Can Policy Uncertainty Drive the Dollar?

This article reviews the risk-based literature on international arbitrage deviations, exchange rates, and countries’ borrowing costs. It synthesizes recent work identifying policy uncertainty as a key primitive in risk-based models of global finance and investment. Volatile and unpredictable policy environments alter forward-looking investors’ expectations and portfolio decisions, thereby influencing exchange rates, excess currency returns, and the cost of capital—effects especially pronounced in emerging markets. We discuss how increased global policy uncertainty can create conditions under which a policy risk premium also arises for the US dollar. We present preliminary evidence consistent with this hypothesis.