Political Uncertainty and Finance: A Survey

• DOI: http://doi.org/10.1111/ajfs.12257
• Published date: 01 June 2019
• Author: Lili Dai,Bohui Zhang
• Date: 01 June 2019

Political Uncertainty and Finance: A Survey

Lili Dai

UNSW Business School, UNSW Sydney, Australia

Bohui Zhang*

School of Management and Economics, Shenzhen Finance Institute, and CUHK Business Schoool, The Chi-

nese University of Hong Kong, China

Received 22 April 2018; Accepted 3 May 2019

Abstract

An emerging stream of literature investigates the impact of political uncertainty on financial

markets. In this survey, we review this line of literature from four perspectives, namely, asset

prices, corporate policies, financial intermediaries, and economy and households, suggesting

that political uncertainty generally increases market friction and as a result changes corporate

behavior and adversely affects the economy. At the end of the survey, we discuss a few future

directions worth being explored in view of the relationship between political uncertainty and

finance.

Keywords Political uncertainty; Asset prices; Corporate policies; Financial intermediaries;

Economy; Households

JEL Classification: G12, G18, G21, G28, G34, G38

1. Introduction

Uncertainty is a key channel through which political factors affect financial markets.

During periods that feature political instability, the uncertainties associated with

possible changes in government policies and in the macro-environment may dra-

matically increase capital market participants’ risk perception (see, e.g., P

astor and

Veronesi, 2012, 2013). In this survey, we summarize the current evidence on the

relationship between political uncertainty and finance. The motivation underlying

this effort is to provide researchers with information regarding current academic

developments concerning the relationship between politics and finance and we wel-

come further contributions in this area.

1

*Corresponding author: School of Management and Economics, Chinese University of Hong

Kong, Shenzhen, Guangdong, China, 518172. Tel: +86-755-2351-8868, email: bohuizhang@

cuhk.edu.cn

1

For a related survey from an economic perspective, see Bloom (2014).

Asia-Pacific Journal of Financial Studies (2019) 48, 307–333 doi:10.1111/ajfs.12257

©2019 Korean Securities Association 307

The increase in the perceived risk associated with high political uncertainty can

affect financial policy in two ways. First, political uncertainty increases external

investors’ risk perception, leading to a higher cost of equity capital. P

astor and Ver-

onesi (2012, 2013) build a theoretical foundation for the pricing of political uncer-

tainty and show that investors demand a risk premium to compensate for political

uncertainty. Their theory has been empirically supported in terms of various finan-

cial assets such as bonds, stocks, options, and commodities (e.g., Gao and Qi, 2013;

Brogaard and Detzel, 2015; Kelly et al., 2016; Liu et al., 2017; Hou et al., 2018).

Second, political uncertainty increases management’s perceived firm cash flow risk

because individual firms’ cash flows are exposed to both idiosyncratic shocks and

aggregate shocks (see, e.g., Berkman et al., 2011) for the relationship between politi-

cal uncertainty and aggregate asset return and volatility. Therefore, the chances of

experiencing financial shortfalls and tapping external equity markets tend to

increase during periods of high political uncertainty.

Aligned with these two channels through which political uncertainty can exert

an impact on finance, in Section 2 of the remaining part of the survey, we review

the literature on the relationship between political uncertainty and asset prices. In

Section 5, we review the association between political uncertainty and corporate

policies. In Section 10, we discuss the existing studies covering the impac t of politi-

cal uncertainty on financial intermediaries, and the impact of political uncertainty

on households in Section 11. Section 12 provides our views on possible areas of

future research into political uncertainty. We conclude the survey in Section 13.

2. Political Uncertainty and Asset Prices

First, in this section, we review the literature on the effects of political uncertainty

on asset prices for securities including stock, corporate, and municipal bond, as well

as those in the option, CDS, and commodity markets. We also review the studies

that investigate the markets of foreign exchange and sovereign bond and other asset

price properties such as liquidity and tail risk.

2.1. Equity Markets

Prior studies analyze the asset pricing implications of political uncertainty in a the-

oretical setting (e.g., P

astor and Veronesi, 2012, 2013). P

astor and Veronesi (2012)

develop a general equilibrium model and prove analytically that the expected value

of the stock return at the announcement of a policy change is negative. In P

astor

and Veronesi (2012)’s equilibrium model, a firm’s profitability follows a stochastic

process and can be impacted by the prevailing government policy. Meanwhile, the

government acts as a quasi-benevolent decision maker who considers both inves-

tors’ welfare and relevant political costs when making its policy decision. At the

announcement of a policy decision, the change in stock prices largely depend s on

two factors: whether a policy change happens and the extent to which this result is

unexpected. Solving for the optimal government policy decision, a policy change is

L. Dai and B. Zhang

308 ©2019 Korean Securities Association