Exchange rates and political uncertainty: the Brexit case

Abstract

AbstractThis 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 portfolio model that relates changes in the Leave probability to changes of the British pound's market price, both via expectations and via a political risk factor. We estimate the model for multilateral and bilateral British pound exchange rates. We find that the Leave probability predicts a depreciation of the pound, consistent with the outcome post‐referendum, and that the time‐varying political risk affects exchange rates independently.