"Political Processes and Foreign Exchange Markets"

Bernhard, William and David Leblang

bernhard@uiuc.edu
dleblang@unt.edu

Abstract:


The efficient markets hypothesis implies that the forward 
exchange rate--the price of the currency deliverable 30 
days in the future--should be an unbiased predictor of the 
future spot exchange rate. Empirical studies, however, 
conclude that the forward rate is biased. We argue that 
democratic political processes affect the forward rate 
bias. In particular, elections, cabinet negotiations, and 
cabinet dissolutions may generate uncertainty about the 
future composition of the government and its commitment to 
the exchange rate. Since economic agents will be less able 
to predict future exchange rate movements during periods of 
political uncertainty, the forward bias will increase 
during these periods. We test the effect of political 
events on the forward bias using data from eight industrial 
democracies between 1974 and 1995. Using both ordinary 
least squares and seemingly unrelated regression, we find 
that political uncertainty helps explain forward rate bias.