Explain how a currency speculator would use something like the Big Mac Index in order to make a profit trading currencies.
What will be an ideal response?
The Big Mac Index is meant to be a simplified illustration of the theory of purchasing power parity (PPP). PPP really looks at a basket of goods, not one single good, and would consider goods that are transportable since it is an extension of the law of one price. Big Macs are really not transportable. Finally, the price of the Big Mac is highly dependent on local costs such as wages, taxes and rent. That being said, a speculator would look at something like the Big Mac Index to determine which currencies are overvalued and which are undervalued. A speculator could profit by buying undervalued currencies (expecting their values to rise to where they "should be" in accordance with PPP) or by making forward transactions in overvalued currencies (sell them when they are high and expect to buy them at a lower price over the course of the contract). A speculator would use a much more sophisticated tool than the Big Mac Index for such trading, but the index does give us a general idea of what is possible.
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