Relationship between implied probability of political event and currency exchange rate: Evidence from Brexit

Abstract

This paper explores a single research question, namely: How does implied probability of political event, which is considered negative for economy, influence on the currency exchange rate? In order to study this question, I applied data from UK (Brexit) referendum on EU membership and analyzed the relationship between the implied probability of Leave vote and GBP/USD exchange rate. The main data in this study consisted of implied probability drawn from betting xchange and closing GBP/USD exchange rates including 86 observations from business days before actual referendum voting. First, I applied ordinary least square method (OSL) and vector autoregression (VAR) to find statistical relationships for the whole data set. As a result, I identified a negative and statistically significant relationship between the implied probability of Leave vote and GBP/USD exchange rate. Additionally, I used impulse response functions to analyze the influence of a shock on implied probability of Leave vote on GBP/USD exchange rate. I found out that shock in implied probability of Leave vote had negative influence on GBP on days one to nine ahead from the shock. However, this influence was statistically significant only on days one and two ahead from the shock. The accumulated response was statistically significantly negative six days ahead from the shock. I further divided data periodically into two 43 business day sets in order to study whether the influence is stronger in period closer to the polling day. I applied ordinary least square method (OSL) to these two data sets. The influence of implied probability on exchange rate was statistically significant in period closer to the polling date, while there was not statistically significant influence in the first data set. Results of this paper have implications for corporations and investors affected by changes in exchange rates.