TAILIEUCHUNG - Understanding Asset Values: Stock Prices, Exchange Rates, And the “Peso Problem”

The work reported here was conducted in the Penn Exchange Simulator (PXS), a novel stock-trading simulator that takes advantage of electronic crossing networks to realistically mix agent bids with bids from the real stock market [1]. In preparation for an open live competition, we developed three parameterizable trading agents and defined several instantiations of each strategy. We optimized each agent independently, and then conducted detailed controlled experiments to select the strongest of the three for entry in the live competition. It is important to realize from the outset that this research is primarily an agent study pertaining to the interactions of particular agents in a fixed economy. Although PXS. | Understanding Asset Values Stock Prices Exchange Rates And the Peso Problem Sometimes the present depends on the future people carry umbrellas when there is a forecast for stormy weather football teams in the lead play zone defense late in the game since they expect their opponents to pass advancepurchase airfares are higher for holiday-travel times when passenger traffic is expected to be heavy. In each of these cases and many others Keith Sill is a senior economist in the Research Department of the Philadelphia Fed. Keith Sill 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. No one knows the precise origin of the term 3 BUSINESS REVIEW SEPTEMBER OCTOBER 2000 peso problem but it is often attributed to Nobel laureate Milton Friedman in comments he made about the Mexican peso market of the early 1970s. At that time the exchange rate between the . dollar and Mexican peso was fixed as it had been since 1954. At the same time the interest rate on Mexican bank deposits exceeded the interest rate on comparable . bank deposits. This situation might seem like a flaw in the financial markets since investors could borrow at the low interest rate in the United States convert dollars into pesos deposit the money in Mexico and earn a higher interest rate then convert the proceeds back into dollars at the same exchange rate and pay off their borrowings making a tidy profit. Friedman noted that the interest rate differential between Mexico and the United States must have reflected financial market concerns that the peso would be devalued. Otherwise the

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