The price of political uncertainty…

Bryan Kelly, Lubos Pastor and Pietro Veronesi have this interesting piece in voxeu.

The authors develop a measure of political uncertainty and see its impact on fin markets:

Despite obvious ties between political uncertainty and financial markets, the nature of this connection has not been studied in detail. This column describes a theoretical framework for evaluating the influence of political uncertainty on financial markets. Political uncertainty commands a risk premium, especially when the economy is weak. By raising firms’ cost of capital, it depresses investment and real activity. Furthermore, by raising risk premia, political uncertainty destroys market value.

I guess they missed seeing what is happening in India at the moment. Despiyte huge political uncertainty, markets have been so buoyant. But then how much times it takes to correct the beliefs? It could just happen over a few if political outcomes are not as favorable.

The authors use stock options to figure political uncertainty:

Assessing the market impact of political uncertainty in the data is a challenge. This uncertainty may depress prices and economic activity but, as the model shows, an economic decline can also precipitate political uncertainty. It is difficult to distinguish the cause from the effect. How can we measure the impact of political risk on financial markets? In Kelly et al. (2014), we offer an answer. Our approach tracks equity index option prices from 20 countries around national elections and global summits.

Elections and summits are well suited for our analysis because they can result in major policy shifts and, since their dates are usually determined far in advance, they are a source of exogenous variation in political uncertainty.

Options are ideally suited for this analysis for two reasons.

  • First, they have relatively short maturities, which we can choose to cover the dates of political events. An option whose life spans a political event provides protection against the risk associated with that event. Since the political event is often the main event that occurs during the option’s short life, the option’s price is informative about the value of protection against political risk.
  • Second, options come with different strike prices, which allow us to examine various types of risk associated with political events, such as tail risk.

We calculate three option-market variables: the implied volatility of an at-the-money option, the slope of the function relating implied volatility to moneyness, and the variance risk premium. These variables capture the value of option protection against three aspects of risk associated with political events: price risk, tail risk, and variance risk, respectively. To take out non-political effects, we normalise each variable with respect to nearby options that do not span the political event.

The model seemed to be working in practice:

We find that at-the-money options whose lives span political events are on average 5% more expensive than neighbouring options that don’t span the event. Furthermore, the well-known implied volatility smirk dramatically steepens around such events as investor demand for insurance against tail events soars. For example, among put options that are 10% out-of-the-money (and thus provide better protection against tail risk than at-the-money options), options whose lives span political events are more expensive by 16% compared to neighbouring options. We also find that political events are associated with abnormally high variance risk premia, so that insurance against variance risk is also more expensive ahead of such events.

All three option-market variables take larger values in weaker economic conditions. For example, at-the-money options providing protection against political events are 8% more expensive when the economy is weak but only 1% more expensive when the economy is strong.

The European sovereign debt crisis is once again highly illustrative. Leading up to the Greek elections in 2012, those elections were widely viewed as a de facto referendum on Greece’s continuation as a member of the Eurozone. With one of the leading political parties proposing renegotiating Greece’s treaty with Europe, a plausible election outcome would have involved a Greek exit from the Eurozone, with uncertain consequences for other vulnerable Eurozone members such as Italy and Spain.

Shortly before the Greek elections, the average ‘excess’ implied volatility across all European countries was five times larger than its full-sample mean, indicating an unusually high price of political uncertainty. The countries whose options were the most affected by these elections were Spain and Italy, which were arguably ‘next in line’ to exit the Eurozone after Greece. The effects on Germany and France, the key Eurozone players, were also large. In contrast, the least affected European countries were Sweden and Switzerland, neither of which is a Eurozone member.

Another prominent example is the US presidential election on 4 November 4, 2008 (Obama vs. McCain), and the nearby G20 summit on 14-15 November 2008. The US excess implied volatility in November 2008 exceeded the full-sample mean by a factor of eight! It makes sense for such a ‘double-whammy’ event to experience large pricing effects: options expiring after two political events should be more valuable as they provide protection against the political risks associated with both events.

Not sure what it is for India,. I guess none of this will be true for India’s case as of today..The analysis might reveal that we are into amazingly political stable times…it might again invoke Joan Robinson’s dictum on India- each and its opposite is likely to be true in India..

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