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Purchasing Power Parity (PPP) in Forex Trading

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When people hear about Purchasing Power Parity (PPP), they normally either think of it as some stupid simplification and that is so far away from the reality that it should be dismissed or believe in it like it is some kind of gospel and that everything happening with economies, prices, and currencies can be explained by PPP. This false dichotomy stems from the fact too many people know almost nothing about PPP. At the same time, there are many traders who would benefit from studying purchasing power parity as a driver for currency rate changes. If you know how it works, PPP could be one of your best fundamental analysis tools that, among other applications of course, can be applied to Forex trading.

What is PPP?

Purchasing power parity, or PPP, is an economic theory that implies that international currency rates should be balanced according to the relative cost of goods and services in the given countries.

For example, if the basket of goods costs $1,000 in a country X and the same basket of goods costs $2,000 in a country Y, then the PPP relation is 1:2, which means that the currency of the country X should appreciate by 100% relatively to the currency of the country Y. Ideally, if their current exchange rate (Y/X) is 2.0000, it should become 1.0000.

Did you know? A half-joking version of PPP is calculated by The Economist and is called the Big Mac Index.

Real life examples

Let's get to more real examples. According to IMF, the nominal GDP of the eurozone (19 EU countries that adopted the euro) was at $15.167 trillion in 2020. While the GDP of the Eurozone in PPP terms was at $19.686 trillion that year. That means that the EUR/USD was undervalued by about 30% according to PPP. If we consider the average EUR/USD rate in 2020 as 1.1508, then the PPP-adjusted rate should be about 1.4960.

Another example is China. IMF lists China's nominal GDP for 2020 as $14.341 trillion, while the GDP (PPP) is listed as $23.324 trillion, which signals about an overvaluation of the Chinese yuan by 62.6%. The 2020 average USD/CHN rate of 6.9022 should have been 4.2449 according to the purchasing power parity.

Why PPP isn't that good actually?

So, why is it a bad indicator to use as the main currency rate forecast tool? First, even as an overvaluation/undervaluation metric it is far from perfect — it has its flaws in calculation and in its interpretation as the currency rates disparity (it may just signal an inflation disparity rather than an imbalance in the foreign exchange rates). Second, it is just one of many factors that influence currency pairs. Trade balance, supply and demand, interest rates, risk aversion and risk appetite, political stability, and other factors affect currencies at a significant extent, which is comparable to that of PPP (and sometimes even exceeds it).

How to use PPP in Forex trading?

Despite its disadvantages and a lack of short-term opportunities for trading, PPP can be used successfully in Forex. It is a long-term fundamental indicator, which means that you can use it to predict the future of the currency rates using the long-term horizon of several years. If you consider all the fundamental indicators in a complex, PPP should definitely be one of them, and if all others are balanced, the PPP can be chosen as the leading influencing factor.

For example, you could go long on the Chinese yuan now and in 3–4 years you would probably be in profit (if something horrible doesn't happen there of course).

If you have any questions or comments about using the concept of purchasing power parity (PPP) in Forex trading, please use our forum to start a discussion.