Hedging on the Hill: Does Political Hedging Reduce Firm Risk?

Abstract

We examine whether firms’ political hedging activities are effective at mitigating political risk. Focusing on the risk induced by partisan politics, we measure political hedging as the degree to which firms’ political connections are balanced across Republican and Democratic candidates. We find that greater political hedging is associated with reduced stock return volatility, particularly during periods of higher policy uncertainty. Similarly, greater political hedging is associated with reduced crash risk, investment volatility, and earnings volatility. Moreover, the reduction in earnings volatility appears to relate to both a firm’s taxes and its operating activities, as we find that greater political hedging is associated with reduced cash effective tax rate volatility and pretax income volatility. We further find investors are better able to anticipate future earnings for firms that engage in political hedging, suggesting that political hedging helps improve firms’ information environments. Lastly, we perform an event study using President Obama’s Clean Power Plan. We find that on the days this policy proposal was debated in Congress, energy and utility firms experience heightened intra-day return volatility (relative to other firms and non-event days). However, this heightened volatility is mitigated for energy and utility firms that are more politically hedged. Overall, we conclude that political hedging is an effective risk management tool that helps mitigate firm risk.

Keywords: Political connections; Hedging; Stock return volatility; Earnings volatility; Firm risk; Risk management

JEL Classification: G32