There are several features of currency returns that make currency an attractive asset class for institutional investors. Still, the FX market has become popular also in the world of individual investors, and therefore, it is beneficial to study various factors in this currency world. One of these factors is an FX value, deeply connected with a Purchasing power parity (PPP), a theory concerning the long-term equilibrium exchange rates based on a relative price level of two countries. The concept mentioned above was founded on the law of one price – the idea that in the absence of transaction costs, identical goods in different markets would be priced the same. No surprise, different countries consume different baskets of goods; however, it is partially possible to asses a relative price level. More precisely, it is possible to find out which country is “cheaper” and on the other hand, which country is “more expensive” for living.
PPP theory states that price differences between countries should narrow over time by the exchange rate movements or by different rates of inflation (which also has some implications on exchange rate movements). Concentrating on the FX market in the long-run, currencies tend to move towards their “fair value”. Consequently, systematically buying “undervalued” currencies and selling “overvalued” currencies leads to a profitable trading strategy in the medium-term. Last but not least, the world of academics recognizes the value in the foreign exchange market as one of the critical factors, as well as FX momentum or FX carry.

Menkhoff, Sarno, Schmeling, and Schrimpf in “Currency Value” have shown that measures of currency valuation derived from real exchange rates contain significant predictive content for FX excess returns and spot exchange rate changes in the cross-section of currencies. Most of the predictability mentioned above stem from persistent cross-country differences in macroeconomic fundamentals. This suggests that currency value mostly captures risk premia, which vary across countries but are relatively static over time. Moreover, their results do not support the standard notion that trading on simple measures of currency value is profitable because spot exchange rates are reverting to fundamental values. When the real exchange rates are decomposed into underlying macroeconomic drivers, it was found that refined valuation measures relate more closely to “currency value” in the original sense in that they predict both excess returns as well as a reversal of exchange rates.
Additionally, as it was already mentioned in the description, different countries consume different baskets of goods, and it is partially possible to asses the relative price level – to identify which country is “cheap” and which country is “expensive”. The price differences between countries narrow very slowly over time. A rebalanced portfolio, which has the most undervalued and overvalued currencies, helps to capture gains from the exchange rate convergence to the fair value.