Peso Problems: Their Theoretical and Empirical Implications

This paper examines how the theoretical and empirical implications of asset pricing models are affected by the presence of a "peso problem"; a situation where the potential for discrete shifts in the distribution of future shocks to the economy affects the rational expectations held by market participants. The paper examines the ways in which "peso problems" can induce behaviour in asset prices that apparently contradicts conventional rational expectations assumptions. This analysis covers the relationship between realized and expected returns, asset prices and fundamentals, and the determination of risk premia.