The world’s forex market is considered the most significant financial market available, and it trades above $6 trillion daily. Unlike most trading, such as in stock or bond markets, the forex market is volatile regarding geopolitical matters.
Events such as elections, trade wars, conflicts, and changes in policies and regulations cause fluctuations in forex, thus affecting the values of different currencies, the stability of the markets, and even trading approaches. This article explains how geopolitical risks factor into informing traders and investors in forex trade.
Understanding Geopolitical Risks in Forex Trading
Geopolitical risks describe risks arising from political conditions, conflict, policy, diplomacy, or a change in power between nations. These risks cause many disturbances in the international economy, which impacts currency value and exchange rate. To make good decisions, traders must understand the current political climate and what may cause reactions in the forex market.
For instance, the surprising Brexit vote in 2016 led to a sharp fall in the British pound (GBP) due to the U.K.’s unknown future outside the European Union. This example shows how markets can respond to a geopolitical event in this manner, thus showing how political events can cause forex fluctuation.
Another good example is the trade war between China and the United States, which lasted several years and impacted not only these countries’ economies but also those of other nations. Trade wars affect the forex market because they change the balances of trade, affect investors’ sentiment, and even result in changes to the policies of the central banks in the respective countries.
Forex Volatility Triggered by Geopolitical Events
Political risks are associated with forex volatility, meaning wide variations in the price of the foreign exchange within a short period.
Fluctuations in the price are normal if new political events occur, such as acts of God and political crises, such as war or scandals.
That means forex fluctuations are a threat as they imply high risks and a chance that rapid exchange rate changes can lead to significant profits.
Currencies that are considered safe-haven assets, such as the U.S. dollar (USD), Swiss franc (CHF), and Japanese yen (JPY), tend to appreciate during periods of heightened geopolitical risk. Conversely, currencies from politically unstable or conflict-prone regions, such as emerging market currencies, may depreciate.
For instance, when tensions escalated between the United States and North Korea in 2017, the Japanese yen surged against the U.S. dollar as investors sought refuge in a more stable currency.
This demonstrates how geopolitical events drive market participants to adjust their positions quickly, creating volatile trading conditions.
The Role of Political Stability in Forex Markets
Stability in political activities is one of the primary requisites needed to foster the growth of forex markets. As for political appearance, nations with stable governments and good policies attract more foreign direct investment, hence having solid currencies.
However, political instabilities arising from coups, protests, or leadership changes deter investors from investing in the economy, resulting in currency devaluation.
A perfect example of the effect of political stability or the lack of it on the forex markets is the eurozone debt crisis, especially in some eurozone members, such as Greece, Spain, and Italy.
Speculation ranging from political instability to fiscal mismanagement caused investors to lose confidence in European currencies, particularly during the European debt crisis of the early 2010s, resulting in low EUR.
There is also the currency risk, where even in mature democracies, political instability results in such risk.
For instance, in the U.S. presidential election held in 2020, the markets experienced temporary volatility, mainly due to a potential controversy over the electoral outcome.
Investors focused more on the political factors because political changes usually affect the fiscal and monetary policies, trade relations, and, more importantly, market confidence in the U.S. dollar, which has remained comparatively stable.
Trade Wars and Their Impact on Forex Markets
Trade wars are also another geopolitical factor that has a direct interface with forex markets. A trade war is when two or more countries place high tariffs or other barriers on imported goods and services due to perceived injustices in international trade.
These disagreements distort the supply and demand chains of imports and exports, cause fluctuations in the price of commodities, and impact forex through differences in payment balances.
The U.S.–China trade war is a vivid example of the last few years. A lengthy battle ended with variations in global markets, such as the Chinese yuan (CNY) and the U.S. dollar (USD) rates.
When tariffs were implemented, and the negotiations stopped, the yuan devalued, and this was due to uncertainty concerning China’s economic growth and China’s prospect of trade with the U.S.
Trade wars usually lead to turbulence in the business environment, hence the audience in business transactions.
Under such circumstances, other forex traders who may wish to trade focus on safer currencies, such as the U.S. Dollar and Japanese Yen, but they stay away from the currencies that are highly risky due to the conflict.
Market Reactions to Currency Risk
Fluctuation risk, or exchange rate risk, is the possibility of experiencing currency trading loss because of the fluctuation of currency value compared to the other.
Currency risk also becomes amplified by geopolitical events since traders can quickly fail to determine how a specific government or even a central bank will react in response to changing events.
The market’s response to currency risk movements depends on the level of the geopolitical event and the currencies affected. It also posits that due to certain psychological factors, traders may decide to either sell or buy to cushion themselves from various shocks that may come along, thus causing drastic fluctuations in currency pairs.
This market reaction occurs not only from the realistic effect of the occurrence on the economy but also from perception and anticipation.
Another classic example of currency risk is the Russian Crimea’s invasion in 2014. The Russian ruble (RUB) was the worst performer as Western countries imposed sanctions, and investors pulled out from the Russian market.
In response, the Central Bank of Russia increased interest rates to support the ruble. Still, it only partially addressed the market concerns, highlighting that geopolitical risks become long-term issues for stabilizing the currency rates.
Hedging Against Geopolitical Risks in Forex Trading
Since the forex market is sensitive to geopolitics, it is customary for traders to put up hedges that effectively manage uncertainties. Hedging protects oneself from fluctuations in the foreign exchange market by having mirror operations in other markets or currencies.
For instance, traders may use gold, which is considered solid in political instabilities, as an assurance against currency devaluation. Some traders employ options and futures contracts to hedge currency risk to be somewhat prepared for any shock from the volatile geopolitical environment.
However, hedging, though it lowers risks, has agreed that such risks are not fully protected. Forex markets are still unpredictable, and even if a trader is very careful, he may be unaware of a geopolitical event.
Conclusion
Price volatility presents one of the most significant challenges to forex trading since geopolitical risks define the forex markets’ direction, and traders need updated information on political events worldwide. Be it trade wars or political stability, these occurrences can create massive volatility in the currency rates in the forex market.
Preparing for the unexpected is critical for traders, and strategies such as hedging can protect an unpredictable market. By staying informed and adaptable, traders can navigate the impact of geopolitical events on forex trading with greater confidence.
