Political Uncertainty and Risk Premia

TLDR: This article developed a general equilibrium model of government policy choice in which stock prices respond to political news, which implies that political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions.

About: This article is published in Journal of Financial Economics.The article was published on 2013-12-01 and is currently open access. It has received 1067 citations till now. The article focuses on the topics: Risk premium & General equilibrium theory.

Figures

Fig. 7. Stock price level, volatility, and correlation: The effect of policy heterogeneity. This figure is constructed in the same way as Fig. 6 except that it plots additional quantities of interest—the stock price level, measured by the market-to-book ratio, the volatility of each stock’s return, and the correlation between each pair of stocks. All quantities are plotted at time t = τ − 1 for different values of ĝt and three different levels of heterogeneity among the new policies, defined as H = σg,H −σg,L. In addition, the dash-dot line in each panel represents the value of the given variable in the hypothetical scenario in which the government cannot change its policy at time τ . Comparing the dash-dot line to the other three lines thus highlights the effect of precluding the government from changing its policy.

Table 2 Political uncertainty and economic conditions

Fig. 3. The equity risk premium and its components. This figure plots the equity risk premium and its components as a function of ĝt, which is the posterior mean of the old policy’s impact g 0 as of time t. High values of ĝt indicate strong economic conditions; low values indicate weak conditions. The flat blue area at the bottom represents the component of the risk premium that is due to “capital shocks,” i.e. shocks to capital Bt in the absence of any updating of beliefs about g 0. The middle green area represents the component of the risk premium that is due to “impact shocks,” which reflect learning about the old policy’s impact g0. The top red area represents the component of the risk premium that is due to “political shocks,” which reflect learning about CL and CH . The three areas add up to the total equity risk premium. The values of ĉLt and ĉ H t are set equal to their initial value at time 0, so that both new policies are equally likely. All quantities are computed at time t = τ − 1 when the political debates begin. The parameter values are in Table 1.

Fig. 8. The equity risk premium and its components: Business-cycle model extension. For the model extension on policy-unrelated business cycles, this figure plots the equity risk premium and its components as a function of economic conditions. The four panels correspond to different values of σS , which reflects the precision of the additional signal S, or dSt from Eq. (55), that agents use to learn about the business cycle variable µt (higher σS means a less precise signal). The flat blue area at the bottom represents the component of the risk premium that is due to “capital shocks,” i.e. shocks to capital Bt in the absence of any updating of beliefs about g0. The green area, second from the bottom, represents the component of the risk premium that is due to “impact shocks,” which reflect learning about the old policy’s impact g0. The red area, third from the bottom, represents the component of the risk premium that is due to the additional signal S. Finally, the yellow area at the top represents the component of the risk premium that is due to “political shocks,” which reflect learning about CL and CH . The four areas add up to the total equity risk premium. The values of ĉLt and ĉ H t are set equal to their initial value at time 0, so that both new policies are equally likely. All quantities are computed at time t = τ − 1 when the political debates begin. The parameter values are in Table 1; in addition, µ = 10%, β = 0.35, and σµ = 2%.

Fig. 4. The equity risk premium and its components: The effects of σg and σc. Each of the four panels is analogous to Fig. 3—the flat blue area at the bottom represents the risk premium due to capital shocks, the middle green area represents the risk premium due to impact shocks, and the top red area represents the risk premium due to political shocks. The three areas add up to the total equity risk premium. The parameter values are in Table 1, except for σg and σc, which vary across the four panels.

Fig. 5. The equity risk premium and its components: The effects of h and t. Each of the four panels is analogous to Fig. 3—the flat blue area at the bottom represents the risk premium due to capital shocks, the middle green area represents the risk premium due to impact shocks, and the top red area represents the risk premium due to political shocks. The three areas add up to the total equity risk premium. The parameter values are in Table 1, except for h and τ − t, which vary across the four panels.

Frequently asked questions

Q1. What are the contributions in this paper?

Political uncertainty reduces the value of the implicit put protection that the government provides to the market. 

Q2. What are the future works in this paper?

Their analysis opens several paths for future research. For example, it would be useful to extend their model by endogenizing the political costs of government policies, relying on the insights from the political economy literature. The authors empirically examine one time-series proxy for political uncertainty in the U. S. ; future work could construct other proxies, look across countries, and test the predictions of their model in a variety of other settings. 

Q3. What is the effect of a higher consumption growth on stock prices?

In that economy, an increase in consumption growth improves welfare but decreases stock prices, due to consumption smoothing: higher consumption growth leads investors to sell stocks and bonds to consume more today, pushing interest rates up and stock prices down. 

Q4. What are the three types of shocks that affect stock prices?

The authors show that stock prices are driven by three types of shocks, which the authors call capital shocks, impact shocks, and political shocks. 

Q5. What is the effect of a policy change on agents’ beliefs about g0?

As a result, a policy change resets agents’ beliefs about gt from the posterior N (ĝτ , σ̂ 2 τ) to the prior N ( µng , σ 2 g,n ) . 

Q6. Why is uncertainty irrelevant when the government cannot change its policy?

The reason is that uncertainty about the political costs of the potential new policies is irrelevant when the government cannot change its policy.