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Understanding the Peso Problem: Implications for Market Efficiency and Forecasting

The peso problem arises from market forecasts that reflect the potential impact of rare but significant events, leading to distorted investor behavior and forecast errors. First identified in the 1970s in Mexico, this problem illustrates the inconsistencies in expected exchange rates, as investors react to perceived risks. The continued examination of peso problems through various models shows their disruptive influence on market efficiency tests and highlights the challenges of rational expectations in financial forecasting. This analysis explores the consequences and underlying mechanisms of the peso problem after Wassenaar.

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Understanding the Peso Problem: Implications for Market Efficiency and Forecasting

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  1. De Problema Pesonis Peso problems after Wassenaar? E.R. AfmanA.L. Vleesch Dubois

  2. What is the peso problem? • A peso problem arises when the market forecasts reflect the possibility of major events that occur relatively infrequently (Maurice Obstfeld) • The peso problem is the perception, embedded in a price or rate, of a small probability of a large change(Dictionary of Financial Risk Management)

  3. Why peso? • First observed in the 1970s in Mexico • US$/peso rate fixed for 20 years • Yet: interest-rate differential • UIP invalid! • -> Market expected devaluation • Peso devalued 46% in August 1976

  4. Why is it a problem? (1) • Investors act on uncertain events • Possibility of “catastrophic event” leads to irrational behaviour • Forecast error: systematic under-/ overestimation • Distortion of market efficiency • High interest rate (risk premium) very costly

  5. Why is it a problem? (2) • Measurement problems! • Ex ante: anticipated event is rare or unprecedented; no historical data for chartists to predict • Ex post: serially correlated forecast errors in data set which cannot be explained (Finance-Minister Problem)

  6. Academic literature • Peso problems disrupt test for market inefficiency • Cannot be explained with rational expectations theory • Hard to filter out of data set! • Which models can we use to capture magnitude of the problem?

  7. Models for peso problem • Find other occurrences of same event and find trend (not always feasible) • Regression analysis of UIP deviations • Bubble theory • Regime switching models

  8. Application: DFL/DM 1983:Wassenaar

  9. Dutch & German interest rates

  10. Interest-rate differentials

  11. Conclusion • After Wassenaar, the DFL/DM interest rate was completely stable • But: Dutch interest rates were significantly higher than German rates in 1985-1989 • UIP deviation • Peso problem?

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