If you've not heard of it before, the Big Mac index is an index published by the Economist, and it uses the price of a Big Mac to predict if currencies are over/undervalued.
This index depends on one theory: the law of one price. The law of one price states that the price of a good everywhere should be the same eventually, because of arbitrage. What does that mean? For example, if the price of gold in Britain is cheaper than in France, I could buy in Britain, among many arbitrageurs, and sell in France. This would equalize the prices eventually, so no discrepancy by more than the transportation cost can occur.
The Big Mac hypothesizes that the price of a Big Mac should be the same everywhere in the world since it's the exact same product. So, the real exchange rate between two currencies should be the ratio of Big Mac prices. For example, according to the law of one price, if a Big Mac is a dollar in the US and 20 Turkish liras in Turkey, one dollar must equal twenty Turkish lira. No more, no less.
If the Turkish lira is trading at 27 per dollar, it must be undervalued, if it's trading at 15 per dollar, it must be overvalued. Because I could purchase a Big Mac in the US for 15 Turkish lira, and sell it for 20 Turkish lira in Turkey. If I do this enough times, I'd increase the supply of a Big Mac, and the supply of Turkish liras, or the demand for dollars to purchase a Big Mac, the ratio of Big Mac prices and the exchange rate with equalize.
If you traded using this assumption and the Big Mac index though, you'd be a mediocre currency trader at best. The Swiss franc has been overvalued for years, and the Malaysian Ringgit(I bet you haven't heard of that before), was undervalued for around 50 percent for decades. Why does this happen, why don't we buy a boatload of Big Macs in Malaysia and sell them in Switzerland?
I think the answer seems pretty obvious now. Commodities usually behave according to the law of one price. Coffee beans or crude oil, for example, have similar prices all over the world. (Even those can sell for different prices though, the price of oil in California for example, is much higher than the price in Missouri)However, perishable goods behave differently. Imagine that you ground the coffee beans and made an Iced Americano. Where can you sell that, well you have to be quick, so around wherever you live. You can't ship it to anyone, same with a Big Mac.
The fact that these goods cannot be transported prevents arbitrage, which in turn leads to the price discrepancy surviving. For example in some parts of Canada, groceries are extremely expensive, but no one tries to sell more there, because it's very costly to get them there. So sorry Swiss McDonald's lovers, I don't think Big Macs are getting any cheaper soon. Because Switzerland is one of the richest countries, they have a higher willingness to pay, and employing people and renting in Switzerland is much more expensive than in Malaysia, which increases the prices. As a burger-lover who lives in a country with a 36% undervalued currency, I'm in no hurry to get a Big Mac, and I would advise any aspiring trader out there to look for other strategies.
Source: The Economist (https://www.economist.com/big-mac-index)
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