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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