The termpeso problem generically refers to situations in which the possibility of a significant change in the distribution of future shocks to the economy influences the expectations of economic agents. The interaction of expectations and shifts in the distribution of economic shocks can lead to behavior in the prices of assets such as stocks and foreign exchange that is not in accord with the predictions of standard economic theory.
The precise origin of the term is uncertain, but is often attributed to comments made by Milton Friedman regarding the Mexican peso in the early 1970s. At that time, the Mexican peso traded at a fixed rate against the U.S. dollar while the interest rate on Mexican bank deposits exceeded that on comparable U.S. deposits. The existence of such an opportunity to earn a profit with little or no risk might appear to present a problem for rationalagent- based models of financial markets. Such an interest differential would fail to be arbitraged away, however, if investors thought that the peso would be devalued in the future. Indeed, in August 1976, the peso was allowed to float against the dollar and subsequently declined in value.
See also capital mobility; exchange rate forecasting; foreign exchange intervention; forward premium puzzle; interest parity conditions; sovereign risk
- Evans, Martin D. D. 1996. ‘‘Peso Problems: Their Theo retical and Empirical Implications.’’ In Statistical Methods in Finance, edited by G. S.Maddala and C. R. Rao. Amsterdam: Elsevier, 613 46.
- Evans, Martin D. D., and Karen Lewis. 1995. ‘‘Do Long Term Swings in the Dollar Affect Estimates of the Risk Premia?’’ Review of Financial Studies 8: 709 42. Both this and the preceding work by Evans study the ways in which peso problems can affect inference about foreign exchange risk premiums.
- Hamilton, James D. 1989. ‘‘A New Approach to the Eco nomic Analysis of Nonstationary Time Series and the Business Cycle.’’ Econometrica 57: 357 84. Develops a methodology for incorporating Markov regime switch ing into models of economic time series. The technique has since been used in many papers that formally analyze peso problems.
- Jorion, Philippe, and William Goetzmann. 1999. ‘‘Global Stock Markets in the Twentieth Century.’’ Journal of Finance 54: 953 80. Collects data on equity returns for 39 markets going back to the 1920s and shows that U.S. equities had the highest returns of all countries over 1921 to 1996.
- Sill, Keith. 2000. ‘‘Understanding Asset Values: Stock Pri ces, Exchange Rates, and the ‘Peso Problem.’’’ Federal ReserveBank of PhiladelphiaBusinessReview(September/ October): 3 13. An introduction to how peso problems can affect the relationship between economic models and data.