Is firm-level political risk priced in the equity option market?

Abstract

We provide evidence that firm-level political risk exhibits a robust negative association with subsequent delta-hedged option returns. The effect holds both in a cross-sectional and in a time-series context. Furthermore, it is more pronounced among firms with high default probability, high information uncertainty, and high option demand, while it is mitigated for politically active firms. Using Brexit as a quasi-natural experiment and a difference-in-difference approach, we find that after the referendum option returns significantly decrease for the firms that are exposed to Brexit risk. Overall, we show that political risk is an important determinant of individual stocks’ volatility risk premium.