Measure a Currency's Deviation From Purchasing Power Parity

[Fairman]

Measure a Currency's Deviation From Purchasing Power Parity

The purchasing power parity rate for EUR/USD, as estimated by an international organization, is 1.30. The spot rate is 1.10. How far is the euro from PPP, and what can you conclude?

Compute the deviation. Spot divided by PPP is 1.10 divided by 1.30, which is 0.846. The euro trades 15.4 percent below its PPP value, so it is undervalued by that measure.

Reverse the view: the dollar is overvalued by 1.30 divided by 1.10 minus 1, which is 18.2 percent.

Now interpret carefully. PPP is a long-run anchor. Currencies can stay far from it for years. Over horizons of five to ten years, studies find that deviations tend to shrink, with a half-life often estimated at three to five years. That means a gap of 15 percent might close by about half in three to five years, if nothing else changes, which is about 3 percent a year.

Check the practical use. A 2 percent annual drift is small relative to a pair's annual volatility of 7 or 8 percent. It would be invisible in any one year. So PPP is a poor timing tool.

It can still inform allocation for long-term investors, and it can warn about extremes. A currency 30 or 40 percent away from PPP is unusual.

Different PPP estimates give different numbers, depending on the basket and methodology.

Exercise: look up PPP estimates for two currencies and compute their deviations from spot.

[Fairman]

A small inconsistency in the post is worth clearing up. If the 15.4 percent gap closes by about half over three to five years, that's roughly 7.7 percentage points over that period, which works out to about 1.5 to 2.5 percent a year, not 3 percent. The later reference to a 2 percent annual drift fits that range. Either way, the conclusion holds: an annual drift of around 2 percent is small compared with the 7 or 8 percent typical annual volatility of EUR/USD, so it would be invisible in any single year's price action.

[Amanhasnoname]

I used PPP in my own planning once, when I held a long euro position against the dollar for several months because the pair looked so cheap against its fair value estimate. Spot was nowhere near the anchor, but it moved further away for nearly a year, and I closed with a loss and a lesson about timing.

As the reply pointed out, the drift is slow compared with a normal year of volatility. Since then I use PPP only as a background filter. If I am thinking about a long term position, I check that the gap is on my side, but I never use it to time an entry, and I ignore it completely for anything held under a few weeks.

One practical thing I noticed is that different sources give quite different PPP figures for the same pair, so I average two of them and treat the result as a wide band instead of a single line. That makes the idea more honest.