Canadian Investment Review

The Price of Political Uncertainty

Written by Caroline Cakebread on Monday, February 6th, 2017 at 1:34 pm

Uncertainty abounds in the wake of the U.S. Presidential election and while equities are still riding high, carrying pension plan funding levels higher and higher, it’s been disturbingly difficult for investors to get a handle on where the markets will go next. Which is why this paper caught my eye – The Price of Political Uncertainty: Theory and Evidence from the Option Market comes from a team of researchers at the Chicago Booth School of Business seeking to understand how options are priced under different political scenarios. The focus here is on how prices move around both elections and political summits.

The findings can perhaps help investors understand how to better protect their portfolios against politically-driven market swings and how the price of options shifts in different political situations. Although the authors haven’t yet tested their model in the current political environment (the paper first appeared in 2015) it offers some helpful context for plan sponsors seeking to bolster their portfolio against shocks by using options.

The team first reasserts the fact that political uncertainty is priced into the option market – and finds that weak economic conditions make those options more expensive, hence exacerbating the effects of political uncertainty. And it’s not just country-specific. Weak economic conditions mean that uncertainty and its effects on the market are more likely to spill across borders and into other countries.

That might seem like stating the obvious given today’s situation, however it’s a helpful reminder for investors thinking about protecting their portfolios with options. Bottom line – if you think options are valuable now, just wait until economic growth starts to slide.

The authors also conclude by admitting much more work needs to be done to understand the link between politics and market movements – and while this early work on market reactions to summits and elections is a good starting point, there’s a long road ahead before we fully understand how markets move in relation to politics.

This could prove to be a large and untapped field…

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