The Peso Problem

The story below is referenced whenever the phrase "Peso Problem" pops up. I have to admit that I was unware of it, or rather, I was unware of that particular phrase. I soon realized that Peso Problem is just a cute phrase for what statisticians call a "tail risk". If you google Peso Problem you get all kinds of financial variables from interest rate curves to equity risk premium linked to Peso Problem.

Krugman aruges on his blogthat Friedman should not be credited for coining the phrase "Peso Problem" but rather him or his MIT classmate Bill Krasker. Go figure.

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Equity prices and the ``peso problem''
The Hindu, 1-Oct-2000
B. Venkatesh

INFOSYS Technologies currently trades at a price-earnings multiple of over 100 whereas BHEL trades at just five times its earnings.

What drives investors to pay over 100 times the current earnings to buy one share of Infosys? Or, why are they reluctant to pay more than five times the earnings to buy one share of BHEL?

Research papers on asset values contain answers to this question. One such research paper by Mr Keith Sill, an economist at the Federal Reserve Bank of Philadelphia, states that a financial asset is valued after factoring the possibility of some unprecedented event in the future.

For argument's sake, BHEL may be trading at only five times its earnings because the market fears the company will be eventually forced out of business by ABB.

Such an event may or may not occur. But at this point in time, it may be just that the market is factoring the improbable event into the stock price.

Economists call such a condition the ``peso problem''; for, such a condition was observed by the Nobel laureate, Milton Friedman, in the Mexican peso market in the early 1970s.

At that time, the exchange rate between the Mexican peso and the US dollar was fixed. The interest rate in Mexico was, however, far higher in the US.

Such a situation presented investors opportunity for easy profits. How? An investor could borrow at a lower rate in the US, convert the money into peso and invest in Mexican bonds. On redemption of the bond, the investor could reconvert the peso at the same exchange rate, pay the loan and pocket the gains.

Milton Friedman stated that the interest differential between the two countries may have been due to the market expecting the peso to be devalued against the US dollar. And sure enough, in 1976, the market expectation actually came true as the peso was allowed to ``float'' against the dollar.

Hence, the next time you find an otherwise good stock trading at low levels, think for a moment whether it is because of some ``peso problem''!