In this post I want to cover one of the factors that enters into the creation of the benchmark index outlined in my Trading Approach. This factor is called Value, and provides an underlying fundamental reason for trading various currencies.
To explain value let’s assume that the water company Evian sells an identical bottle of water both in the UK and in the US. These two bottles are identical. Same water, same glass bottle, same label, same everything. In essence a tourist from the US could come to the UK and exchange one bottle for another without anybody disagreeing to value!
Now let’s say that the US price of 1 bottle is $1.30, and let’s say that the price of one bottle in the UK is £1.00. So the actual exchange rate GBP/USD according to these equivalent bottles is 1.30 (the US price divided by the UK price).
Now let’s go into the market. The exchange rate is 1.45.
Why aren’t the two values the same? In both cases, by exchanging two identical bottles from two countries or exchanging cash, I should come up with the same exchange rate.
There are various reasons: for instance Evian is a French company, and so maybe transportation costs to the US and the UK are different, which factors into the mismatch of the hypothetical exchange rate.
Regardless, it turns out there is still a value mismatch. And just like in equities where people have the notion of value stock and a value trade, the value trade in this example is to short GBP/USD until it hits its value of 1.30 as determined by real goods in the real economy. The exchange rate is a market aberration.
The way to trade this across the universe of currencies is to establish the value of each currency and then on a monthly basis figure out which currencies to buy and which currencies to sell.
For most of 2015 the value trade has been short CHF versus long JPY. That trade took right off in the second week of January after the SNB removed the EURCHF floor, however throughout the year, timing the price action right, would have milked the trade several times over.
If we pull up the CHFJPY chart:
So how do we determine the values of these currencies?
For starters these value exchange rates are called Purchasing Power Parity values (PPP). And they tend to be quoted against the US Dollar, as it is the ubiquitous currency, and US is the biggest importer of goods.
Several international organizations calculate these PPP values. We will use the numbers from the OECD. These numbers get published at the start of every calendar year. Since they are only published once a year, does it mean that these don’t change throughout the year? Well since they represent the value of goods, and the prices of goods change due to inflation, we would need to adjust these numbers by the relative inflation rate of the two countries forming the currency pair.
However, inflation rates are at present historic lows, and so these adjustments won’t make much of a difference (at least for now!).
We obtain the PPP numbers from the OECD website.
We list the newest values and the actual market rates (as of 8th February 2016). Note that all values are quoted with the USD as base currency (so for instance USDEUR rather than EURUSD):
By taking the ratio of the PPP rate versus the market exchange rate we obtain the Real Exchange Rate (RER), which should equal to one if the market rate equaled the PPP value. A RER that is above 1 means the currency is overvalued. A RER value that is below 1 means that the currency is undervalued. Ordering them according to the RER we obtain following table:
|Market Value (USD base)
So the cheapest currency is the EUR and the most expensive is the CHF. So the value-trade would be long EURCHF. That is we sell the most expensive and go long the cheapest currency. In essence this is a relative-value trade, and it has to be, since currencies always come in pairs!
Here’s a recent chart of this currency pair:
One possible way of trading this dynamically is to repeat the process on a monthly basis. Obviously the PPP values will remain unchanged throughout the year. However the exchange rates will oscillate. This is due to the vagaries of Mr. Market as Warren Buffett likes saying.
The performance of just this factor by itself over the last twenty years looks like this:
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