Capital Ideas - Summer 2013 - page 8

Summer 2013 | Capital Ideas
ChicagoBooth.edu/capideas
6
G
lobal stock markets in the past few years seem to
have paid as much attention to politics as to cor-
porate fundamentals, with prices surging and plung-
ing in response to every twist in the eurozone crisis or
the political gridlock in the United
States. However, a formal frame-
work to study the effects of political
uncertainty on markets has been
missing from mainstream finance
theory. To fill this void, Chicago
Booth Professors
Lubos Pastor
and
Pietro Veronesi
have developed a
new general equilibrium model of
government policy choice in which
stock prices respond to political
news.
The model predicts that po-
litical uncertainty reduces the po-
tential benefits from government
interventions. This uncertainty
increases risk premia in asset mar-
kets. It also makes stocks more
volatile and more correlated, espe-
cially in weak economic conditions
(see graphic).
At any given time, Pastor and
Veronesi explain in their paper,
uncertainty about what actions
governments will take in the future
affects how investors trade. Inves-
tors form their beliefs about those
future actions by observing political signals in debates,
statements, and news stories. They respond to such
political news, thereby affecting asset markets.
The researchers find that stocks’ risk premium is
most influenced by politics in weak economic con-
ditions. This is because when the economy is doing
poorly, the government is most likely to “do something
about it,” that is, change policy—but the question of
which area of policy will be changed leads to greater
uncertainty.
Moreover in a weak economy, market prices are
influenced by two opposing forces. On the one hand,
investors have confidence that the government will in-
tervene. On the other hand, their confidence is com-
promised by the fact that they cannot diversify away
the risk that stems from government intervention.
Consequently, the market becomes more volatile, and
stocks move more in tandem in response to political
uncertainty.
In today’s extremely volatile political climate, the
risk premium from political uncertainty is having
significant impact on already weak economies. The
model from Pastor and Veronesi could help investors
and governments understand those risks and thus of-
fer new tools that could be used to mitigate them.
Robin Mordfin
Lubos Pastor and Pietro Veronesi, “Political Uncertainty and Risk
Premia,” University of Chicago Booth School of Business working
paper, April 2013.
Measuring how politics shapes portfolios
loss would result in a 0.02 percent
rise in the share of regular gasoline
used, relative to the total gas used.
Instead demand for regular
gasoline rose far faster than the
math had suggested, increasing
as a share of fuel purchases from
80.2 percent to 81.6 percent. Had
the fungibility model held, “the
gasoline price spike in 2008 would
have had to decrease household
incomes by almost $100,000,” the
authors write.
The authors suggest this departure from the fun-
gibility principle is due to consumers doing more
complex mental accounting at the pump—reacting
more to gas prices than to other factors such as over-
all income. When gas prices rise, a
household that buys premium gas
is likely to switch from premium
to regular. However in a recession,
as long as gas prices are low, that
same household may keep buying
premium.
Why are consumers so sensi-
tive to gas prices? The authors
propose that models of decision-
making used in psychology (see
graphic) “might plausibly account
for a violation of fungibility.”
—Vanessa Sumo
Justine Hastings and Jesse M. Shapiro, “Fungibility and
Consumer Choice: Evidence from Commodity Price Shocks,”
Quarterly Journal of Economics, forthcoming.
FRONT
&
CENTER
FINANCE
The uncertainty
effect
When policy uncertainty is high,
so are stock correlations. Here,
uncertainty is measured using
an index cocreated by Booth
economist
Steven J. Davis.
What recession?
’06
’09
’08
’07
Percent
Billions of dollars
*Share of regular gas in
spending on regular, midgrade,
and premium gasoline
Regular gas
share*
(Weekly)
Total retail
sales
(Monthly)
83
82
81
80
79
78
77
76
75
380
370
360
350
340
330
320
Jan. ’00
Dec. ’10
80
70
60
50
40
30
20
10
0
350
300
250
200
150
100
50
0
Stock
correlation %
Policy Uncertainty
index
(Monthly)
cb politics
RECESSION
1,2,3,4,5,6,7 9,10,11,12,13,14,15,16,17,18,...48
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