Geopolitical events increase FX risk

A multitude of factors contribute to the constantly changing exchange rates. Of them, geopolitical risks are particularly powerful inducers that can cause notable shifts in the value of currencies. 

In this blog, we will explore the complex relationship between geopolitical events and foreign exchange markets, focusing on the ways in which trade disputes, political instability, and conflicts can affect exchange rates.

The introduction of uncertainty is the main mechanism by which geopolitical events impact currency swings. Market volatility then rises because of this uncertainty.

While managing geopolitical risks, one must not only respond to these developments, but also plan ahead, position oneself strategically, and take advantage of instability. 

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What are geopolitical events?

Geopolitical events are occurrences that impact the political and economic relationships between countries on a global scale. These events often influence international relations, trade, security, and economic stability.

Examples of geopolitical events include wars, conflicts, diplomatic negotiations, trade agreements and economic sanctions.

For instance, the Brexit referendum, where the United Kingdom decided to leave the European Union, is a geopolitical event that had significant implications for trade, migration, and political alliances.

Similarly, the ongoing tensions between the United States and China over trade policies and technological dominance represent geopolitical events with widespread ramifications.

These events can lead to shifts in alliances, changes in economic policies, and fluctuations in global markets. They are closely monitored by governments, businesses, and investors as they can create both opportunities and risks.

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How geopolitical events increase FX risk?

Geopolitical uncertainties influence currency volatility that frequently ripples through several currency pairs. Predicting these events’ effects on the currency market gets much more complicated because they can have simultaneous effects on several countries. 

The way traders respond to an incident that affects one currency might affect others as well. For instance, increased trepidation among traders in well-known currencies like the USD and EUR may persuade dealers to shift their holdings to safe-haven currencies like the Swiss franc or the Japanese yen. 

Central banks hold enormous power in creating currency pair volatility. Monetary policies can help stabilize or destabilize a currency. For instance, during the covid pandemic, the US Federal Reserve lowered borrowing costs for consumers and companies by setting the federal funds rate to 0%, which devalued the USD.

By adjusting interest rates, buying, and selling their own currency, issuing forward guidance, and implementing quantitative easing, central banks aim to impact monetary policy.

Military conflicts or political upheavals can disrupt economic stability, causing rapid fluctuations in currency values. Investors tend to seek safe-haven currencies, like the US dollar or Swiss franc, during such times, driving up their value and leading to sharp declines in riskier currencies.

Trade disputes, such as tariffs or sanctions, can hinder international trade flows, affecting the balance of payments and currency stability. For example, the US-China trade war led to significant volatility in the Chinese yuan and the US dollar, as tariffs and retaliatory measures created economic uncertainty.

Political instability or conflicts can trigger capital flight, where investors pull their assets out of a country to avoid potential losses. This outflow of capital can devalue a country’s currency, exacerbating FX risk.

During the Eurozone crisis, countries like Greece and Italy experienced severe currency devaluation as investors sought safer markets, leading to heightened FX risk for businesses and investors operating in those regions.

Geopolitical events often influence central bank policies, particularly interest rates, which directly affect currency values. For example, in response to economic sanctions or trade disputes, central banks may adjust interest rates to stabilize their economies.

Changes in interest rates can affect or deter foreign investment, influencing currency demand and causing fluctuations in exchange rates.

During geopolitical crises, investors flock to safe-haven currencies, leading to their appreciation. For instance, during the 2016 Brexit referendum, the British pound experienced significant depreciation due to political uncertainty, while the US dollar and Swiss franc gained value as investors sought stability.

This fight to safety increases FX risk for businesses with exposure to these currencies as sudden shifts can impact profits and financial planning.

The bottom line

Undoubtedly, assessing FX risk in the face of geopolitical events is crucial for businesses to maintain financial stability and protect profit margins.

Rapid currency fluctuations can lead to unexpected costs and revenue losses, making it essential for companies to closely monitor geopolitical developments. By understanding and anticipating the potential impacts of these events, businesses can implement effective risk management strategies.

Excel Currencies provides expert guidance and tools to help businesses reduce FX risk, ensuring they remain resilient amidst geopolitical uncertainties. Contact us today to know more.