Why do some currencies behave unpredictably, defying the logic of interest rate differentials?
Welcome to the world of risk differentials, the unsung hero (or villain) in the currency valuation story!
Risk differentials significantly influence currency values by affecting the behavior of investors and traders in the FX market.
What are Risk Differentials?
Currency values are driven not only by interest rate differentials but also by risk differentials.
Think of risk differentials as the “danger premium” between countries.
Risk differential is the difference in perceived risk between countries.
While an interest rate differential gives carry traders an incentive (higher yield) to buy one currency over another, a risk differential reflects how much extra return investors demand to compensate for one country’s higher political, economic, and other risks.
Interest rate differentials refer to the difference in interest rates between two currencies in a pair. This differential plays a key role in determining currency strength, as higher interest rates tend to attract foreign investment, increasing demand for that currency. Conversely, lower interest rates may lead to capital outflows, weakening the currency.
The Risk Premium Effect
Picture this scenario: Two countries have identical interest rates, but Country A just had its third government collapse this year, while Country B is stable as a mountain.
Country A’s currency will likely trade at a discount. Investors need extra compensation for the political roller coaster they’re boarding!
High interest rates are usually attractive to investors because they offer better returns. But if political risks are too big, they might scare investors away, making those high interest rates less appealing,
Even though the high interest rates are supposed to make the currency attractive, the uncertainty caused by political risks undermines investor confidence.
This is why we often see currencies behaving in ways that make interest rate-focused currency traders scratch their heads in confusion.
In essence, if two countries have similar interest rates but one is viewed as riskier, its currency may trade at a discount (or require higher yields).
Shocks to investors’ risk perceptions (“FX risk premium” shocks) can reinforce or offset the effects of interest rates on exchange rates, depending on whether a given shock makes one currency’s assets seem safer or riskier relative to another’s.
This helps explain why exchange rates often deviate from what interest rate differential alone would predict…investors demand a risk premium for holding assets in currencies seen as less stable or more prone to adverse events.
Risk premiums are the additional compensation that investors demand for holding assets or currencies with higher perceived risk. A higher risk premium in one currency compared to another can make the latter more attractive, leading to its appreciation. For example, if investors perceive a foreign currency to be riskier due to political instability or economic uncertainty, they may require a higher risk premium, potentially leading to a decline in its exchange rate.
Four Flavors of Risk That Drive Currency Values
Let’s explore the several dimensions of risk differentials: political, sovereign credit, macroeconomic, and regulatory, and how these have influenced major currency pairs in recent history.
1. Political Risk
Political instability or uncertainty significantly influences exchange rates as investors adjust for the risk of unfavorable outcomes.
A country with greater political risk (elections with uncertain outcomes, geopolitical tensions, social unrest, policy paralysis) will often see its currency weaken compared to countries with stable governance.
The Brexit saga clearly demonstrated this effect with the British pound. As markets began pricing a higher probability of a “Leave” vote before the 2016 referendum, the pound steadily declined.
When the Leave outcome materialized, GBP plunged about 7% overnight against major currencies, despite no immediate change in interest rates.
This reflected a sudden increase in perceived UK risk. Markets believed Brexit would harm the British economy, so they demanded a higher risk premium (via a cheaper pound) to hold UK assets.
As the likelihood of a risky political outcome rises, investors shy away from the affected currency.
In the Brexit case, as the probability of a Leave victory approached 50%, having exposure to the pound became riskier, and investors reallocated their portfolios away from the currency. Essentially, mounting political uncertainty translated into a political risk premium on GBP.
When political uncertainty clears, a currency can rebound if the “risk discount” lessens.
For example, years after the referendum, when a decisive pro-Brexit election victory in 2019 finally resolved doubts about whether Brexit would happen, the pound briefly jumped about 2%. Markets interpreted the resolved uncertainty as reducing the risk premium on GBP.
More generally, currencies often weaken ahead of contentious elections or referendums and recover if a market-friendly or at least decisive outcome reduces uncertainty.
Political risk differentials also explain why currencies like the Japanese yen and Swiss franc (from countries with stable governments and low geopolitical risk) tend to strengthen during global political crises.
2. Sovereign Credit Risk
Sovereign credit risk is the perceived risk of a country defaulting on its debt or falling into a fiscal crisis.
Currencies are extremely sensitive to a country’s fiscal credibility and debt sustainability. If investors believe one country’s government finances are shakier than another’s, they may require a premium (higher yields and/or a weaker currency) to hold that country’s bonds or other assets.
The Eurozone sovereign debt crisis (2010-2012) provides a clear example.
As Greece, Italy, and other peripheral euro members saw their bond yields spike on default fears, the euro weakened significantly against safer currencies like the U.S. dollar and Swiss franc.
Capital fled euro-denominated assets into safer harbors. Concerns bout a euro breakup or debt defaults in peripheral euro countries pushed the safe-haven Swiss franc to record peaks against the euro.
The Swiss franc surged so much on safe-haven inflows that the Swiss National Bank eventually had to cap its appreciation.
This exemplified a risk differential: Switzerland’s rock-solid credit and political stability made the CHF tremendously attractive relative to a risk-plagued euro.
Only when decisive actions (like the European Central Bank’s backstop commitments) reduced euro breakup fears did the euro stabilize.
Even among major non-Euro currencies, sovereign risk differences play a role. The U.S. dollar generally has minimal default risk, backed by the world’s deepest government bond market.
This contributes to the dollar’s safe-haven status. However, if U.S. fiscal credibility comes into question (during debt-ceiling standoffs or unpredictable fiscal policy shifts), the dollar can be affected by a rising risk premium.
3. Macroeconomic Risk
Beyond political and credit concerns, broader macroeconomic stability is a key component of risk differentials.
Investors prefer currencies from economies with predictable growth, low and stable inflation, and credible economic policies.
Economic policy refers to the actions and strategies implemented by governments and central banks to influence a country’s economy.
These policies aim to achieve key objectives such as stable economic growth, low unemployment, price stability (controlling inflation), and sustainable public finances.
They are typically divided into monetary policy (controlled by central banks, involving interest rates and money supply) and fiscal policy (managed by governments, involving taxation and public spending).
Other types of economic policies include trade policy (tariffs, trade agreements), regulatory policy (business and financial market rules), and structural reforms (labor laws, infrastructure investments).
If one country’s economy is prone to booms and busts, high inflation, or economic policy mismanagement, its currency will carry a risk discount against more stable peers.
Late 2022 provided a vivid example of policy-induced macro risk with the British pound.
The UK government’s surprise “mini-budget” which proposed unfunded tax cuts and spending increases, alarmed investors about fiscal sustainability and inflation, undermining confidence in UK policy.
Even though expectations for Bank of England rate hikes increased (which ordinarily might support the currency), the pound plunged to a record low against the dollar!
The rise in UK interest rates was overwhelmed by a rise in the perceived risk of UK assets.
Sterling’s sell-off reflected a higher risk differential, where investors required a cheaper pound to compensate for the UK’s suddenly uncertain macro-policy outlook. Only after the fiscal plan was reversed and credibility partially restored did the pound recover.
More generally, currencies of countries with high inflation or growth volatility tend to trade at a discount.
If Country A consistently hits its inflation targets and maintains steady growth while Country B experiences wild swings in inflation and recurrent recessions, investors will view B’s currency as riskier. They might demand higher interest rates in B (an added risk premium) and still prefer A’s currency for its stability.
Over the past year, the U.S. and euro area experienced high inflation, but the U.S. responded faster with monetary tightening, helping bolster confidence in the dollar relative to the euro.
Meanwhile, the UK faced a unique inflation surge and some policy stumbles, which kept the pound relatively weaker until risks moderated.
Central banks’ credibility is crucial: if a central bank is perceived as “behind the curve” or subject to political pressures, its currency can suffer.
For example, the Bank of Japan’s prolonged ultra-easy policy has at times made the yen a funding currency, but if markets believe policy normalization might be mishandled, that risk can weigh on the yen.
4. Regulatory and Legal Risks
A more subtle but important set of factors are regulatory, legal, and institutional risks.
These include the risk of sudden changes in laws or regulations (capital controls, nationalization of assets, contract enforcement issues) and the overall strength of institutions (rule of law, property rights, regulatory transparency).
If investors fear that a country’s rules might change arbitrarily or that their investments aren’t protected, they will view that country’s currency as riskier.
Major advanced economies generally score highly on institutional stability, but even among them, perceived erosion of institutional norms or unpredictable policy shifts can hurt the currency.
In early 2025, the U.S. surprised markets with aggressive tariff threats (the “Liberation Day” tariffs).
Usually, during global turmoil, the dollar gains as a safe haven. But this time, the dollar fell sharply alongside U.S. bonds, an unusual tandem decline attributed to fears that unpredictable U.S. policy was undermining confidence in dollar assets.
The regulatory/policy risk introduced by sudden tariff moves caused a reassessment of the dollar’s structural appeal.
This is a reminder that even the world’s reserve currency carries a risk premium that can rise if its institutional predictability is called into doubt.
Regulatory risk differentials are more commonly seen between developed and emerging markets.
Emerging economies that have resorted to capital controls or have weaker legal protections tend to have persistent currency risk premia.
If Country X has a history of freezing capital outflows in a crisis, investors will always discount X’s currency relative to a freer market.
Risk Sentiment Cycles and Safe-Haven Flows
Risk differentials are not static, they tend to manifest most prominently during global risk sentiment shifts.
In periods of market stress (“risk-off” episodes), the gap between safe-haven currencies and riskier currencies widens dramatically.
Investors flock to currencies perceived as safe havens (typically the U.S. dollar, Japanese yen, and Swiss franc).
And they dump currencies seen as higher-risk or “high-beta” (like the Australian and Canadian dollars, the British pound, and to some extent the euro).
During the 2008 global financial crisis, the U.S. dollar and yen (funding currencies for many carry trades) soared in value as investors unwound positions in riskier currencies.
When volatility spiked, the higher a currency’s yield had been, the more it plummeted against the dollar and yen. High-yield “target” currencies like the Brazilian real, Turkish lira, and Australian dollar were hardest hit.
The risk reversal was so severe that for every 1% extra interest yield a currency offered, it suffered roughly a 2.6% greater depreciation during the crisis, wiping out years of carry trade gains!
This illustrates how, in a risk-off environment, investors prioritize safety over yield: the risk differential explodes in importance, penalizing previously high-yielding currencies.
Even among major currencies, we see this dynamic. In recent risk-off episodes, such as during U.S.-China trade tensions or the early 2022 Russia-Ukraine war fears, the U.S. dollar and yen rallied while the euro, pound, and commodity currencies fell.
This seesaw is essentially the market re-pricing risk differentials on the fly: in calm “risk-on” times, higher-yielding or growth-linked currencies tend to strengthen (their risk premium shrinks), but in “risk-off” times, those currencies’ risk premium shoots up and their value falls.
The Japanese yen is a quintessential safe haven: despite near-zero yields, it often appreciates during global turmoil.
Why? Investors know Japan has ample external assets (significant holdings of foreign investments outside its borders) and low political risk, so they trust the yen as a store of value when uncertainty reigns.
Conversely, the euro, despite being a major currency, usually weakens in global risk aversion because parts of the euro area are perceived as vulnerable and the euro lacks the single safe-haven status of the USD or JPY.
While the U.S. dollar is considered the premier safe haven (benefiting from most crises), if a U.S.-centric shock undermines confidence in U.S. assets, the dollar can temporarily lose that status.
Managing currency exposure requires watching these risk sentiment cycles, as well as the ebb and flow of global risk appetite, which can dramatically amplify underlying country risk differentials.
Bottom Line: Risk Differentials Matter
Risk differentials are an important, independent driver of currency values alongside traditional fundamentals like interest rates and trade flows.
A currency’s strength or weakness cannot be fully understood without accounting for the market’s perceived risk of the underlying country.
Political instability, sovereign credit stress, macroeconomic volatility, and regulatory uncertainty all elevate the risk premium required by institutional investors, usually translating into a weaker currency relative to a safer counterpart.
We have seen this across major currency pairs: the USD, EUR, JPY, GBP (and others like CHF) constantly react to not just yield gaps but risk gaps.
The euro’s slide during the debt crisis, sterling’s Brexit-related volatility, the yen’s bursts of strength during global panic, or the dollar’s gyrations with unpredictable U.S. policy. All underscore that exchange rates incorporate a risk-assessment mechanism.
As forex traders, the takeaway is that lower risk can be as important as higher return in supporting a currency.
A country that maintains political stability, fiscal soundness, economic predictability, and reliable institutions often enjoys a stronger currency than a higher-yielding but riskier alternative.
In the currency world, it’s not just about who pays the most; it’s about who helps you sleep at night!
