Recently there has been some concern over Euro/Dollar trade, while some analysts are pointing out that Euro might take further dip, especially with further easing from European Central Bank (ECB) as early as next week, whereas others are pointing to Euro might be too over-shorted.

We, thought it would be good idea to evaluate the confusion, from fundamental point of view.

In our pursue for fundamental evaluation we look at the following, over this and next few articles -

• Big Mac index
• Purchasing power parity
• Long rates
• Short rates
• Ultra-short rates
• Policy divergence
• Current account

What is Big Mac index?

The Big Mac index was invented by The Economist in 1986, to evaluate the fair level of currencies. It is basically based on purchasing power parity (PPP). Any fluctuation in price of Big Mac burger in US and Europe would be adjusted by movement in exchange rate so the cost remains same.

It is not a very accurate measure of PPP, however it gives fair idea of the exchange rate and PPP.

However, PPP though tend to hold over longer horizon, it is not a good measure of currency movement in the short term. Nevertheless, if a currency is fundamentally overvalued or undervalued, longer term funds (sovereign funds, insurance, pension, warren buffest) might push money in or out of the currency or decide on their hedging strategy.

Where Euro stand?

According to latest estimate available, July 2015, Euro could be undervalued more than 20%. Fair price of Euro should be around 0.77 per Dollar or 1.29 Dollar per Euro.

So lower the Euro, higher will it be away from fundamental value and greater will be the turn for mean reversion.

Caution

A currency can remain over or undervalued for quite a long time. Euro has not been undervalued since 2002 and by 2003 it was overvalued against Dollar, according to Big Mac. However, that overvaluation reached close to 50% by 2008, before reversing course.

So just have a feel of the fundamental and don't place ur short term call based on this undervaluation.