“Brexit”: A Case Study in the Relationship Between Political and Financial Market Uncertainty

• Author: Lee A. Smales
• Date: 01 September 2017
• DOI: http://doi.org/10.1111/irfi.12100
• Published date: 01 September 2017

“Brexit”: A Case Study in the

Relationship Between Political and

Financial Market Uncertainty

LEE A. SMALES

School of Economics & Finance, Curtin University, Perth, Australia

ABSTRACT

This letter explores a single research question: How does political uncertainty,

outside of the election cycle, influence financial market uncertainty? Using

the UK (Brexit) referendum on EU membership as a novel event to examine

this question, I identify a positive and well defined relationship between polit-

ical and financial market uncertainty. Implied volatility in both UK and

German financial markets rises as uncertainty around the polling result in-

creases. Political uncertainty is most important for investors as the polling date

draws near and in the instances when opinion polls indicate the outcome is

particularly close. This result has implications for firms making financing

and investment decisions, and investors making portfolio choices, around

the time of important political events.

JEL Codes: G1; G10; G18

I. INTRODUCTION

Uncertainty in the political arena impacts both the real economy and financial

markets. Ambiguity as to the future direction of fiscal and other government

policy produces indecision in corporate investment decisions; ultimately, this

may harm growth and reduce employment. In turn, this may impact financial mar-

kets in at least two ways. First, there is the effect of reduced growth on prospective

returns. Second, investors have uncertainty as to whether there will be changes to

the tax (and more general economic) regime that will impact net returns.

In this letter, I explore a single research question: How does political uncer-

tainty, outside of the election cycle, influence financial market uncertainty?

There has been very little research in this area outside of studying the usual

election cycle. The UK referendum on European Union membership (commonly

referred to as “Brexit”) provides an ideal and novel setting in which to investigate

this important question. The answer has ramifications for the portfolio choice of

investors, the investment decisions of firms, and the level of growth in the real

economy.

Pastor and Veronesi (2012, 2013) form a theoretical model to explain the

influence of political uncertainty. They theorize that uncertainty is created as,

© 2016 International Review of Finance Ltd. 2016

International Review of Finance, 17:3, 2017: pp. 451–459

DOI: 10.1111/irfi.12100