What price do we pay for political uncertainty?
Day after day, stock prices react to news about what governments around the world have done or might do to change the rules of the economic game. As equity prices fluctuate, they reveal investors’ assessments of how political risks impact economic activity into the indefinite future, conveniently summarized in present value terms.
Day after day, governments, too, react. They read the tea leaves of unemployment numbers, housing starts, or market swings and decide whether and how to respond.
For researchers looking to discover the price of political uncertainty, the inconvenient truth is this: in the real world, politics and the economy are intertwined. Just as political uncertainty can depress prices and economic activity, economic weakness or decline can give rise to political uncertainty.
Distinguishing cause and effect
Three economists at the University of Chicago Booth School of Business—Bryan Kelly
, Lubos Pastor
, and Pietro Veronesi
—have hit on an ingenious way to isolate the politics from the economics. They focus on political events that are independent from economic conditions: national elections and global summits.
However turbulent the markets or dismal the quarterly earnings reports, they don’t cause elections or global summits to be held; both kinds of events are simply fixtures of the political calendar. And, however stable the national or international political outlook, elections and summits both present financial markets with a time-limited uncertainty. On a particular date, someone will be elected and someone won’t; some policy will be rejected in favor of another.
Investors can hang on every word of policymakers in uncertain times.
On the market side, the researchers chose an equally special set of instruments: equity index options. Options have relatively short maturities, and they can be chosen to span the dates of fixed political events. The prices of those options can then be compared to the prices of others nearby that don’t span the events. Finally, options come with different strike prices, that is, different prices at which the option holder can exercise the contract by buying or selling the underlying security.
In the same way that insurance premiums vary depending on coverage, options expiring in the same month cost more or less, depending on their strike price. Which option you buy reflects—and provides protection against—what type of risk you think you might run: price risk (the risk that the price of the underlying stock might drop), tail risk (the risk that the drop will be large), and variance risk (the risk of rising volatility in the stock’s return).
Armed with index option data from 20 countries; the dates of those countries’ parliamentary or presidential elections and of Euro, G8, and G20 summits; and data from the OECD, IMF, or Datastream describing general economic conditions during all the periods in question, the researchers looked to see how option prices behaved in the presence of political uncertainty.
The envelope, please
What Kelly, Pastor, and Veronesi saw confirmed their theory: when politics take the lead, markets lose. Options cost more when they span political events.
How much more depends on what kind of risk the options are insuring against. Take at-the-money options, for example—options whose strike price is equal to the underlying asset’s market price. Those that span political events are, on average, 5.1 percent more expensive than nearby options that don't. To put it another way, if you want to buy a little protection against price risk, that protection will cost you 5.1 percent more if you happen to be buying it in a month that has an election in it.
The data also confirm another of the researchers’ intuitions: the political premium varies, depending on the general state of the economy. When the economy is weak, the odds of policy change grow, and the political premium grows, as well; 5.1 percent becomes 8 percent. When the economy is strong, policy change becomes less likely, and the political premium drops to 1 percent.
Options that offer insurance against extreme events, like tail risk, are particularly pricey ahead of elections and summits. For example, among options to sell whose strike prices are 5 percent below the underlying asset’s market price—providing protection against big price drops—those that span political events are, on average, 9.6 percent more expensive than those that don’t. If the option is 10 percent below the asset’s market price, the average political premium rises to a whopping 16 percent. Insurance against variance risk also goes up when the contract’s term includes an election or summit.
The price (back of the envelope)
A 5.1 percent premium on an individual purchase is significant. Apply that premium market wide, and you’re talking real money.
Say you were to purchase enough one-month, at-the-money put options to insure the total market value of the S&P 500 Index in March 2014:
Multiply that by the price premium for one-month, at-the-money put options that span political events:
Times the ratio of the price of a one-month, at-the-money S&P 500 put option to the level of the same index:
The price of political uncertainty comes to
That’s roughly the cost of
A large Hadron collider ($11 billion) + 2 Hubble space telescopes ($1.5 billion each)
Clean water for the entire planet ($10 billion) + 2 space shuttles ($1.7 billion each)
The cost of 2014 national school lunch program ($9 billion) + Fiji ($4 billion) + the Seychelles ($1 billion)
Of course, we may not want another Hubble telescope, and Fiji may not be on the market. Even if it were, it’s unlikely we’d want to trade our political system for it. Political uncertainty is an integral part of democracy. But knowing the price of that uncertainty in real dollars—in market value destroyed, in higher costs of capital to firms—we may want to think hard about how to decrease it.
Learn more about the price we pay
This brief and video are produced as part of the Price of Policy Uncertainty, the institute’s research initiative that studies the economic impact of uncertainty. Produced with the generous support of the MacArthur Foundation, this is the second in a series highlighting the work of leading researchers at the University of Chicago and elsewhere who are exploring key questions in this area. You can see the first video in the series here.