The causality link between political risk and stock prices

Abstract

Purpose Prior studies have paid close attention to the impact of political risk on financial markets. Following this strand of literature, this paper aims to focus on the causality link between political shocks and their impacts on emerging stock markets. Design/methodology/approach This paper highlights an innovative counterfactual model for political risk assessment. Based on a natural experiment, i.e. the Taiwan Strait Crisis in 1995-1996, this study utilizes one data-driven approach, e.g. the synthetic control methods (SCMs), to estimate causal impact of this political shock on Taiwan’s stock market. Findings Major findings in this study are consistent with existing literature on the price of political risk, e.g. political uncertainty commands a risk premium. The SCM estimations suggest that Taiwan’s stock prices dramatically underperformed its newly industrialized peers and other developed markets during the crisis. The SCM results are statistically significant and robust to various cross-validation tests. Research limitations/implications Findings in this study indicate that political risks could generate enormous impacts on emerging financial markets. In particular, political uncertainty following new geopolitical dynamics requires proper identification and assessment. Originality/value To the author’s knowledge, this paper is the first rigorous counterfactual study to the causality relationship between political uncertainty and stock prices in emerging markets. This paper is distinct from previous studies in applying a data-driven approach to combine the features of learning from others (cross-sectional) and learning from the past (time series).