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The causality link between political risk and stock prices: A counterfactual study in an emerging market

Huiqiang Wang (Neil Griffin College of Business, Arkansas State University, Jonesboro, Arkansas, USA)

Journal of Financial Economic Policy

ISSN: 1757-6385

Article publication date: 30 May 2019

Issue publication date: 6 August 2019

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).

Keywords

Acknowledgements

The author is grateful for help from the editor and constructive comments from the anonymous referee. He also thanks Andy Naranjo at the University of Florida, Patricia Robertson at Arkansas State University and Annie L. Boatwright.

Citation

Wang, H. (2019), "The causality link between political risk and stock prices: A counterfactual study in an emerging market", Journal of Financial Economic Policy, Vol. 11 No. 3, pp. 338-367. https://doi.org/10.1108/JFEP-07-2018-0106

Publisher

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Emerald Publishing Limited

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