The “Peso problem” in hedge fund land

One of the long-lasting explanations for the risk premium in some forward exchange rate markets is called the "Peso Problem" answer. With this argument, there is a premium with holding an asset with a low probability of a large negative event. This event could have occurred in the distant past or it may not have occurred at all and is a perception by the market. In the case of the currency markets, it is a large devaluation.

A peso problem is now affecting credit markets and the hedge funds with credit exposure. Investors want to be compensated for the chance of a large negative event in these markets and would like a premium even if the data may not suggest the risk exists. This problem can also be placed in terms of the language of Nassim Taleb, investors want compensation for "Black Swan" risk. Investors believe such an animal exists even without observing it.

What type of credit time bomb could exist that has "peso" or "black swan" characteristics? We already know that defaults of sub-prime loans will go up. No doubt managers are reviewing portfolios to understand their holdings. The issue could be a large failure or it could be a something which could be more far-reaching. While doubtful, one scenario could be a downgrade of structured products by rating agencies. Ratings for CBO/CDO are based on the structure of the deal and stress-testing. There is not the expectation for a credit event such as a systematic change in the characteristics of the collateral.

The whole idea of a black swan problem is that surprises do occur and by their very nature they are unanticipated. While we do not readily foresee one of these events, the nature of the peso problem is that it is expected and discounted in the price of securities.