A “peso problem” and the EUR – another description of carry

The presence of structural/political uncertainty leads to a “peso problem” with the euro. The “peso problem” describes the impact of a low probability yet high impact negative event on asset prices that does not occur in-sample, as some would put, a “Black Swan”.[1] A “peso problem” explanation has been most recently used to describe the returns for carry. The relatively high returns are compensation for the chance of a large negative skew event. These events can be classified as potential regime changes.[2] The expectation of a regime change in the euro may also apply to GBP which has fallen significantly since the surge in Greek risks and the BOE inflation report. A peso problem increases the chance of overshoots or deviations from prior models of exchange rates.

The Greek fiscal crisis may force a regime change to enhance the stability of the EMU. Any potential solutions for how the EU will operate going forward changes the regional risk profile. The profligate spending of some will more heavily weigh on the value of the total. Regime learning concerning the EU will add a risk premium to the euro as well as other currencies which may have a chance of large negative fiscal events.

Sovereign CDS spreads are giving clear signals of change in risk when sorted by relative debt to GDP levels across countries. The prior link between interest rates and the euro has been broken and a new relationship which may not be as highly correlated will determine capital flows.[3]

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[1] The “peso problem” was first modeled by Bill Krasker to explain deviations from interest rate parity. It was also alluded to by Milton Friedman and has now been used to discuss the chance of any large negative skew events across many asset classes.

[2] Deviations from market/model efficiency have also been modeled as a bubble or as a learning process whereby the market figures out what is going on over time. The result will be the same as the peso problem solution however the stories are different.

[3] It has generally been the case that the EUR will react to changes in LIBOR spreads with a fairly tight relationship. The risk is that the EUR may not be dominated by German behavior but by a looser weighted average of EU country rates. Note that there is no true EU bond market since the EU does not have borrowing authority.