The effects of economic policy uncertainty exposure

This thesis comprises three empirical studies that investigate the effects of exposure to uncertainty surrounding economic policies in listed firms. The main factors tested are firm fundamentals, its stock returns, and its investments into research & development (R&D). Uncertainty exposure is measured at the firm level and is derived from Baker et al.’s (2016) economic policy uncertainty (EPU) index, where high levels of exposure mean that firms are more vulnerable to changes in economic policy.

The first study investigates the association between firm fundamentals and exposure to EPU. It offers new insights into how firms statistically exposed to the EPU index differ from those that are not. The evidence revealed emphasises the importance of distinguishing between statistically significant and insignificant exposure to EPU as firms with significant EPU exposure tend to be larger and perform better financially. They are also typically more engaged in the debt market. Among exposed firms, financial performance, market value, and short-term are negatively associated with EPU exposure, while debt-to-equity, market-to-book value, beta, cash holdings, and R&D expenditure are positively associated. High EPU exposure is more common in research-intensive and policy-sensitive industries, such as healthcare and technology, while utilities and real estate are the least exposed. The study contributes to the literature by highlighting the varying impacts of EPU exposure on firm fundamentals, which can help firms with better risk management, financial planning, capital budgeting, and resource allocation. Additionally, investors can benefit by anticipating and managing uncertainty to make better informed investment decisions.

The second study examines the impact of both EPU and climate policy uncertainty (CPU) exposures on asset pricing under the risk-return trade-off framework. It notes that uncertainty related to climate policies, which raises the CPU index, also has economic implications that overlap with the EPU index. The study investigates the association between stock returns and policy uncertainty exposures, while controlling for firm size, which has been largely overlooked in previous research. Using a double sorting technique, the study finds that stocks exposed to policy uncertainty – either positively or negatively – generate higher returns than those with zero or near zero exposures. This suggests that these stocks are riskier and, thus, investors require higher returns as compensation. A portfolio analysis reveals that the Fama-French five-factor model does not fully explain the returns on portfolios sorted by EPU and CPU exposures. To address this, two new risk mimicking factors for EPU and CPU exposures are incorporated into the model to enhance the five-factor model’s explanatory power. The presence of these factors supports the argument that EPU and CPU exposures lead to significant abnormal returns. This research therefore not only highlights the importance of considering EPU and CPU exposures in investment strategies and asset pricing models, it also provides robust evidence of their strong association with stock returns even when controlling for size effects.

The third study investigates how EPU exposure influences innovation investment, measured by R&D expenditure. Firm-level EPU exposure is expected to be superior in explaining firm decisions, such as innovation investments, because it contains rich firm-level information regarding the varying effects of EPU on individual firms. The results reveal a strong positive association between EPU exposure and investments into R&D, which aligns with the growth options theory. However, this effect is not uniform across industries. It greatly affects sectors like consumer non-cyclicals, basic materials, and energy. Moreover, firms with better growth prospects are more influenced by changes in EPU exposure. These findings remain robust across different model specifications. This study contributes to the literature by emphasising the importance of EPU exposure in firm-level decision-making. As one of the first studies in the field to underscore the significance of considering EPU exposure as a way of explaining firm-level innovation investments, this paper also enriches the literature on the role of policy uncertainty in finance.