The foreign exchange market (FX) is one of the most exciting, fast-paced markets around. And for a long time, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, and extremely wealthy individuals.
Eventually more and more people wanted to enter the fray, and one basic rule of foreign exchange is whether your currency is over or undervalued compared to the one you are basing it on, for example the dollar. So, a method was devised to help make this idea more digestible.
Relaxed, humorous and half-hearted are just a few descriptions accredited to the Economist’s introduction of the Big Mac Index since its creation in 1986. The idea behind the Big Mac Index was to measure the percentage of overvaluation and undervaluation between two currencies in each nation by comparing prices of a Big Mac hamburger. The index was never intended to be precise with regards to the changes in currency, it was simply a tool designed to help explain the idea of exchange rates.
While the original index was based on the Big Mac we have decided to use a falafel sandwich which is made by Just Falafel. Just Falafel is a vegetarian fast food chain of restaurants, founded in 2007.
It has about 52 restaurants worldwide and is growing. The reason we chose them is firstly because they promote a product that is locally very popular and well known, the second reason is because if we are to use an index to make these valuations we would need a standard product in all locations. That’s why a big mac was originally used.
The idea behind the index is that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services in any two countries, such as a falafel sandwich, meaning that they should cost the same in both countries. For example the price of the original falafel sandwich sold at Just Falafel in the US is USD 6.29 and the price of the same sandwich in the UAE is USD 3.27 so the “raw” index would state that the UAE dirham is undervalued by 48 percent.
Meaning that the UAE currency would need to ascertain what is causing its currency to be undervalued in order to reach a closer value to the dollar. Undervaluation is simply because there’s insufficient demand for it. If no one wants to buy UAE Dirham, then the Dirham is probably going to be undervalued no matter how healthy UAE’s economy is. The opposite is the case if it is overvalued, meaning that if there is a lot of demand for a currency like the euro then it would most likely have an overvaluation compared to the dollar.