Uncertainty about Government Policy and Stock Prices

I was looking at the Journal of Finance today and ran into this paper from last year on uncertainty about government policy and stock prices. It is written by Lubos Pastor and Pietro Veronesi at Chicago. In light of events last week surrounding the Labour/Green electricity policy announcement and subsequent loss of shareholder wealth in the form of share price declines for CEN, TPW and IFT I thought I’d share some findings from academia on the issue.

The paper is available ungated through Stanford if you don’t have access to Wiley Online Library – Uncertainty about Government Policy and Stock Prices.

Some interesting findings:

  • policy changes tend to occur after downturns in the private sector
  • political uncertainty relates to uncertainty about whether government policy will change
  • impact uncertainty has to do with the fact that firms have beliefs about current policy that would apply to changes to policy (I’m interpreting this as firms realise a new policy could lower return on capital outlay but they are unsure as to what extent that will be)
  • “If the government derives an unexpectedly large political benefit from changing its policy, the policy will be replaced even if it worked well in the past.”
  • There are two effects that explain the price fall – policy changes are generally made after a market experiences a downturn in profitability (this is not happening in electricity) but the discount rate increases because the firm needs to learn how to deal with the new policy (pushing stock prices down)
  • negative announcement returns tend to be larger because they occur when the announcement of a policy change contains a bigger element of surprise. The probability distribution of the announcement returns is left-skewed and, most interesting, its mean is below zero—we prove analytically that the expected value of the stock return at the announcement of a policy change is negative. We also find that this expected announcement return is more negative when there is more uncertainty about government policy. When impact uncertainty is larger, so is the risk associated with a new policy, and thus also the discount rate effect that pushes stock prices down when the new policy is announced. When political uncertainty is larger, so isthe element of surprise in the announcement of a policy change

  • If firms think the risk from an announced policy is to high they will shift from high risk investments to low risk investments in order to maintain the firm’s (shareholder’s) wealth
  • 4 of the model’s factors seem to be at play in the NZ electricity market
  • One of the biggest assumptions is a quasi-benevolent government!
  • The authors think their work could help bridge the gap between asset price movements and political economy

While I can follow the math, I would definitely not be able to do something similar. It’s graduate level stuff. Nonetheless, the academic literature in finance has something to offer us in explaining why stock prices experience shifts after policy announcements and how impact uncertainty and political uncertainty affect both government and firm behaviour which of course affects asset prices.

This paper can also help explain to non-economists / finance people why a firm that invests in big capital projects will apply the brakes when they are not able to predict the likelihood of a new policy being introduced that would change the net present value of investment projects by increasing the discount rate through higher risk premia caused by “jump risk” after a policy announcement.

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