In: Accounting
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) ?
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.