Question

In: Accounting

Suppose the current exchange rates between the US dollar ($) and the Indian rupee (INR), Thai...

Suppose the current exchange rates between the US dollar ($) and the Indian rupee (INR), Thai Bhat (THB) and Philippine peso (PHP) are 68.0724 INR/$, 32.1836 THB/$, and 52.3803 PHP/$, respectively. In addition, you observe that a Big Mac costs 180.00 INR in India, 119.00 THB in Thailand, and 134.00 PHP in the Philippines. If the US average price of a Big Mac is 5.28$,
a) What would the Big Mac Index imply for the over- or undervaluation of these currencies vis-à-vis the US$?
b) If you were a foreign exchange trader, what would you do in response to the answer to part a) ?

Solutions

Expert Solution

a) The Big Mac is undervalued in all the countries (as shown in the table below) based on USD. For example, a Big Mac costs INR 180 in India which roughly converts to $2.6442 which is only half the value of the Big Mac in US ($5.28). Similar are the cases in Thailand and Philippines.

Big Mac Rate
Rate/USD Country Currency Local USD Under/(Over)valued %
A B C = B / A 1 - (C / $5.28)
        68.0724 India INR           180.00           2.6442 50%
        32.1836 Thailand THB           119.00           3.6975 30%
        52.3803 Phillippines PHP           134.00           2.5582 52%
          1.0000 US USD               5.28           5.2800                   -  

b.) Essentially, if it were any other non-perishable product (eg. Bottles, Laptops, Helmets, etc.), as a foreign exchange trader, I would be able to make arbitrage profit by buying from one of the undervalued countries and selling in USD. For example, if I were to buy a burger from Phillippines at $2.5582 and sell in US at $5.28, I would make a direct profit of $2.72 per Big Mac.

However, as it is a food product, the lower rates in these countries would be attributed to lower cost of raw materials and higher population, which would maximize profits as a whole albiet it is lower profit margin per Big Mac. It is also to be noted that it is not possible to ship a fully cooked Big Mac from one country to another. Maybe as a foreign trader, I could ship the low cost raw materials and still make a bigger profit. Again, the food laws are different between countries which may have an adverse effect on the whole process.  


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