INVESTIGATING THE IMPACT OF POLITICAL UNCERTAINTY ON STOCK MARKET VOLATILITY

Abstract

Stock markets tend to quickly absorb the news related to political decisions that are likely to directly or indirectly impact the revenues and profitability of firms operating in the country. Investors are often concerned about political uncertainty because of the risk of expropriation, disruptions in market access, ambiguity in government regulations, currency, debt and fiscal crises, policy reversals, political upheaval, etc. While political uncertainty is generally accepted as an essential factor in investment analysis, little available research, especially in India, has examined the relation between stock market volatility and political uncertainty. The importance of this topic and the scarcity of available research on this topic in the context of India motivated the researcher to pursue research on the impact of political uncertainty on stock market volatility. India is a multiparty political system, and several times, no single party has got a clear majority to form the Central Government in India. In such cases, the leading political party had to take support from several other political parties to gather the number of Lok Sabha seats required to form the government. When an alliance of multiple political parties forms the government, there are chances that one or more political parties may become discontent and withdraw from the coalition. This may lead to new alliances forming the government, leading to leadership change even before general elections. This is expected to increase political uncertainty until the new government proves its majority in the parliament. Such change in political leadership may result in policy changes that can potentially increase the variance of stock returns, thereby leading to higher volatility in stock markets. This research has attempted to determine the impact of political uncertainty arising due to political leadership changes on stock market volatility. When an alliance of multiple political parties forms a government, political differences among the parties that form the alliance to form the government leads to uncertainty in the economic and other policies of the government. However, if the leading political party has a greater number of seats, it will have more say in the alliance. It can potentially give more concrete direction to the economic and other policies of the government, thereby reducing political uncertainty. This research has also attempted to determine whether the number of seats of the leading political party of the coalition government impacts volatility in stock markets. ii Election years are associated with uncertainty about the future, and due to this uncertainty, the financial markets view the election year negatively. New information is released during elections, and investors tend to balance their portfolios based on this new information. Therefore, it is expected that stock market volatility will increase around elections. This research empirically examines whether stock markets become more volatile due to political uncertainty in the election year. The results of this study indicate that political uncertainty does affect stock markets in the context of India. When political leadership changes before general elections, the stock market volatility increases. Furthermore, volatility in stock markets increases when the leading political party wins a smaller number of seats in general elections. The analyses were done in this study also indicate that stock markets become relatively more volatile in the election year. Also, the study's analysis and corresponding observations corroborate the effect of political uncertainty on market liquidity over time and the impact of such changes on equity returns.