Democratic processes, political risk, and foreign exchange markets

In contradiction of the efficient markets hypothesis, empirical studies conclude that the forward exchange rate - the price of the currency deliverable thirty days in the future - is a biased predictor of the future spot exchange rate. Many financial economists attribute this bias to the existence of a risk premium. We argue that democratic political events - elections, cabinet formations, and cabinet dissolutions - make it more difficult for economic agents to forecast exchange rate movements. Risk premia, therefore, should exist more often during these events than when the government's tenure in office is secure. Using data from eight industrial democracies between 1974 and 1995, we find that risk premia exist more often during political processess. Nevertheless, hypotheses based on incumbent partisanship, partisan change, electoral systems, and E.M.S. membership cannot account for variations in how these events affect currency markets.