The Impact of Elections on Foreign Exchange Markets

Elections can significantly impact foreign exchange (Forex) markets due to their influence on economic policy, political stability, and investor sentiment. Here are some ways elections shape Forex market dynamics:

The Impact of Elections on Foreign Exchange Markets

1. Introduction

Elections have become less predictable, and the immediate impetus for this study is the upcoming general elections in Greece. General or parliamentary elections in the European Union seem to end the process of economic and political uncertainty. Democratic processes, at first glance, seem to express broad societal views, but in recent years, international markets have become an equally important source of information. As a result, all securities that provide information can anticipate future changes in economic policies. Specifically, a country’s share of holdings in a foreign exchange futures or options market can be used to assess the economic policies that are most consistent with the forecast financial information of public opinion polls.

Concern arises because a portfolio adjustment is made as a result of buying the currency of a reserve currency-rich country during the four-week period preceding the resolution of the political risk. The approach is part of the broker’s research, but fundamental news is used much earlier than the election results. It measures the impact of election results on high-frequency US currency portfolios during several days, and the study is part of a growing literature that examines the role of various structural changes in the exchange rate. Commercial and speculative traders face large peer-to-peer transaction costs in the future, and the returns to dealers must be exploited from settlement to settlement. To take advantage of the opportunities caused by the revelation of information and to stabilize the international financial system, trillions of transactions are processed every minute in the interbank foreign exchange market.

1.1. Overview of Foreign Exchange Markets

Foreign exchange markets (FX markets) are the world’s largest financial markets. The latest estimates suggest that on average over 1.7 trillion US dollars of transactions occur in FX markets daily. They dwarf most equity markets, which trade at most a few billion US dollars daily, and have average transaction sizes that are an order of magnitude larger than equities traded. They are also by far the largest arena of speculative investment. FX markets also facilitate trade flows and foreign investment, which such flows are results of, and in large measure enable the internationalization of these operations.

Though in one sense large, FX markets are not a single continuous market. Rather, they consist of distinct markets that supply foreign exchange for a variety of purposes with varying risk exposures. Banks and other dealers supply these markets and are the central intermediaries of FX markets. One impetus to the creation of separate corporate markets occurred when it was ruled that the realized losses by US banks on their own foreign exchange holdings were non-deductible capital losses. This rule encouraged US banks to deal with the non-bank public in a corporate or consumer market, since the banks would bear less exchange rate risk in this market than in the bank-related markets.

1.2. Importance of Elections in Forex

Section 1: Introduction

Elections typically occur in most countries at least once every four years. Such a political cyclical event has the potential to generate significant swings in the exchange rate. The large swings of the Canadian dollar at the beginning of 1993, around the first round of the French elections in 1995, or those of the Russian rouble at the beginning of 1996, are not rare examples. The existence of such exchange rate swings requires an examination of how large elections really are in price formation on the foreign exchange markets.

Section 2: Importance of Elections in Forex

Elections are conventionally important political and economic game-theoretical events at both the national and international levels. In most cases, they are voluntary, strategic, and well-defined events. At the national level, usual decisions involve the choice of the government, the party, or the president, with specific potential economic implications. Such decisions affect both internal and external economic policies. Internal policies involve issues such as fiscal policies, monetary policies, and international economic policies. Typically, governments, particularly when close to an election, conduct countercyclical economic policies to ensure their re-election. Besides this, governments are typically willing to spend more than to tax because they can use the budget deficit to sustain their political survival. Sheer election cycle theories have been developed to provide a theoretical framework and empirical verification of how these discretionary and monetary policies are manipulated by successive governments.

2. Theoretical Framework

Given the closed nature of binary or multi-candidate political contests, we would expect investors and consumers affected by government economic policies to spend some effort to correctly anticipate the outcomes and compute future policy impacts of divergent policy alternatives associated with the various candidates. Hence, there should be a demonstrable effect of an impending election on the prices of financial assets and on foreign exchange markets. This is particularly true of foreign currency markets, given the permanent nature of changes in currency exchange rates and the fact that realized future policies are generally uncertain until election day, unlike the situation with interest rate decisions, which may generally be anticipated with some assurance by market participants.

There are several methods one might pursue to test the hypothesis that the information from election years is different from the signals associated with longer-term holdings or anticipated policy differences to be expected from the competing parties. The purchasing power parity literature suggests traders are interested in a long-term equilibrium rate that incorporates policy differences. Hence, if an immediate change in the direction of the dollar is associated with an election, and the equilibrium rate produced by the various purchasing power parity methodologies ends up predicting the exchange rate in the direction in which it moved immediately post-election, then we could conclude that a policy change was anticipated, but its political resolution before the expected time of occurrence contradicted expectations, resulting in a temporary deviation from PPP. If the change persisted into the future, then this would be a clear indication that there was a shock to expectations generated by the election regarding future government policy that was not anticipated prior to the election.

2.1. Efficient Market Hypothesis

In the foreign exchange and other financial markets, one of the leading theories is the “Efficient Market Hypothesis” (EMH). The strong efficiency hypothesis of the EMH argues that as all information is impounded into price, it should have no predictive power. That is, if only “news” contains information, as soon as that news is released, the gathered consensus of market participants should be revealed in the market price, and the authoritative announcement should be powerless to move the market. But while the strong version of EMH has to be considered unrealistic, the weak form holds that it is very unlikely that any technical trading method should be able to produce regular profits. The conventional tests of the EMH have consequently been statistical.

However, a number of studies have found that prices very often move irrationally in the short run; such that the weak form appears to hold in the long run, but are quick to add that this is not at all inconsistent with the hypothesis that news travels quickly enough such that there are no profits to be made from it. Indeed, this paper demonstrates that very often it is not firms who react to election news and adjust their prices, but rather speculators. At the same time, while the EMH does not require that the news should be “rational”, that is not at all to say that data can be ignored. This was the major criticism of the EMH offered by Fama, and subsequently there has been an ongoing debate.

2.2. Behavioral Finance Theories

This theory suggests that the effects of investor sentiment on election results and the underlying economic conditions that these responses reflect will in turn impact exchange rate movements. Sentiment influences investor expectations. It has generally been found to increase the influence of these political determinants. Sentiment is often influenced by institutions that structure ideas and symbol systems of meaning. When political events induce a higher level of these sentiments, they reinforce the influence of investor expectations on the foreign exchange market. The relationship between investor sentiment and foreign exchange movements is thus non-stable.

It is also stressed that though both political and economic conditions are likely to have an impact on exchange rate movements, they do not assume the existence of a ceteris paribus relationship between foreign exchange management and political events, which is usually observed in conventional relationship tests. Instead, it is noted that terms such as expectation, volatility, and information are absent from most research regarding this area. These observable influence values in the range suggest behavioral factors explaining the election effect. Political determinants (behavioral factors) are not guaranteed to have an immediate effect on exchange rates when a large group of swing voters are in situations where there are no changes in these political determinants.

3. Empirical Studies

In this section, we review the empirical literature on the impact of elections on exchange markets. Our review is based on two criteria that we believe are essential for conducting a comprehensive review: first, the type of exchange rate measure used, and second, the type of election event analyzed. By type of exchange rate measure, we distinguish between exchange rate level measures, such as spot, forward, and interest rate differentials, and exchange rate volatility measures. Additionally, by type of election event analyzed, we divide the studies into the pre-election and post-election period analyses and distinguish between national and sub-national level elections.

Election events take place at different points in time and differ in their importance to the domestic electorate as well as to international investors. National elections that entail a change of executive for a country are arguably the most important. Such events involve presidential and parliamentary elections in democratically ruled countries, as well as alternative institutions in non-democracies. Sub-national elections, which include local and regional elections, arise from decentralization, a process that involves the delegation of authority and resources from the central government to lower-level political authorities. Consequently, political commotion at the sub-national level can also affect a country’s credit risk.

3.1. Case Studies of Election Outcomes

Although each election is unique, there are some general patterns that provide insight into how election outcomes are likely to have affected exchange markets in a select few countries. We have already discussed both the Italian and French parliamentary elections in 1986, which had the usual market-moving outcome of defeat for the government. In both cases, the reaction of exchange markets was modest and short-lived, reflecting possibly the widely anticipated upset in each case as well as the fact that the subsequent changes in policy would almost certainly be in the same direction as those that had occurred under the previous administration. The return of the Conservative government in the British general election of 1987 was perceived by the markets as a confirmation that continuing Conservative policy in favor of lower inflation would be generally favorable. The response of exchange markets was buoyant, reflecting the perception that the enterprising rather than cozy policy would prevail. Since the Conservative government had been expected by opinion polls to gain an outright majority, the size of this majority surprised the market and further strengthened the existing majority. This increased responsiveness and efficiency in deciding economic policy was also perceived as a dollar-positive development.

3.2. Statistical Analysis of Election Periods

This section tests the weight of the election cycle effect in the foreign exchange returns. The null hypothesis that the dummy variable, incumbent, has a zero coefficient was tested for the total sample and the separate subsamples for the franc and the yen using the annual data for 1973-2000. The estimation allowed for the variation of the presidential elections in Austria, Belgium, Finland, Luxembourg, Norway, Portugal, Spain, and Sweden. The null hypothesis was tested for the low-frequency data for the pre-Euro period, i.e., for the total sample and the separate subsamples for the franc and the mark using data for 1987-1998. The change in the election term of Spain in 1982-86 was ignored because of the lack of consistent data on foreign exchange rates.

The examination also tried to assess the regularity in the midst of the election term, which is likely to persist in the parliamentary systems characterized by the high turnover in government readiness. They recoded preelection as 1 (0) for the first quarter of the election year. This binary proxy variable for the tenure of the government lists the fact that the elections in France are held in May while the German polls are scheduled for September. There were two realizations of the proximity index, i.e., 27 for the French six-year period and 35 for the German four-year period. Most of their values close to one were associated with the first type of elections. There was a significant negative reaction on the market represented by the current changes in the currency returns. The coefficient accompanying the dummy variable for the first quarter was negative and statistically significant.

4. Key Factors Influencing Forex During Elections

Trading on the forex and other financial markets is determined not only by objective economic and political factors but also by the expectations produced by them. These expectations can give rise to sharp fluctuations in exchange rate quotes in the absence or presence of strong fundamental reasons for this, that is, when data on the key indicators for a country is affected by a release season. The close approach of elections or political events triggering concerns over internal political threats within a country’s financial and economic system normally causes these fluctuations. Yet financial and economic structures are basically the highest indicator of a country’s independence as a power, and such concerns raise the natural question of the impact they have on a state’s currency, which serves as the world’s number one reserve asset.

These expectations almost ineluctably increase foreign investors’ uncertainty towards economic system parameters and national currency dynamics and can reduce the demand for a state’s securities, also resulting in a long-lasting increase in exchange rate quotes. On the internal forex market, this often leads to mass buying of foreign currency and a depreciation of the national currency. This situation is particularly critical for those states with a high foreign debt that effectively service it through conversion against their national currency. Besides, these processes involve substantial threats of reducing the financial sector’s willingness to extend loans to domestic industry, putting pressure on interest rates and bringing forward the realization of already tested monetary technology, making the rates less market-driven and more inertial. In turn, currency fluctuations also feed into inflation through a price rise in imported goods.

4.1. Political Stability and Instability

Researchers have attempted to refine the measure of political risk and to distinguish political instabilities from political changes. The reflection of the distinction in financial and exchange rate markets is of particular interest. They highlight the market consequences of political stability and instability. They note that the financial market responds differently to political events leading to political stability and political events leading to political instability. These distinctions extend to the forex market as well. The so-called political tension index (PTI) is the simplest and most intuitive way of distinguishing instability from maintaining the status quo, i.e., the risks associated with a change in policy versus the non-occurrence of a change in policy. They show that the increase in political tension represents an increase in future risk. These findings support the work of others who showed that the political tension index has a significant negative impact on portfolio and capital flows.

However, changes in political tension, i.e., an increase or decrease in the likelihood of a political event, also affect the value of the assets of the parties. When PTI increases, the value of rights and claims, to which those actors have effective political power, decreases. Already, the expectations of power and, consequently, the capital value of these assets should decline. It should be noted that assets cannot be sold on the market for a specific period. So effective trading on PTI is a strategy for investing in trend formation, setting no specific time limit for trading. Prior to the PTI increase, the accumulating investment establishes a market positioning. There is an increase in risk. On the other hand, the market response to the appearance of this event is quite contrary to the formation of a trend. Once the PTI is released, the political actors acquire liquidity rights. A larger governmental share of these contracts has a share in the formation of a governmental inception for the reduction of the liquidity premium. The market becomes more adaptive than reactive. On the day the PTI is released, it matches the sale of liquidity rights by accumulating ownership rights more precisely with those they have just sold in the market.

4.2. Economic Policies and Reforms

The Impact of Elections on Foreign Exchange Markets

Governments play a central role in the economic policies of a country. The way in which economic policy is implemented greatly influences the quantity and quality of economic indicators like the flow of foreign funds, growth rate, employment rate, current and budget account balances. The characteristics and qualifications of individuals in key governmental positions play a significant role in determining the economic policies and adequacy of a nation.

During election periods, market expectations about the country’s regime could change because of the differences that could potentially emerge between the results before and after the election. In contrast, two opposing parties can bring different sources of political power. A broader spectrum of decision-making processes, including problems like unemployment, income, and long-term policy resulting from exchange and interest rate fluctuations, can be seen during the election period. Therefore, the progress towards increasing the competitiveness of the business environment, which will be formed as a result of the election, will have a significant impact. This perception, which reflects the market’s expectations about the future, reflects short and long-term equilibriums in the exchange and interest markets.

5. Volatility and Risk Management Strategies

For hedging purposes, the principal concern is the development of appropriate risk management instruments. The two most important strategies for managing volatility on exchange markets are forward retranslation versus time diversification. A forward retranslation strategy consists of estimating the anticipated volatility of a foreign investment at a point in time and then protecting the portfolio with exchange transactions and forward exchange agreements covering the period ahead. A proper assessment of the investor’s characteristics and knowledge of the behavior and dominant factors on exchange markets would seem to be necessary, but the fact that the expected volatility is a uniformly consistent forecast might be a very strong argument in favor of retranslating the value of financial flows.

Diversification is the principal technique used by professional investors. By buying international assets over a period, an investment portfolio will have its average and expected returns diversified, and its performance and the risk-return tradeoff may be improved. If applied to all international assets, this strategy could lead to a strong real convergence of exchange spot rates, verify the forward rate—spot rate relationship, and thereby lead to the disappearance of a forward market. The main problem, however, is that the management of international portfolios is currently being given a very difficult time by the restraint achieved on domestic financial markets, by the curing of the valuation rule of insurance and the banking rules, and by the strong profitability of national capital markets.

5.1. Volatility in Forex Markets

The volume of trading on the foreign exchange markets and the availability of detailed price data make the foreign exchange market an ideal laboratory to analyze the presence of and the information content of various economic indicators. Given that the daily rhythm of the markets is well known and almost all important news is announced around the same time worldwide, it is also an ideal environment in which to study truly unexpected as opposed to expected news or news that is not perfectly forecast on a day-to-day basis. Most studies of the effect of economic announcements patiently distinguish expected from unexpected news, and they measure the reaction to news in a variety of ways, usually all consistent with an efficient marketplace. The effect of economic events on volatility, in general, and on the shape of the volatility term structure, in particular, are evident in many financial markets. However, since the flexibility of the forex markets adjusts worldwide, the effect is most visible in forex data. Small open economies display a definite election effect in their foreign exchange markets. Significant large positive returns before central elections are followed by positive returns, and insignificant before regional elections. Inefficient forex markets for very frequent but ultimately unanticipated data suggest an obvious trading strategy. When data are scheduled, the forex markets should fully incorporate the expected information. However, there should be an inefficiency and potential trading opportunity when the announced news is not released or is released contrary to survey projections.

5.2. Hedging Strategies

Corporations operating internationally often find themselves with little option other than employing foreign currency market hedge strategies to offset the risk of adverse exchange rate movements. This risk is potentially heightened during periods of major market volatility, such as that which often signals the run-up to national elections. One often-quoted strategy used by corporations is to lock in a future delivery date for an identified cash flow in a foreign currency. Alternatively, the short-run weight of a financial decision may be very high, and hence, the foreign exchange contract more accurately reflects a partial, tailored position in the financial market. Irrespective of the particular reason for proceeding, the corporate need to exchange the currency at a future date is matched by another party willing to accept a payment in that currency at the same future date. It is the forward premium and other considerations that will collectively determine the forward exchange rate negotiated.

These risk management strategies potentially involve injecting even more volatility into the foreign exchange markets as the activities of the corporations are superimposed onto each day’s natural foreign exchange market activity. These hedge strategies effectively enhance the ability of the operators to ‘weekend’ in other currencies. Hence, ‘hedge speculation’ is a phrase often used to describe the actions of the corporate bodies operating in this area. With few potential counterparties, the spot foreign exchange dealers may well be required to shoulder the brunt of these activities until the future cash-flow deadlines are achieved. When no counterparties are available to absorb the excess supply of a particular currency, market volatility is predictably the result, even if the corporate actions are taken with all the necessary efficiency and caution. Adding perhaps the emotional dimension of a national poll to the issue cocktail, the scene is set for a spike in short-term foreign exchange volatility.

6. Role of Central Banks and Government Interventions

The government of a country has some control over the authorities who are responsible for making announcements of market moves. There are times when a government experiences difficulty and its spokesmen wish to spread the prospective news when the market gives no comfort that an appropriate decision reflecting the problem is imminent. Except in the area of exchange rates, the central bank is supposed to be independent in influencing the underlying market forces. Thus, only in the exchange market will a government see a way of gaining direct intervention to influence events. We are more concerned with the direct exchange rate activities associated with government intervention. Such intervention can take a number of different forms or a mixture of forms. They come under three main categories: spot operations, forward or swap dealings, moral suasion, and foreign exchange and gold reserve operations.

The highly organized spot markets have a limited capacity to absorb sales or purchases of foreign exchange without affecting the exchange rate. Foreign exchange volumes are much greater during the day than at night. Central banks can make overnight operations that can temporarily influence market conditions. Such operations are generally limited in volume and price off the normal spot market rate. Forward and swap operations can take place to spread the influence over time. Central banks can also undertake market operations involving foreign exchange and gold reserves to influence exchange rates, particularly where these are up against taking big risks. Such operations are also done for emergency purposes in an endeavor to rescue a currency from a free fall.

6.1. Central Bank Policies

Following previous studies, the study assumed that monetary authorities adjust the level of intervention in the foreign exchange market according to the exchange rate arrangement. A freely floating regime, as a typical example, is characterized by the decision to leave almost everything on the market. In contrast, a managed float is characterized by an active exchange rate policy. In freely floating systems, therefore, the exchange rate is almost equal to a random walk, and central banks have no incentive to affect the degree of exchange rate variability. However, literature in the foreign exchange market has argued that central banks in managed floating regimes intervene with the objective of maintaining targets or limiting rate movements to avoid fluctuations.

A switch regression analysis was conducted to evaluate the changes in the official foreign exchange interventions of various countries over the observation period. The main conclusion was that, for a given shift in the exchange rate regime, an economy with stronger fundamentals used policy intervention to balance the volatility. However, in response to both the cyclical and non-cyclical phenomena, economies with more sound policies were found to have used intervention in the past, mainly for intervention sales. The main conclusion is that countries with stronger fundamentals are using less as a policy tool to support the exchange rate.

6.2. Government Interventions

One important issue, which has received much attention and on which a large literature exists, is the analysis of the nature of government intervention itself. We can adopt one of two positions on this question. According to the first, simplistic position, the government intervention equation is entirely passive and governments are, in practice, relatively powerless. They make mistakes in the sense that they can forecast poorly the actions of the foreign exchange markets and are informed of the possible high costs of even relatively large government interventions. Therefore, government interventions have minimal impact on exchange rates and will not really prevent a major correction of the basic problem.

The alternative position is that games are played between government and foreign exchange markets – the markets are the drivers in the road and governments are merely passive. Central banks must act in the crucial fundamental time dimension of the current economic shock and small movements can rapidly turn into large ones, particularly as foreign exchange markets are prone to respond to crowd psychology. A pure reduction to this question of the unrealistic character of government interventions within the short-run fluctuation in the foreign exchange rate is not whether the intervention decisions are passed or the basic tools are clumsy.

7. Technological Advancements in Forex Trading

The rapidly growing Forex market has integrated a number of advances in the area of telecommunications and information technology. It has seen the development of a fast retrieval and instantaneous data processing system with international backbone networks. There is a clear trend among users towards the use of laptops and cellular phones, and also towards the use of communication software to be able to access the systems from anywhere in the world. The use of real-time data for decision-making also spreads rapidly among users. Although there is significant noise in most real-time price data, in these price movements there is also important information that is useful to Forex traders who have learned how to differentiate between noise movements and those that carry significant information. The number of people accessing the Forex market at different times from different places in the world is constantly increasing. With access and technology, the user can view and access these Forex systems with a point and click of their mouse. Moreover, most Forex quote providers can, on request, also provide charts of most currency exchange rates. With additional software, traders can also trade concurrently over the phone. Even small currency exchange and Forex brokerage companies are beginning to use and develop Forex trading systems on their own, or purchase them from other companies and modify them for their own needs. There are also a number of companies worldwide that aim to provide information by establishing a global network. Small and large vendors have established operations, based anywhere in the world, in data provision, or with real-time charting and trading software. The number of people interested in this market is really interesting; international end-users and traders who utilize the Forex market consist of exporters and importers, multinational companies, foreign direct investors, speculators, foreign exchange brokers, etc. The international clearing system, like the real-time system, which can financially facilitate the system’s operation is really interesting.

7.1. Algorithmic Trading

The Forex market is no longer made of humans but of algorithms. In 1970, the New York Stock Exchange became fully electronic and showed that human broker floors and colorful ties are disposable when serious computer work beckoned. Today, high-frequency traders whose algorithms swap currencies in milliseconds account for 40% of the market. The less quantitatively savvy could blissfully ignore what an algorithm did on July 31, for example, if these did not amplify market ecstasies and crises.

Automated trading has put a large number of traders in the Forex market, and earlier studies concluded that this improves liquidity. The fact that exchanges now gang up to have automatic liquidity providers or to impose resting-time restrictions on orders only proves this point. This liquidity effect is, however, unsatisfactory for the following reasons. First, central banks reduce this liquidity effect with their actions by as much as 87.7% on average (14.2% for the Fed and 110% for other central banks). Second, the liquidity improvement does not relate to any signaling effect on information. When the market expects information, say a few days before meetings, our policy information proxy jumps up and is significantly positive. At this stage, policy meetings have no private information, so the market’s jump can only come from media or analyst releases. Of these, some are media while others have actionable consulting services, which means that on meeting-day morning, both spokes have released some messages to the market. The news stories are part of a leading standard and have autocoded tags.