Political Risk and Foreign Exchange Rates: an Efficient-Market Approach
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JOURNALOF INTERNATIONALBUSINESSSTUDIES, FALL 1985
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of market efficiency holds that the exchange rates fully reflect all publicly available information; (3) the strong form asserts that all information (both public and private) is reflected in exchange rates. As noted by Jacque [1981 ], most of the tests of the efficiency of the foreign exchange market have been of the weak form. In this paper, a test of the semi-strong version is performed. It is well known that a great deal of publicly announced information is prone to affect exchange rates. Here, a subset of the whole set of publicly availableinformation will be considered, namely the occurrence of events which alterthe business environment. Three main questions will be asked: (1) (2) (3)
Does political risknewshavean informationcontent? Does the foreignexchangemarketadjustto the arrivalof this information quickly? Do foreignexchangeinvestorsearnabnormalreturns?
The answers to these questions are of interest in the light of Frenkel's [19811 seminal work on the recent experience of flexible exchange rates. Frenkel [ 1981] found that duringthe 1970s unanticipatedevents, "news", have been a major determinant of exchange rate movements.2 The author used the unexpected change in the interest rate differential as a measure of news since the time series in this variableis likely to reflect the relevant news rapidly. In this paper we identify a type of event (political risk) and we determine whether unanticipated occurrencesof this event cause foreign exchange rates to change. Moreover, our investigation of the speed of adjustment of exchange rates to political risk news should provide evidence on Frenkel's [1981 ] contention that the foreign exchange market appears to operate efficiently with respect to news. Political risk, a topic of growing interest in the academic community and the financial press, is an elusive concept which is not well amenable to empirical measurement (see, for example, Brewer [1983a]). However, following Robock [1971 ], we may consider the following operational definition: "political risk in international businessexists (1) when discontinuities occur in the environment, (2) when they are difficult to anticipate and (3) when they result from political change. To constitute a 'risk'these changes in the business environment must have the potential for significantly affecting the profit or other goals of a particular enterprise." Essential to this definition are, therefore, the concepts of discontinuity and of direct effects on the firm. Moreover, events that are either expected or easy to anticipate do not constitute political risk. As emphasizedby Aliber [ 1973 ], investors in foreign capital markets may also regard their investment as exposed to political riskwhen exchange barriersmay change unexpectedly. Therefore, in this research we shall consider unanticipated events which af
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