URGENT

b. Compare the Economist’s Big Mac Index to the Ipod index (launched in 2007 by

Commonwealth Securities of Australia) and to the Billy Index (Bloomberg’s Index

of Ikea Billy’s bookcase). Why should or shouldn’t we expect different patterns

from these indices?

Big Mac Index

In 1986, the Economist invented a relaxed guide to compare currencies and see if they hold at their correct level. Instead of going through complicated theories and trying to calculate the best exchange rate between the dollar (US) and any other currency, they considered comparing an everyday item which is the burger. The Burger is available in almost all countries and has a price denominated in that local currency. Typically, the price between the burger in two countries comes from the varying costs that come with creating/making that burger and bringing it to a plate, which means they can be easily compared. In this case, the McDonald’s Big Mac is produced in about 120 countries.

This index is based on the theory of purchasing-power parity. It works on the core notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods in any two countries. In other words, the same product will stand at equilibrium price in two different currencies.

This adjusted index addresses the main idea and criticism that most people would expect average burger prices to be cheaper in poor countries than in rich ones because labor costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area).

http://www.economist.com/content/big-mac-index

Disadvantages:

1) First, the Big Mac makes sense as a substitution for a “basket of goods” it is not a perfect “basket”. Even though in reality, no basket of goods is perfect. Maybe China is actually more efficient at producing a Big Mac and Colombia is less efficient thereby generating a lower or higher price.

2) Second, for policy reasons, countries will take actions to either devalue or increase the value of their currencies. Generally a lower currency value encourages exports and a higher currency value encourages internal consumption (buying).

Example: A country can take its own currency and buy dollars in order to weaken its own currency and strengthen the dollar. The dollar has been the world’s reserve currency for quite a while and many countries have bought dollars to store as foreign reserves. This increases the demand for the dollar and a simple supply and demand calculation shows that this increases the value of the dollar while decreasing the value of the purchasing currency.

Ipod Index:

A Sydney based bank developed a new indicator for purchasing power based on Apple's iPod and as an alternative to the long-standing Big Mac Index. The Commonwealth Securities of Australia launched the IPod Index which was predicting a 15% drop in the Australia dollar against the US dollar – and this started to drive exporters.

Similar to the Big Mac Index:

1) The Economist used the iconic burger because it is made the same way the world over.

The Common wealth chose an item that is known very well around the world. With the same approach, Commonwealth Securities has devised the iPod Index

Example: Apple sold 21 million iPods in one quarter of business.

2) One item is used to compare and assess whether a particular currency was under or overvalued against other currencies. Analysts have a range of ways to both explain exchange rate levels and forecast futures movements. Also, it has a good track record in predicting the direction of currencies.

The theory is that if a Big Mac in Australia is cheaper than it is in the United States when expressed in US dollars then the Australian dollar may be perceived as undervalued. One way that this imbalance in Big Mac prices may be corrected would be for the Australian dollar to rise against the US currency.

3) To gauge its accuracy, but the first reading of the iPod Index of 26 countries - based on the two gigabyte iPod nano in US dollars - suggests that the US dollar has potential to rally.

Differences:

1) Commonwealth Securities chief economist Craig James said the Big Mac index can be distorted by taxes, transport costs, labor laws and trade barriers in each country.

"No PPP approach is perfect, just as no currency model is completely accurate," said Mr James.

2) Location where the product or basket item is made

"A key difference between the iPod and Big Mac approaches is that Big Macs are made in a host of countries across the globe whereas iPods are predominantly made in China," said CommSec chief economist Craig James.

"Simply, an iPod nano should broadly cost the same across the globe. If there were substantial price differences customers would switch their purchases to other countries, especially given the power of the internet."

3) The iPod index does not meet all the criteria to illustrate purchasing power theory, as freight costs will vary from country to country, and countries like the United States may get bigger discounts.

4) But, said Mr James, the iPod is tradeable across country borders and is the same around the globe.

"So it may provide a purer assessment of currencies."

5) Brazil is the dearest place to buy an iPod at US$327.71, and the lowest is in Canada at US$144.20.

Australia is in 19th place at $US172.36 ($A219.44), four places above the US at $US149.00.

6) The consumer has more choices

Billy Index

In 2009 from Bloomberg, the analyst Kristian Siedenburg comes up with this new index. Like the Economist’s "burgernomics", he uses Swedish furniture firm IKEA; the popular Billy bookshelf prices across the globe. Like the Big Mac, the Billy is readily available and popular worldwide. In 2011, the "Billy bookshelf index" suggested that prices were highest in the Dominican Republic and Israel, and lowest in the Netherlands.

The index was originally meant to be similar to the Big Mac Index published by The Economist. IKEA has been accused of being the McDonald's of the furniture industry, Siedenburg decided to compare the prices of a popular, standard shelf made by Ikea -- known as the Billy shelf -- in 38 countries around the world. And where the Big Mac is expensive, the Billy shelf can be cheap.

Advantages:

1) The Billy bookshelf is a useful tool of comparison, being a good value and widely sold product that satisfies a universal need.

Example: The Bloomberg news agency published its first Billy Bookshelf Index comparing the listed price of the bookshelf from in 38 countries.

2) In addition, IKEA only adjusts the prices of Billy bookshelves once a year, which is much less frequently than McDonalds tweaks the cost of their flagship burger, making the Billy index much slower to respond to economic trends than the Big Mac barometer.

Differences:

1) Economists will complain that the bookshelf isn't a suitable consumer good by which to measure general well-being. Ikea's prices for the shelf stay the same for a year and too few of them are bought, both factors which make the Billy a less reliable tool for economic measurement.

2) This isn't the first time an agency has used Ikea to make a statement about the financial soundness of various currencies in various countries. In 2004, the European Consumer Centre in Düsseldorf looked at 75 Ikea products across 17 European countries. Back then, the survey found that prices differed substantially across Europe, with sofas in Poland being far cheaper than sofas in Germany, for instance. The survey was supposed to give price-conscious EU consumers information but it also indicated how unified -- or not -- the euro zone was with eastern countries, like Poland and the Czech Republic.

3) The Billy Bookshelf Index, however, differs because bookcases are considered durable goods, rather than consumer goods, meaning they aren’t purchased as often.

“Ikea changes its prices only once a year,” Siedenburg told The Local

4) But while the Billy Index may not be as useful as the Big Mac Index for illustrating the dynamics of purchasing power parity, it still may come in handy in discussions about business competition, transport costs, and price wars, he explained.

5) In addition, IKEA only adjusts the prices of Billy bookshelves once a year, which is much less frequently than McDonalds tweaks the cost of their flagship burger, making the Billy index much slower to respond to economic trends than the Big Mac barometer.

c. Do you have any recommendation for improvements for these indices or for a

new index? In what way can corporate financial officers, international investors,

individual investors and global travelers use the insights provided by these

indices?