of major currencies: the Nominal Effective Exchange Rates (NEER) and the Real Effective Exchange Rates (REER). Both are calculated by comparing the relative trade balance of a country’s currency against each country within the index, but the REER is adjusted by the ratio of domestic price to foreign prices.
Using the BIS time-varying weights, we also look and comment the development of the CNY NEER and JPY REER over the past twenty years.
Abstract: In this article, we introduce the Purchasing Power Parity, a theory that stipulates that in the long run, the exchange rate between two countries should even out so that goods essentially cost the same in both countries. The research organizes as follows. In Section 1, we introduce the PPP theory based on the work of Dornbusch (1985), presenting the absolute and relative versions of PPP. In Section 2, we provide three difference analysis and compare the exchanges of Canada, Britain and Japan (all vs. USD) against their PPP values using Eurostat-OECD data. Section 3 presents the Real Exchange Rate (RER), a rate which seeks to measure the value of a country’s goods relative to the those of another country at the prevailing exchange rate.