Purchasing power parity also known as PPP essentially states that there is a law of one price. The same good should cost the same everywhere minus the cost of transporting it. That means that in theory a Big Mac should cost the same minus a few cents for shipping in every McDonald’s on the planet. Excluding airport McDonald’s that are always overpriced.
Of course what happens is that over time in a floating rate environment currencies will drift away from the one price to varying degrees. It is very rare when two currencies are priced fairly, or at parity, although it does happen from time to time.
So how can we take advantage of this? If they rarely trade at parity is there any advantage to trading an overpriced or under priced currency? Well there are a few ways in which we can make money off of this. It turns out that over time currency pairs tend to trade back towards an equilibrium, or parity. They may drift for a few years in one general direction until they are very over or under priced but then they come back to where they should be before overshooting to the other side.
So who actually invests in this concept and strategy? Well currency traders do but the main practitioners in this sphere are the global macro investors. By studying currencies they can trade currencies and even trade stocks and bonds better due to the extra knowledge.
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