Political Uncertainty and Financial Market Quality

Abstract

We examine the effects of political uncertainty surrounding the outcome of U.S. presidential elections on financial market quality. We postulate those effects to depend on a positive relation between political uncertainty and information asymmetry among investors, ambiguity about the quality of their information, or dispersion of their beliefs. We find that market quality deteriorates (trading volume and various measures of liquidity decrease) in the months leading up to those elections (when political uncertainty is likely highest), but it improves (trading volume and liquidity increase) in the months afterwards. These effects are more pronounced for more uncertain elections and more speculative, difficult-to-value stocks (small, high book-to-market, low beta, traded on NASDAQ, or in less politically sensitive industries), but not for direct proxies of the market-wide extent of information asymmetry and heterogeneity among market participants (accruals, analysts' forecast dispersion, and forecast error). These findings provide the strongest support for the predictions of the ambiguity hypothesis.