Better the Devil You Know: The Role of Political Uncertainty in Determining Financial Market Uncertainty

Abstract

The Australian federal election cycle, which occurs every 3 years, causes much media attention and invokes much consternation regarding investment decisions in both the real economy and financial markets. This paper constructs measures of political uncertainty and formally explores their relationship with market uncertainty, as measured by implied volatility. The empirical evidence suggests that increasing (decreasing) levels of uncertainty around the election result induce higher (lower) levels of market uncertainty. An increasing (decreasing) likelihood of the incumbent party, whose economic policies are well-known, reduces market uncertainty – particularly if the incumbent is the more conservative L-NP Coalition – in a case of the market preferring the devil it knows. The results remain significant even after controlling for a number of macroeconomic variables.