Monday, February 4, 2013

Why the Big Mac Index is an Inefficient Predictor of Forex Valuations

By Grant de Graf

The Economist has once again posted its Big Mac Index, a measure of the strength of foreign exchange rates, based on the purchasing-power parity (PPP) of a McDonald burger. The Big Mac uses a single point of reference (the Mac) to calculate the over or under valuation of a currency , the theory being that prices and exchange rates should adjust over the long run, so that identical baskets of tradable goods cost the same across countries.

Using the PPP of the Mac for measuring the strength of a currency as opposed to a basket of goods does have distinct advantages, in that the noise and deflections which may exist in selecting a broad spectrum of goods, is removed. However, there is another factor which will intrinsically effect PPP.

The PPP of a currency, will always reflect the fundamental political and economic attributes of a region, which serve to skew it's value. For example in Switzerland, the Swiss franc is used by investors as a safe haven. Consequently, it is priced in at a premium. Conversely, South Africa is considered an economically and politically high risk region, hence the discount at which the rand trades.

Similarly, currencies of other emerging markets or volatile regions also tend to trade at a discount, with the exception of Brazil 's real. Brazil's price enigma can be attributed to the capital controls which the country maintains and to the fact that many traders use the Brazilian real, as a point of reference and security to price in other currencies in the region.

A similar pattern can be observed with the pricing of options. When implied volatility of specific equities experience a spike, relative to their historical volatility, thus reflecting an apparent overvaluation, some traders view this as an opportunity to sell the option and profit from the anomaly. Invariably, the incongruousness is a function of weakness within the equity or the underlying company. Without the appropriate hedge, many a trader has been wrong-footed.

The Mac Index is a good exercise to measure currency valuations, but to trade on the apparent anomaly, can be dangerous.    

Top 15 Factors Governing Financial Risk in 2013

The following variables will play a critical role in governing financial risk in 2013:

  1. Sovereign debt
  2. Political instability
  3. Regulation
  4. Environment
  5. Social
  6. Technology
  7. Infrastructure
  8. Economics
  9. Environment
  10. Energy
  11. Global workforce
  12. Natural resources
  13. Currencies
  14. Market volatility
  15. Austerity
Other variables that should also be on the radar screen:
  • Litigation
  • Health
  • Natural disasters (event risk)
  • Climate
  • Education
  • Copyright protection

Reality of Euro Crisis Comes to Light

Uri Dadush, senior associate and director of the International Economics Program of the Carnegie Endowment for International Peace,in an opinion for the Wall Street Journal, expresses disbelief with the suggestion the Euro Crisis is over, in his article, "Who Says the Euro Crisis Is Over?"

His points are well foundered and can be summarized as follows:
  1. 18 million people still remain unemployed in the euro zone.
  2. Markets incorrectly believe that European Central Bank President Mario Draghi's emphatic promise that the ECB will buy the bonds of troubled countries has all but eliminated the risk of a collapse.
  3. The risk of relapses triggered by domestic rifts or an external economic shocks will remain high.
  4. The euro zone can fail even if the single currency survives.
  5. Application of "boiling frog" allegory: If you put a frog in scalding water, he said, it will jump out. But if you place it in cold water and slowly raise the heat, it will stay put, eventually being boiled to death.
  6. Instead of a region of shared and uniform prosperity, the euro zone has become a study in internal divergence.
  7. Unemployment is at 26.8% in Greece, 26.6% in Spain, 16.3% in Portugal, 14.6% in Ireland, 11.1% in Italy—and joblessness is still rising in all of these countries. Meanwhile, the unemployment rate is 5.4% in Germany and 7.8% in the U.S.
  8. Italy's gross domestic product has fallen by 6% since the pre-crisis peak in 2007, whereas Germany's is up 8%. In the U.S., where the world financial crisis began, GDP has surpassed its pre-crisis peak by 7%. By comparison, Europe's GDP is only 2% above its pre-crisis level.
  9. The fiscal stance in Europe remains contractionary, reflecting the inexistence of a large central government, the inability of the periphery countries to borrow, and a fiscally conservative government in Germany, where the effect of the crisis has been felt much less.
  10. The limited monetary-policy response, which is now changing belatedly, was also the result of a conservative approach by the core, especially Germany.
  11. Falling interest-rate spreads and improving financial markets are not enough to reignite growth and competitiveness.
  12. In Brussels, plans for a banking union are advancing, but at a snail's pace. Proposals for forgiving official-sector debt holdings are dead on arrival. Fiscal union is not on the table.

Creativity vs. Execution

Merissa Meyer, Yahoo's new CEO makes an interesting observation in conversation, with Bloomberg's Erik Schatzker, at the World Economic Forum in Davos. (See video below for shortened version, key points of the discussion.)

Meyer depicts creativity within a company, in a novel and interesting light.  

"One would think that the opposite of creativity is stagnation," she argues. "But there is a school of thought, which suggests that on the opposite side of creativity is execution." In other words, if a company is focused on creativity, many aspects of execution (in respect to growth, may be compromised) or visa versa. 

Ostensibly, Yahoo is in execution mode, which means that the company will focus on taking the platform (spawned from creativity) to optimizing the experience and making functionality more accessible to users.

Jan. 25 (Bloomberg) -- Highlights from Yahoo CEO Marissa Mayer's conversation with Bloomberg's Erik Schatzker at the World Economic Forum in Davos.