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I.

The two paradoxes

In an article in The Journal of Economic Perspectives, Nalebuff (1989) discussed the

The Envelope Paradox, the Siegel Paradox, and the Impossibility of Random Walks in Equity and Financial Markets

Envelope Paradox. There are two envelopes, say a green one and a red one, which contain x and 2x dollars; however, you do not know which amount is in which envelope and you do not know x. You are provided at random with one of the envelopes, say you got the green one, you open it and find y. You conclude that the red envelope contains y 2 or 2y, both with a probability of 1 . So, on the average, 2 5 y and, being risk neutral, you should agree 4

you expect the red envelope to contain

Friedel Bolle

February 2003

to exchange the envelopes. The problem is that you could argue the same way after receiving the red envelope: This is called the Envelope Paradox.

Now assume that you have an amount of y dollars which you can change into euros

Abstract

It is shown that the Siegel Paradox is very close to the Envelope Paradox. While the latter is understood, i.e. reduced to the unveiling of hidden assumptions ( Nalebuff, 1989), there is an ongoing discussion about the significance of the further (fro Siegel, 1972, to Kemp and Sinn, 2000, in this journal), in particular about its significance for currency speculation. The comparison of the paradoxes help to unveil the hidden assumptions in the Siegel Paradox.

today at an exchange rate of 1 and change it back tomorrow at an exchange rate of a = 1 or 2, both with a probability of 1 . Being risk neutral you should do it because 2 2 you can expect to have 5 y afterwards. The owner of a sum of y euros could argue 4 1 the same way: That is the essence of the Siegel Paradox (Siegel, 1972) . Where is

the connection? It is simply that you know that your envelope contains y dollars and you know that the other envelope contains y euros, but you do not know the worth of the euros. Or the other way round.

JEL classification: C 73, G 10

One might argue that there is no real paradox because, from one point of view, one increases one’s wealth in terms of dollars and from the other point of view in terms of euros and thus there might be no paradox involved in this (Boyer, 1977). But this argument is misleading if there are other sources of exchange rate variability than inflation. Assume that you own a portfolio of y dollars and y euros. You consider as

Europa Universität Viadrina Lehrstuhl für Volkswirtschaftslehre insbesondere Wirtschaftstheorie (Mikroökonomie) Große Scharnstraße 59 15230 Frankfurt (Oder) Tel. 0335/5534-2289, Fax 0335/5534-2390 e-mail: bolle@euv-frankfurt-o.de

the first option to exchange, today, your dollars into euros and change them back tomorrow. Thus you expect to have tomorrow a new portfolio of ( 5 y dollars, y 4

**euros). If you choose your second option, namely to exchange your euros today and
**

1

Though with a more general distribution of exchange rates

where n is large enough. Nalebuff (1989) shows that the Envelope Paradox. 4 The expectation value of our new portfolio is (b 1 y euros. III. in every period we exchange all the dollars we have to euros and all the euros we have to dollars. We simply would carry out the transaction only every nth period. if 4 4 consistent extension of the currency game is a world where exchange rates follow a random walk. On the other 4 4 euros tomorrow.. So. i. For a general distribution of exchange rates you find Ea > 1/E (1/a). b1 y dollars) with 4 dollars euros should be 5 . But this is no different a story than we have told without a futures market.e. but if one tries to explain (away) the paradox as outlined by Nalebuff (1989) one is faced with a difficulty. in every period multiplied by a factor of a or 1 with probability a 1 .) Let us now simply combine the two 2 alternative strategies. Note that. So. II. requires infinitely many. 1 euro is expected to be worth 5 tomorrow. starting from a portfolio (y euros. then an owner of 2 would not change his envelope.3 5 y euros). these are dollars and euros compensated for inflation. 1 dollar is expected to be worth 5 euros should be 4 2 exploit exchange rates or equity prices which follow a simple geometric random walk. 1− 1 2a a As xi > i for sufficiently large i. 3 2 4 If there were transaction costs.. change them back tomorrow you expect the portfolio (y dollars.$2 possible and an exchange of envelopes requires both owners n n-1 agreement. as long as there is such a stochastic process. as stated above. amounts of money.e. i. etc. etc. Equivalence of the paradoxes? We have seen above that the Siegel Paradox provides us with a simple strategy to The Siegel Paradox is often stated as the impossibility to find a sensible futures market price. They buy or sell tomorrow in order to sell or buy the day after tomorrow. both times you increased your expected wealth which is a real paradox. y dollars). $2. There must be other players in the game who . In the example above. it is clear that the most simple n 1 1 = ∑ x i 1 − 2a 2a i =0 i n i with a > 1. rates which are. x = 2 > 1. equally probable (which is impossible). so the dollar price of 5 . (Below we will generalise the random walk. (2) 1 bn = ∑ a i ⋅ a i =0 n i n −i b1 = 1 1 1 a + ⋅ > 1 for a > 1. . The paradox falls apart if there is an upper limit3 of the money in the envelopes and it either vanishes or is connected with an infinite expectation value if one supposes a distribution of an (unlimited) money supply in the envelopes. (1) Therefore. 2 2 a After n periods. An owner of $ 2 would not change n-1 because he would meet an agreeing partner only if he owns less than $ 2 . n If there are only sums of $1. the expectation value is ( bn ⋅ y euros. thus the dollar price of tomorrow’s hand. no transaction costs can prevent a profit. bn ⋅ y dollars) . with n−i 1 1 2 2 n i n −i i n i n a 1 = ∑ i = 0 2 2a n −i Can we conclude that similar assumptions are also hidden in the Siegel Paradox? One way is to ask where the expected wealth increases should come from. .this is the most simple and consistent way to argue – are motivated by the same rationale as I am. Speculation when exchange rates or equity prices follow a random walk. we would carry out only the aggregate transactions. is the Siegel Paradox equivalent to the Envelope Paradox? The above description seems to imply such an equivalence. What ever exchange rate the futures market chooses you can profit from it.

would leave the paradox untouched but also would provide us x with unlimited discounted wealth. There. There have to be entrants who provide the market with the additional volume necessary for See. A discount rate δ < 1 n n x would make the Siegel 6 Paradox disappear because the above strategy is no longer profitable. This discount rate is not the market rate of interest for risk free assets (which we assume to be 0) but has to be regarded in addition to this rate. in economics. A discount (5) 1 1 Ea > (Ea) . ¡ If you substitute dollars by equity shares and interpret a as the price of equities. then we could start the same backward induction argument with which Nalebuff (1989) provides us in the case of the Envelope Paradox. (Even a weaker assumption could be used. E 1 >1 a problem because. 6 5 . If we assume the random walk breaks down at time T.) It follows 1 E log = 0 . In the case of a limited volume of equities the contradiction to (3) n 1 1 bn > ∑ i 1 − 2a 2a i =0 i n −i n i owning bn y equities in period n is apparent. a (4) Taking the viewpoint of the infinite time horizon or the potentially infinite money and from Jensen’s inequality supply in the envelopes both problems lead to infinite expectation values. So equity prices cannot follow a rando walk! And what about currencies? 1 = n ⋅ 1 − 2a for sufficiently large n. no transactions are carried out except at a rate of a*. from the very beginning all money must be in the game. So the asset has to Second. Let us only assume that the exchange rate a is drawn from a distribution with E(log a) = 0. you see that the same strategy is profitable not only in currency markets but in all markets with regular trade . in the case of the one-period envelope (5) Ea > 1. First. however. E > E . So. however. as mentioned already above. we are used to getting infinite sums over an infinite time horizon – if we do not discount. . for example. in every period the market has to grow. while in the envelope problem we have no choice of the sums in the envelopes. Thus. in the currency game. Let us now drop the assumption of a bivariate distribution. The rejection of such an idea is easier. measuring a personal time preference. Brüggelambert and Crüger (2002). Where does the increase in speculators’ wealth come from? It must come from new market participants. all evaluation takes place in euros: the Siegel Paradox disappears. in the currency game we can choose y and (if risk neutral) we would prefer to choose it as large as possible. E ) which both increase infinitely for n a Is this really possible? n not identical to those in the envelope case.over an infinite number of periods! In option markets or election markets5 where the asset completely loses its value after a certain date. an infinite time horizon is a prerequisite for the Siegel Paradox. The arguments to reject such cases are similar but 1 The value of the assets is (Ean. say that from T on the exchange rate is fixed to a*.5 6 have an intrinsic value. The decision t disregard the rate of interest is sensible if we assume that dollars and euros are held as risk free assets between the points of time when the exchange takes place. the profitability to exchange envelopes in both directions vanishes. a a n n rate δ > 1 . who perhaps enter the market because of the same rationale and with a similar strategy as we once did.

E. Though the geometric mean of exchange rates remains 1. No. 2000.7 successful speculation. One should better conclude that the development of exchange rates and equity prices cannot consistently be described by commonly known random walks. 2000: “A Simple Model Of Privately Profitable But Socially Useless Speculation”. J. in a market with rational participants. Though some of his arguments are similar to those presented here. The Siegel Paradox Economics. Therfore . Article 3. Barry. 1989: “Expected Utility and the Siegel Paradox”. 257-268. Topics in Theoretical Economics. Conclusion Journal of Economics 86. only risk is traded among the consumers in one country. 1989). Quarterly IV. 51. 2002. The Japanese Economic Review. they explain away the paradox: in equilibrium. 50. In my eyes. A. 84-94. Perhaps. No. 303-309. as some authors do. Nalebuff’s Envelope Puzzle. 3. Intermountain Economic Review 8. G.. From the viewpoint of expectation values.. Issue 1. Volume 2. Vol. A.3.. We should not conclude. Siegel. Vol. Nalebuff. Kemp and Sinn. 4) that “(n)ot all Siegel profits are illusory Nalebuff profits”. Journal of Economic Perspectives. M.. I conclude that. Journal of We have seen that the Envelope Paradox is very close to the Siegel Paradox but not completely identical with it. S.. the less risk averse agents profit – but that is no paradox. Vol. The Envelope Paradox disappears if you exclude the possibility that the amounts in the envelope are randomly drawn from a distribution with an infinite expectation value (see Nalebuff. But where should this money come from? All this looks like a pyramid game or like a bubble which necessarily has to burst sooner or later. References Boyer. Edlin. if some market participants hold assets the relative value of which is not touched by inflationary processes(?). 8 disappears if you exclude the possibility that an infinite amount of new money is brought to the market. Sinn. Contrary to the above models. 1977: “The Relation Between the Forward Exchange Rate and the Expected Future Spot Rate”. and Crüger. my arguments are similar to Nalebuff (1989). and the Siegel Paradox in Foreign Exchange”. the algebraic mean tends to infinity – which corresponds to Nalebuff’s (1989) finding that the mean of the money distribution in the envelopes has to be infinite. equilibrium model. 14-21. . No. What does this mean for the currency market? Real profits are possible if exchange rates are determined by random inflation in the two countries involved. He underpins his statement with a small two-period General Equilibrium model where “ Siegel-players” earn profits form “fickle players” who experience a kind of inflation of tastes. and Sinn. that the Siegel Paradox is a real phenomenon which opens small but real opportunities of Edlin (2002) is the only one to compare the Siegel Paradox with the Envelope Paradox as presented by Nalebuff (1989). 1. R. speculation (Sinn. Hans-Werner. Brüggelambert. 171-181. 1989: “Puzzles. 1989.-W. 1972: “Risk. and some of the literature cited there) nor that the usage of logarithmic expectation values is “the solution”. 1. 2002: “Election Markets: Experiences from a Kemp and Sinn (2000) investigate the Siegel Paradox with another kind of Complex Market Experiment” in Bolle and Lehmann-Waffenschmidt (Editors) “Surveys in Experimental Economics”. 2002: “Forward Discount Bias. stressing the contradiction involved in a random walk of exchange rates over an infinite horizon. Kemp. Edlin. he concludes (p. H. This group has to be large enough in order to let Siegel players profit. (It is questionable whether such considerable risk aversion exists). the comparison with the Envelope Paradox has shed some light on the nature of the Siegel Paradox. The Other Person’s Envelope is Always Greener”. S.. a random walk of the exchange rates (corrected for inflation) or of equity prices cannot be expected. 167-191. Interest Rates and the Forward Exchange”. C.

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