Political Interference and Stock Price Consequences of Local Bias

The Financial Review 51 (2016) 151–190
Political Interference and Stock Price
Consequences of Local Bias
Tom A ab o
Aarhus University
Christos Pantzalis
University of South Florida
Jung Chul Park
University of South Florida
Politics can interfere with capital markets. We showthat political interference is a neces-
sary condition for local bias in the stock market. Weextend the framework of Hong, Kubik and
Stein (2008) and find that the inverse relation between market-to-book ratios and the ratio of
the aggregate book value of firmsto the aggregate risk tolerance of investors in a state (RATIO)
is only prevalent among firms located in areas where politics has substantial influence on
local markets. Our results indicate that the impact of politically induced local bias is primarily
demand driven and stronger among firms that are less visible.
Keywords: political influence, local bias, segmented markets
JEL Classifications: G11, G12, H1
Corresponding author: Department of Finance, Muma College of Business, BSN 3403, University of
South Florida, Tampa, FL 33620; Phone: (813) 974-9680; Fax:(813) 974-3084; E-mail: jpark5@usf.edu.
We appreciate Srini Krishnamurthy (Editor) and two anonymousreferees for their helpful comments and
suggestions that have improved this paper. Tom Aabo acknowledges financial support from the Tuborg
Research Centre for Globalization and Firms.
C2016 The Eastern Finance Association 151
152 T. Aabo et al./The Financial Review 51 (2016) 151–190
“All politics is local.”
Tip O’ Neill, Speaker of the House (1977–1987)
1. Introduction
We build on the methodologies of Hong, Kubik and Stein (2008) and Kim,
Pantzalis and Park (2012) and demonstrate that in a U.S. setting, political interference
is a necessary condition for local bias in the stock market. Specifically, our tests
document the positive relationship between aggregate risk tolerance of investors in
thesameregion(RATIO) and market-to-book (M/B) ratio that captures the degree of
local bias consistent with Hong, Kubik and Stein (2008) and provide evidence that
the relationship is only prevalent among firms located in areas where there is a greater
concentration of political power.1The rationale for using the Kim, Pantzalisand Park
(2012) measure of concentration of political power (political alignment index [PAI ])
as a proxy for the likelihood of political interference with markets is that uncertainty
about future policies’ impact on firm cash flows and local politicians’ influence
increases with their proximity to political power.2We further confirm that our results
are: (1) primarily driven by the demand side (i.e., the denominator of RATIO), (2)
most pronounced among firms with limited visibility outside their home region (in
line with the results of Hong, Kubik and Stein, 2008), (3) highly evident during the
earlier years of our sample, prior to the introduction of significant changes in market
microstructure and improvements in information delivery, and (4) robust to the use
of a battery of alternative measures of political interference with capital markets.
Although there is widespread acceptance of the notion that politics interferes
with international markets occasionally causing countries’ capital markets to become
segmented from the rest of the world, the mainstream financial economics literature
has largely ignored the role of politics in domestic capital market segmentation.3In
line with the reasoning of Kaldor (1972), we argue that politics can induce dynamic
geographic segmentation of domestic capital markets, especially in a country like the
United States whose political system entails both a federal government and a large
number of state governments.
In the U.S. political system, drafting, approving, and implementing effective
new policies requires cooperation among politicians across different layers of the
1Hong, Kubik and Stein (2008) term this effect an “only game in town” effect.
2Kim, Pantzalis and Park (2012) find that political geography has implications for the cross-section of
stock returns on the U.S. market. They use a PAI to capture the alignment of each state’s leading politicians
with the ruling (presidential) party, and find that firms whose headquarters are located in high (low) PAI
states outperform (underperform) those located in low (high) PAI states. They determine that the results
are consistent with the notion that proximity to political power has stock return implications as it reflects
firms’ exposure to policy risk.
3There are few exceptions. For examples, see Heaney and Hooper (2001) and Boyreau-Debray and Wei
T. Aabo et al./The Financial Review 51 (2016) 151–190 153
federal and state governments. When local (i.e., state) political considerations become
disproportionately instrumental in shaping future policies or investors’ perceptions
about future policies, states can become geopolitically segmented entities and their
(local) capital markets could become segmented. In theory, this segmentation of the
domestic capital market can arise due to government interference with local markets
in the form of new regulations or policies that target a certain location or through the
uncertainty surrounding future political agendas and its impact on investors’ behavior
(i.e., perception of risk, familiarity, etc.).
Weinvestigate whether and to what extent political interference with local capital
markets is responsible for the price consequences of local bias. A necessary condition
for the local bias phenomenon is that the domestic capital market effectively becomes
segmented in different locations, causing a large proportion of local firms to have
share prices that are determined by local market conditions, that is, there are market
imperfections that render local market conditions different from national market
conditions leading to local stocks exhibiting a significant local pricing component.4
Thus, a primary investigation into local bias should focus on factors that can cause
geographic segmentation of domestic capital markets.
In the U.S. federal political system, as former Speaker of the House Tip O’Neill
once said, “all politics is local.” In this study, we focus on the U.S. market and posit
that politics can be a major source of the market irregularities causing segmentation
due to its sometimes uneven influence across different local market conditions.5
This could occur in the case of uncertainty regarding the impact of future policies
on firms’ cash flow. Uncertainty about future policies arises because investors have
difficulty assessing: (1) which items will dominate future political agendas, (2) which
congressional bills will be drafted and successfully pass both chambers of Congress
before acquiring the approval of the President, and (3) how easily new regulations
will be implemented at the state level. Since the country’s political map changes
every two years following elections, this uncertainty can vary across geographic
regions (Kim, Pantzalis and Park, 2012) effectively exposing firms in some regions
to greater policy risk than others.6In areas where political uncertainty is substantial,
firms become more difficult to assess (or less “visible” and more like “home” firms
in the language of Hong, Kubik and Stein, 2008) for investors outside their home
4Consistent with this notion, Pirinsky and Wang (2006) report that stocks of firms headquartered in the
same geographic area display comovement in monthly stock returns.
5Politics is referred to here as a process by which groups of politicians make collectivedecisions, generally
related to affairs of the public and the government, and to the methods and tactics used to formulate and
apply policy.
6Political uncertainty can arise from legislative activity that targetsspecific areas or industries. There are
numerous examples, but none more widely cited than those of the interaction of politics at the local level
with defense industry firms (Malecki, 1984).

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