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The word "parity" means equality in value, status, or amount. Purchasing Power Parity is a theory presented by Gustav Cassel in 1920 which states in an efficient market the purchasing power of each currency should be the same in its own country. For example if the exchange rate between British Pound and US Dollar (GBP/USD) is 2 then the price of a good in the United States of America in US Dollar (the local currency) must be twice as the price of the same good in Great Britain in British Pound (the local currency). To be more clear if you can purchase a camera in USA for $1000.00 then the same camera must be £500 in Great Britain.

This theory is more plausible if you consider a basket of goods rather than a specific item. One should also consider those goods that could be easily transferred between the two countries. You may not for example take the price of houses into account as you cannot export them from one country to the other. It is better to avoid those goods that their transfer costs are also very high.

Assuming this theory is reliable then one could analyze the market and find inefficiencies which could result in trade opportunities. For example if the price of a basket of goods in Great Britain is £1000 and the same basket in USA is $1500 then we expect the exchange rate for GBP/USD to be 1.5. Now if the current exchange rate is 2.0 we predict a significant drop in the exchange rate. We expect the exchange rate to drop and approach 1.5 in the future. If you accept this theory then you may go short on this pair.

In reality this theory is of no use for short-term traders. You may consider it for long term targets but for a scalper, a day trader, or even a swing trader this theory is of no use.

One interesting approach to this theory is the Big Mac Index which is presented by the Economist magazine. Click here for more information.

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