Exchange Rate Devaluations and Peso Phenomena in Stock Returns

This paper analyzes how a prolonged external disequilibrium, that may arise if the exchange rate is pegged, will affect the stock market. It is shown that if the central bank refuses to adjust the peg in response to the disequilibrium, stock returns are expected to remain below their equilibrium level. If the central bank finally fails in its defense of the peg and there is a devaluation, this pre-devaluation peso phenomenon will be replaced by a post-devaluation peso phenomenon. Our empirical case rests on the dramatic experiences of the Finnish economy in the 1989-1994 period. We show that the pre-devaluation peso phenomenon is able to account for the seemingly anomalous pattern of systematically dropping stock prices prior to the decision to let the Finnish markka float in September 1992. We conclude that these kinds of patterns are likely to be present in time series of market returns especially for many so called emerging stock markets