Trading on political event strategy. Firms located in states that are politically closely aligned with the President outperform those located in states aligned with the opposition on a risk-adjusted basis by about 27 basis points per month. This is a sizeable effect, considering that the zero-net investment strategy that yields this return requires that portfolios be rebalanced only every 2 years following presidential and midterm elections. The PAI effect becomes even larger (up to 44 basis points) when we experiment with alternative variants of the PAI measure. We find that the PAI effect is greater among smaller firms, and when Democrats control the White House, after midterm elections, and after elections that did not result in a new President. The mechanisms that can cause the PAI effect can be rooted in firms' ability to exploit advantages from political connectedness and/or in greater policy risk associated with proximity to political power. We devise a number of alternative tests to assess the relative importance of these mechanisms. Overall, although we cannot rule-out the possibility that firms in high PAI areas enjoy greater connectedness advantages, we interpret our evidence as consistent with the notion that proximity to political power is important for stock returns in that it may reflect firms' exposure to policy risk. Question. What is the potential risk and limitations of this strategy? Can the risk be hedged? What are alternative ways to replicate the returns of this strategy?

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The potential risks and limitations of trading on a political event strategy include Uncertainty and Volatility Political events can be highly unpredictable and their outcomes may have significant and ... View the full answer