Behavioural Equilibrium Exchange Rate (BEER) model

Abstract: In this article, we introduce another method for evaluating the ‘fair’ value of a currency: the Behavioural Equilibrium Exchange Rate (BEER), a model which is widely used in practice. The BEER model was developed by Clark and MacDonald (1999) and estimates the fair value of currencies according to short, medium and long-run determinants. An important concept is that there is no prior theory for the choice of economic variables; hence, the choice of variables is based on economic intuition and data simplicity and availability.

We also do an application of the BEER and run a Fixed-Effect panel regression on the G10 currencies, using the US Dollar as the base currency, and three widely used macroeconomic variables – inflation, terms-of-trade and interest rates – for our regression. We conclude by commenting the results and making a brief analysis on the Euro (Spot rate versus BEER value).

 LINK ===> BEER_Models

Excel Data ===> Data BEER_New

BIS Nominal and Real Effective Exchange Rates (EER): NEER and REER

Abstract: In this article, we introduce the two effective (i.e. multilateral) exchange rates that measure the value of a specific currency in relation to an average group of major currencies: the Nominal Effective Exchange Rates (NEER) and the Real Effective Exchange Rates (REER). Both are calculated by comparing the relative trade balance of a country’s currency against each country within the index, but the REER is adjusted by the ratio of domestic price to foreign prices.

Using the BIS time-varying weights, we also look and comment the development of the CNY NEER and JPY REER over the past twenty years.

LINK ===> NEER and REER

DATA FILE ===> NEER_REER

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)

Purchasing Power Parity: The Big Mac Index

When it comes to FX long-term projections, I do believe that you already heard of the PPP (Purchasing Power Parity) model. A popular one was introduced in The Economist in 1986 (September 6) by Pam Woodall and is called the Big Mac Index (or Big Mac PPP). Basically, the BMI index measures the Purchasing Power Parity between nations using the price of a Big Mac as the benchmark. The Big Mac PPP between two countries is obtained by dividing the price of a Big Mac in one country by the price of a Big Mac in another country (both in local currencies).

The Big Mac Index for 2015 has not been published yet and the latest index was published on July 24 last year.

Computation
In July 2014, the average price of a Big Mac in the US was $4.80. In Norway, the hamburger costed 48 NOK at that time, which obviously gives you an implied exchange rate of 10 NOK for 1 USD. The actual rate chosen on that day by The Economist was 6.19NOK / 1USD. Therefore, the implied FX rate was approximately 61.6% higher than the actual FX rate, bringing the Big Mac price to $7.76 in Norway.

The chart below (on the right) represents which currency is overvalued (blue) or undervalued (red) against the select base currency, in this case the US Dollar. As you can see, Switzerland and Norway were the two expensive countries with the NOK and CHF overvalued by 61.6% and 42.4% against the Dollar, while Ukrainian Hryvnia UAH was undervalued the most by 66.1%.

Capture d’écran 2015-01-22 à 10.11.44(Source: The Economist)

More elaborate models take into account economic indicators depending on the major activities of the country (export-driven nation, developed or EM economy, …).

Even though we agree that there is no explicit answer regarding which model delivers the correct fair value of a currency (the Art of predicting), I believe that it is interesting to visit  the work that has been done by some brilliant academicians and major institutions (Banks, Investment Managers).