FX Professionals Guide..... Big Mac Index turns 40 years old Post

PPP for professionals 

Purchasing Power Parity (PPP) is one of the oldest and most widely discussed concepts in foreign exchange. Yet it is also one of the most misunderstood.

A common belief is that if a currency is 20% or 30% undervalued according to PPP, it should eventually appreciate by a similar amount. While intuitive, this is not how professional investors typically use the model.

The real question is not whether PPP works. It is whether it is being used correctly.

PPP is a valuation model, not a timing model

PPP estimates the long-run fair value of a currency by comparing inflation-adjusted purchasing power between economies.

It tells us whether a currency appears expensive or cheap relative to its fundamentals.

What it does not tell us is when the market will move towards that fair value.

As one systematic FX manager put it:

"PPP tells you where a currency should settle in the long run, but it does not tell you when or how it will get there."

That distinction between valuation and timing is fundamental.

PPP has little short-term forecasting power

Professional evidence suggests that over investment horizons of one month to one year, PPP provides almost no useful forecasting information.

The information coefficient over these horizons is close to zero, meaning that knowing whether a currency is undervalued today tells you very little about where it will trade over the coming months.

This explains why currencies can remain apparently cheap or expensive for years without moving back towards fair value.

Its strength emerges over longer horizons

While PPP struggles over shorter periods, its predictive power improves considerably over multi-year horizons.

Between two and five years, valuation becomes increasingly relevant, and over horizons exceeding five years PPP can explain a meaningful proportion of long-term real currency returns.

In other words, PPP is not a trading signal—it is a long-term anchor.

Cross-sectional analysis is more powerful than time-series analysis

One of the more interesting insights from systematic investing is that PPP works best as a cross-sectional measure.

Instead of asking whether a single currency is cheap relative to its own history, investors compare currencies against one another at a point in time and identify the most expensive and cheapest currencies across the entire universe.

This approach avoids many of the structural biases that weaken traditional time-series valuation models.

Small valuation gaps are mostly noise

Not every deviation from fair value is meaningful.

Professional systematic strategies generally require currencies to be around 15–20% away from estimated fair value before valuation begins to offer a useful signal.

Minor mispricings simply do not contain enough information to justify investment decisions.

Capital flows dominate exchange rates

If PPP determines value, what determines price?

The answer is capital flows.

Short- and medium-term exchange rate movements are driven primarily by interest-rate differentials, portfolio allocation, economic surprises, central bank policy, investor positioning and shifts in global risk sentiment.

Financial markets are simply much larger than international trade flows.

As a result, exchange rates are often determined by where investors choose to allocate capital rather than by the movement of goods and services across borders.

PPP is only one part of the investment process

Professional systematic investors rarely trade PPP in isolation.

Instead, valuation is treated as one independent source of information within a diversified multi-factor framework.

Standalone valuation strategies are susceptible to "value traps", where currencies remain mispriced for far longer than expected.

By combining independent factors at the portfolio level, investors can benefit from valuation without relying on it as a timing tool.

Some currencies can remain permanently expensive or cheap

PPP should not be viewed as a fixed destination.

Structural changes in productivity, terms of trade, demographic trends and international capital flows can shift equilibrium exchange rates over time.

Reserve currencies such as the US dollar, safe-haven currencies like the Swiss franc, and heavily managed currencies such as the Japanese yen have all spent extended periods appearing significantly misaligned with traditional PPP measures.

These are not failures of PPP so much as reminders that fair value itself evolves.

The real misconception

Perhaps the biggest misunderstanding surrounding PPP is the assumption that valuation automatically leads to price appreciation.

It does not.

A currency can be objectively cheap and continue falling.

An expensive currency can remain expensive for years.

Valuation and forecasting are not the same thing.

Conclusion

Purchasing Power Parity remains one of the most useful tools available for estimating long-term currency value.

However, its strength lies in identifying relative value over long horizons—not in predicting next month's exchange rate.

Professional investors recognise this distinction. They use PPP as one component of a broader investment framework, combining long-term valuation with other independent sources of return.

Understanding what PPP can—and cannot—tell us is ultimately more valuable than simply knowing whether a currency appears cheap or expensive.