PESO-PHENOMENA IN STOCK RETURNS AND EXCHANGE RATE DEVALUATIONS

Most tests of asset pricing theories assume a strict correspondence between ex post observed stock market returns and the market's ex ante expectations. In this project we show that there are cases where this common assumption may be severely misleading. We focus on a case where the systematic deviation between observed stock market returns and those that were ex ante expected by the market is produced by a prolonged external disequilibrium that may arise for countries with a pegged exchange rate. If the central bank refuses to adjust this peg in response to an initial shock in the export demand stock market returns in that country will remain below the unconditional expected market return, that is there is a "peso problem" in observed stock market returns. As an illuminating example we use the dramatic experiences of the Finnish economy in the 1989-1994 period. We show that the pre-devaluation peso problem is able to account for the seemingly anomalous pattern of systematically dropping stock prices that preceded the decision to let the Finnish markka float in September 1992.