As recent weeks have shown, political events can exert a significant impact on financial markets says Yoichi Otsubo
The political and economic crisis that followed the Truss government’s ‘mini-budget’ actually comes against the backdrop of increasing tensions across the world between what politicians say and do, and the response of financial markets.
So much so, that there is growing academic interest in identifying the effects of electoral outcomes and political decisions on asset prices and volatility. Why? Because an election, or another political event such as a referendum, can lead to a dramatic shift in the macroeconomic environment, the institutional framework, and government policy.
This also matters because of the increasing power of central banks across the world, particularly since the financial crisis of 2008 which led to huge bailouts of individual banks and financial institutions, and to huge stimulus to individual economies.
Crucially, measuring the risks from a political event can also affect voters’ decision-making too. This is particularly true for a polarised event such as a referendum where, in the absence of an objective measure of the economic impact of its outcomes in real time, the opposing sides of the campaign typically make sharply contradictory predictions.
This of course is exactly what happened in the UK’s EU referendum vote in 2016 where prior to the vote there was a lot of heated debate about what the impact of a Brexit vote or Remain vote would be on the pound and financial markets.
This is precisely why myself and co-authors Alex Kostakis and Liangyi Mu chose the EU vote for a study into whether one can say before a specific political event what its likely impact will be on financial assets. To answer our own question we felt that the EU referendum provided an ideal laboratory to test the thesis.
In particular we wanted to assess the ability of the option market to detect and quantify political event risk. The option market allows investors to speculate or hedge against the volatility of a particular financial asset with options divided into call options (where the buyer profits if the price of the stock increases), and put options (in which the buyer profits if the price falls).
Through our own detailed financial modelling, what we discovered was that the option market was indeed very informative in detecting the impact of the resulting Brexit vote on the value of the pound well before referendum day. In other words, the option market can detect and quantify the effects of political event risk.
So what is the relevance of our findings? Clearly there is a direct relevance for those investors already well-versed in the option market.
But, as recent weeks in the UK have shown, maybe there are lessons here for politicians and policymakers too in terms of creating a better understanding of the financial impact of specific policy decisions. Not least when the decisions they take can have real and lasting economic consequences for voters.
In short, it’s not a bad idea to learn how to read financial markets and understand the potential consequences of specific political decisions. And when you know the consequences this may also impact significantly how you want to communicate those policies with the market in the first place.