Uncertainty about Government Policy and Stock Prices

Source: Pástor & Veronesi (2012) · Journal of Finance 67(4), 1219–1264 · doi:10.1111/j.1540-6261.2012.01746.x

TL;DR

A general-equilibrium model in which the government is an active decision maker with both economic and non-economic motives. Stock prices fall, on average, at announcements of policy changes; the fall is larger when policy uncertainty is high and when the change follows a short or shallow downturn. Policy changes raise volatility, risk premia, and correlations among stocks, and the jump risk premium associated with policy decisions is positive on average.

The question

How do changes in government policy affect stock prices, given that policy changes are endogenous — the government tends to change policy after performance downturns in the private sector — and that uncertainty about policy is an inevitable by-product of policymaking?

The model

Firm profitability follows a stochastic process whose mean is shifted by the prevailing government policy. The model features two distinct uncertainties (note the paper's terminology):

Policy uncertainty — uncertainty about the impact of a given policy on private-sector profitability (its effect on the mean is unknown and learned over time).

Political uncertainty — uncertainty about whether the current policy will be changed.

The government chooses whether to switch policy by weighing economic welfare and a non-economic (political-cost) component; investors learn about the impact of the current and prospective policies from realized profitability. Policy decisions generate a jump in prices at announcement. The government tends to act after downturns, making policy change effectively a (costly) option exercised in weak states.

Key predictions

Negative average announcement return: prices fall when a policy change is announced (the new policy is adopted only if expected to help, but it replaces a learned policy with a less-understood one).

The expected price drop is larger when policy uncertainty is large and when the change is preceded by a short or shallow downturn.

Policy changes increase return volatility and cross-stock correlations, especially in weak economies.

The jump risk premium for policy decisions is positive on average; policy-related risk is partly non-diversifiable and therefore priced.

Empirical status

Predictions are broadly consistent with evidence of elevated volatility, correlations, and risk premia around elections and major policy events, and with measured economic-policy-uncertainty indices (Baker-Bloom-Davis). The companion Pástor-Veronesi (2013) extends the framework to political uncertainty and risk premia with supporting empirical tests.

Limitations

A stylized equilibrium model; mapping the abstract "policy/political uncertainty" objects to measurable variables is difficult.

Identification around policy events is confounded by concurrent economic news and anticipation (reactions are muted when changes are expected).

Key references

Pástor & Veronesi (2012) — Uncertainty about Government Policy and Stock Prices — Journal of Finance

Pástor & Veronesi (2013) — Political Uncertainty and Risk Premia — Journal of Financial Economics

Baker, Bloom & Davis (2016) — Measuring Economic Policy Uncertainty — Quarterly Journal of Economics

Provenance: verified/generated from the paper's full text.