EURCHF is the FX ‘value’ trade according to PPP

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.

Source: Eikon Reuters, OECD

Purchasing Power Parity (PPP) and Real Exchange Rates (RER)

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.

LINK ===> PPP and RER

DATA EXCEL FILE ===>PPP Value

(PPP Value relative to the US Dollar)