Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior

26 Pages Posted: 25 Jun 2004 Last revised: 4 Apr 2015

See all articles by Maurice Obstfeld

Maurice Obstfeld

University of California, Berkeley - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: April 1987

Abstract

One of the most puzzling aspects of the post-1973 floating exchange rate system has been the apparently inefficient predictive performance of forward exchange rates. This paper explores some aspects of each of three leading explanations of forward-rate behavior. The paper first develops a simple rational-expectations model of the "peso problem" that generates some key empirical regularities of the foreign exchange market: seemingly predictable and conditionally heteroskedastic forward forecast errors, along with possible directional misprediction by the forward premium. The implications of bubbles for tests of forward-rate predictive efficiency are discussed next. It is argued that the existence of bubbles is extremely difficult (if not impossible) to establish empirically. Even though some types of bubble would distort standard tests on the relation between spot and forward exchange rates, it seems unlikely that there bubbles have been an important factor. Finally, the paper examines foreign-exchange asset pricing under risk aversion and suggests that a convincing account of forward-rate behavior should also help explain the results found in testing other asset-pricing theories, such as the expectations theory of the interest-rate term structure.

Suggested Citation

Obstfeld, Maurice, Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior (April 1987). NBER Working Paper No. w2203. Available at SSRN: https://ssrn.com/abstract=307113

Maurice Obstfeld (Contact Author)

University of California, Berkeley - Department of Economics ( email )

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States
510-643-9646 (Phone)
510-642-6615 (Fax)

HOME PAGE: http://emlab.berkeley.edu/users/obstfeld/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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