Understanding Asset Values: Stock Prices, Exchange Rates, and the "Peso Problem"

Keith Sill

Senior Vice President of Research and Director of the Real-Time Data Research Center

September/October 2000

Business Review — Sometimes, the present depends on the future: People carry umbrellas when there is a forecast for stormy weather; football teams in the lead play zone defense late in the game, since they expect their opponents to pass; advance-purchase airfares are higher for holiday-travel times, when passenger traffic is expected to be heavy.

In each of these cases, and many others we can think of, what people expect will happen affects how they behave today. Exchange rates and prices of assets such as stocks and bonds depend not only on the most likely future outcomes but also on possible but less likely outcomes. Sometimes a possible outcome can be so different from today’s conditions that asset prices, which incorporate such extreme possibilities, make financial markets look flawed, even if they are not. Economists call such a condition a “peso problem.”

This article appeared in the September/October 2000 edition of Business Review.

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