The Peso problem in finance is a problem which arises when "the possibility that some infrequent or unprecedented event may occur affects asset prices". The difficulty or impossibility of predicting such an event creates problems in modeling the economy and financial markets by using the past.
It is useful in various contexts, in particular, in analyzing the
Forward premium anomaly The forward premium anomaly in currency markets (also referred to as the forward premium puzzle or the Fama puzzle) refers to the well documented empirical finding that the domestic currency appreciates when domestic nominal interest rates exceed f ...
.
History
The precise origin of the term is unknown, but it is generally attributed to
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
. Mexico in the 1970s, had pegged the
Mexican peso
The Mexican peso (Currency symbol, symbol: $; ISO 4217, code: MXN) is the currency of Mexico. Modern peso and dollar currencies have a common origin in the 16th–19th century Spanish dollar, most continuing to use dollar sign, its sign, "$".
...
to the
US Dollar
The United States dollar (symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the official ...
, a peg which had held for more than 20 years. Friedman noted the large gap between the interest rate on Mexican bank deposits and the interest rate on comparable US bank deposits. Friedman reasoned that interest differential reflected concern in the market that the peso would be devalued. This was eventually realized in 1976 when the peso, allowed to float, fell 46 percent.
Since the currency value had been pegged for a long time, the differential in interest rate looked like an anomaly or flaw in financial markets - an investor could exploit the difference by simple currency conversion and make a profit. The anomaly could be explained once the possibility of a large drop in the value of the peso is admitted.
The empirical work first discussing this was by
Kenneth Rogoff
Kenneth Saul Rogoff (born March 22, 1953) is an American economist and chess Grandmaster. He is the Thomas D. Cabot Professor of Public Policy and professor of economics at Harvard University.
Early life
Rogoff grew up in Rochester, New York. ...
in 1977 which was part of his Ph.D. dissertation. The first treatment in academic literature was by Krasker in 1980.
References
See also
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Economic puzzle
A puzzle in economics is a situation where the implication of theory is inconsistent with observed economic data.
An example is the equity premium puzzle, which relates to the fact that over the last two hundred years, the risk premium of stocks ...
*
Real exchange-rate puzzles
The real exchange-rate puzzles is a common term for two much-discussed anomalies of real exchange rates: that real exchange rates are more '' volatile'' and show more ''persistence'' than what most models can account for. These two anomalies are s ...
*
Equity premium puzzle
The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been obser ...
International finance
International macroeconomics
Economic puzzles
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