Currency Valuation Methods

There are several areas of influence that combine into contemporary currency valuation methodology. One way involves careful evaluation of charts and indexes and requires skill and extensive knowledge. The more informal way is comparing costs for the same item in different countries, called purchase price parity or PPP.

Prior Currency Valuation Methods

Except during WWI, the Great Depression and WWII, the majority of the world’s currencies were backed or guaranteed by a known and real commodity—gold. The value of a currency was determined by the amount of gold a country stockpiled. The strongest currencies were those whose countries had a considerable stockpile.

After WWII and the economic hardship the US and Europe had experienced, a new valuation method called the Bretton Woods exchange system was instituted. The currencies were still backed by gold—called a gold standard, but the inter-valuation of currencies to each other was influenced by gold prices, to simply the system.

The United States dollar became the international trade currency, and when the US removed its currency from the gold standard in 1971, the Bretton Woods system crumbled. Since that time, currencies are valued by much different factors.
Contemporary Valuation Methods
When evaluating a nation’s currency, there are two basic types of analysis of factors—fundamental analysis and technical analysis.

Fundamental Analysis

Fundamental analysis incorporates intrinsic value and envelopes indexes called economic indicators and are periodically released by most governments. Economic reports relay data usually pertaining to one focus area per report or index. Four major area reports are particularly anticipated.

A Gross Domestic Product (GDP) report portrays the widest scope of an economic report and represents the total value of a nation’s produced goods and services for a given year. The GDP is always retrospective in nature: It relays what had happened, never what may happen. Prior to the main report’s issuance, however, two reports precede it—an advanced report and the preliminary report. Neither, however, guarantees information will remain reliable in the GDP report itself. On national scale, a GDP report can be likened to an annual report by a corporation.

Retail sales indicate both consumer confidence in an economy and its willingness to take on debt. If people are buying, they aren’t hoarding funds. As sales activity increases, usually inflation and interest rates will eventually lower.

The Consumer Price Index (CPI) or a national equivalent measures price changes across many categories. When compared to national exports, the CPI can indicate whether the country is importing more goods than it is exporting and the price impact it may have.

Industrial Production outlines the manufacturing, mining and utilities production changes. The utilities industry is especially vulnerable to weather conditions and natural disasters. The production figures of factories and mines portray not only output but under- or over-utilisation of manufacturing facilities.

Technical Analysis

A technical analysis of a currency value incorporates the above factors and used in conjunction with political stability, interest rates, inflation rates, trade balances and demand for the currency as a commodity. As a commodity, currencies are valued against each other based on fundamental analysis factors, a country’s credit rating—the reliability of paying debt—and perception of reliability—whether a down-turn is temporary or long-term.

In a brief encapsulation, currency valuation methods determine one country’s ability to buy goods and pay debt. The standard supply-and-demand interaction determines trade volumes of different currencies, and the two conjoin via technical analysis tools to indicate which currency may rise in value and which currency may decline in value.

Purchase Price Parity

This simple comparison method involves tracking the cost of the same goods or services across differing economies.

The PPP paradigm asks one question: If Product A manufactured in Australia, for example, costs Australians 50 AUD, what does Product A cost elsewhere? If the ‘elsewhere’ is less than 50 AUD exchanged, then the currency is stronger than the AUD. If it costs more than 50 AUD after currency exchange, then the currency is weaker than the AUD.

The PPP method is commonly nicknamed “The Big Mac Method” by tracking the cost of the fast food burger across the globe.