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Peso Problems and Heterogeneous Trading: Evidence from Excess Returns in Foreign Exchange and Euromarkets

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  • Martin D. Evans
  • Karen K. Lewis

Abstract

Theoretical and empirical studies have treated excess returns as processes with time-varying but temporary disturbances. By contrast, empirical evidence indicates that the behavior of asset price levels can be well-approximated by processes with some permanent disturbances. These two observations restrict the relationship between the levels of asset prices and the excess returns they generate. In this paper, we begin by testing these restrictions for foreign exchange and bond returns. Surprisingly, we reject these restrictions for some returns, implying that excess returns contain some permanent shocks. We then evaluate the possible reasons for these results. This behavior appears inconsistent with conventional models of the risk premia. On the other hand, this behavior could arise from the presence of some traders in the market who have "regressive expectations" or from anticipated shifts in the distribution of asset prices inducing a "peso problem". We test and reject a simple model implied by a steady-state presence of traders with regressive expectations. However, we cannot distinguish between a model where the effects of these traders vary over time or where a peso problem exists or both.
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Suggested Citation

  • Martin D. Evans & Karen K. Lewis, 1992. "Peso Problems and Heterogeneous Trading: Evidence from Excess Returns in Foreign Exchange and Euromarkets," Working Papers 92-13, New York University, Leonard N. Stern School of Business, Department of Economics.
    • Handle: RePEc:ste:nystbu:92-13
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    Cited by:

    1. Martin D. Evans & Karen K. Lewis, 1992. "Trends in Expected Returns in Currency and Bond Markets," Working Papers 92-20, New York University, Leonard N. Stern School of Business, Department of Economics.
    2. Jeffrey A. Frankel & Andrew K. Rose, 1994. "A Survey of Empirical Research on Nominal Exchange Rates," NBER Working Papers 4865, National Bureau of Economic Research, Inc.
    3. Alex Maynard, 2003. "Testing for Forward-Rate Unbiasedness: On Regression in Levels and in Returns," The Review of Economics and Statistics, MIT Press, vol. 85(2), pages 313-327, May.
    4. Nikolaou, Agelike & Velentzas, Kostas, 2001. "Estimating the Demand for Cigarettes in Greece: An Error Correction Model," Agricultural Economics Review, Greek Association of Agricultural Economists, vol. 2(01), pages 1-8, January.

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