Exchange Rates and Political Uncertainty: The Brexit Case

Abstract

This paper studies the impact of political risk on exchange rates. We focus on the Brexit Referendum as it provides a natural experiment where both exchange rate expectations and a time-varying political risk factor can be measured directly. We build a simple portfolio model which predicts that an increase in the Leave probability triggers a depreciation of the British Pound, both on account of exchange rate expectations and of political risk. We estimate the model for multilateral and bilateral British Pound exchange rates. The results confirm the model's main implications. When we extend the analysis to a portfolio model of multiple currencies, we find that the cross-currencies restrictions implied by the theory are not rejected by our system estimation. Moreover, the joint estimates of the multi-currency model in the presence of time-varying political risk premium are in many cases consistent with the Uncovered Interest Parity.

The long-run effects of geopolitical risk on foreign exchange markets: evidence from some ASEAN countries

“…Second, we provide estimates of long-run elasticities of exchange rates with respect to geopolitical risk proxied by the GPR index. This complements similar studies that used different proxies of political risks, such as Manasse et al (2020), Suleman (2017), Bouraoui and Hammami (2017) and Bahmanee-Oskooee et al (2019) who found that political risk was associated with domestic currency depreciation. Third, we provide in-depth assessments on the exchange rates of emerging economies in the ASEAN region which have not been thoroughly covered in the past.…”

“…These results are consistent with the findings in the broad literature on the political risk and exchange rate nexus in the sense that political risk tends to harm investors' confidence in the domestic economy resulting in weaker domestic currency value. The theoretical and empirical framework of Manasse et al (2020) The long-run effects of geopolitical risk the risk premium and leads to domestic currency weakening in the context of UK Suleman (2017) found a similar outcome in that higher political risk reduces exchange rate returns in a panel dataset of developed and developing countries. A comprehensive political risk index used by Bouraoui and Hammami (2017) was also shown to undermine the value of the domestic currency in the Arab Spring countries.…”

“…Second, we provide estimates of long-run elasticities of exchange rates in regard to the said index which can be useful in gauging the long-term implications of political events. This complements similar studies that used different proxies of political risks, such as Manasse et al (2020), Bouraoui and Hammami (2017) and Bahmanee-Oskooee et al (2019). Third, we assess the exchange rates of emerging economies in the ASEAN region which have not been thoroughly covered in the past.…”

“…This is a follow up to the earlier study by Krol (2014), who also found that policy uncertainty resulted in more volatile exchange rate fluctuations. Manasse et al (2020) develop an empirical form of the exchange model which is estimated using daily data from 27 May 2015 to 23 June 2017. Various exchange rates are considered with the British Pounds (GBP) as the numeraire.…”

“…These results are consistent with the findings in the broad literature on the political risk and exchange rate nexus. For instance, Manasse et al (2020) found that the increased risk of Brexit weakened the pounds sterling. Suleman (2017) found a similar outcome in that higher political risk reduces exchange rate returns.…”