Peso problems after Wassenaar?
E.R. Afman
A.L. Vleesch Dubois
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)
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
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
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)
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?
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
9/30/1998
12/31/1996
3/31/1995
6/30/1993
9/30/1991
12/31/1989
3/31/1988
0.4
6/30/1986
0.6
9/30/1984
12/31/1982
3/31/1981
6/30/1979
9/30/1977
12/31/1975
3/31/1974
6/30/1972
9/30/1970
12/31/1968
3/31/1967
6/30/1965
9/30/1963
12/31/1961
3/31/1960
6/30/1958
9/30/1956
12/31/1954
Application: DFL/DM
Figure 1: DFL/DM Spot rate
1.2
1
0.8
1983:
Wassenaar
0.2
0
Dec-01
Dec-99
Dec-97
Dec-95
Dec-93
16
Dec-91
Dec-89
Dec-87
Dec-85
Dec-83
Dec-81
Dec-79
Dec-77
Dec-75
Dec-73
Dec-71
Dec-69
Dec-67
Dec-65
Dec-63
Dec-61
Dec-59
Dutch & German interest rates
Figure 2: monthly interest rates
18
Germany
14
Netherlands
12
10
8
6
4
2
0
Interest-rate differentials
jan-02
jan-00
jan-98
jan-96
jan-94
jan-92
jan-90
jan-88
jan-86
jan-84
Figure 3: Interest-rate differentials
jan-82
3
2,5
2
1,5
1
0,5
0
-0,5
-1
-1,5
-2
-2,5
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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