Democratic Processes, Political Risk, and Foreign Exchange Markets

Abstract

3i6 Foreign exchange markets are among the deepest and widest financial markets in the world. Technological innovations and market liberal? ization have made currency markets enormous?by 1992, the vol? ume of transactions topped over $1 trillion each day. Moreover, economic agents can trade currencies with shocking speed?during the September 1992 E.M.S. crisis, British monetary authorities expended over two billion dollars to support the pegged value of the pound in only a few hours. The behavior of these currency markets can affect not only trade flows and in? ternational investment, key determinants of economic performance, but also political outcomes. Consequently, exchange rates have become a highly salient issue, both at the domestic and international levels. Indeed, some political economists assert that rapidly adjusting international markets may overwhelm the ability of policymakers to control policy, and, according to the most extreme view, thwart any meaningful democracy. Understanding how currency markets behave, therefore, is fundamental step to assess accu? rately how the internationalization of economic activity influences demo? cratic politics. We investigate how democratic political events affect currency markets by focusing on the relationship between the spot and forward exchange rate markets. The efficient markets hypothesis implies that the forward ex? change rate?the price of the currency deliverable thirty days in the fu? ture?should be an unbiased predictor of the future spot exchange rate. That is, today's thirty-day forward rate should, on average, accurately pre? dict the spot exchange rate one month from today. Empirical studies, how? ever, conclude that the forward rate is often a biased predictor of future ex? change rate changes. Many economic models attribute this bias to a risk premium, where currency traders demand a higher return for holding the currency.