Currencies are traded against each other based on their intrinsic values. But, exactly how are these values fixed and who determines them? There are a few theories in currency trading that attempt to answer this question. The most popular among them is the theory of purchasing power parity.
This theory states that currencies are exchanged on the basis of how much a group of similar goods would cost in each country. For example, suppose that a basket of basic food basket consisting of a loaf of bread, a dozen eggs and a pound of butter would cost, say, 5 Great Britain Pounds (GBP). If an identical basket of goods in the United States costs US $3, then according to this theory, the exchange rate would be fixed at 5:3 in favour of the GBP. In this case, 1 GBP would be equal to US $ 1-2/3 or 1. 666.
If at any given time, the GBP was currency trading at values higher than US $1.66 then we would say that it is overvalued. When it trades lower than the rate determined by the PPP theory, then pound would be considered as undervalued vis-à-vis the greenback.
Although this theory does a fair job of giving approximate exchange values, it cannot be applied to realistic scenarios. There are many factors that determine the prices of goods in each country, including but not limited to customs tariffs, local taxes and various other regulations.
