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- Purchasing Power Parity (PPP) is a theory that gives implied 'fair' exchange rates based on a relative price level of two countries. Assuming no transaction costs, identical goods in different markets would be priced the same.
- Based on Eurostat OECD calculations of the FX 'fair' value exchange rates using the PPP theory, the chart below shows that the Euro remains the most significantly undervalued currency in the G10 market (nearly 16% undervalued relative to the USD), while the Swiss Franc is the most expensive currency (22% overvalued against the USD).
- Using a 'value approach' based on the PPP theory, EURCHF would be the value trade given the current spot rates.
- However, it is important to know that academic research has found that PPP works only in the long term and therefore currencies like the Euro can remain cheap for a long time before converging back towards its 'fair' value.
- In addition, other FX models such as the Behavioral Equilibrium Exchange Rate (BEER) would price the Euro as expensive if we use the current account (or terms of trade) as one of the explanatory variables.