Scientific Beta: Trade policy risk exposure in equity portfolios

August 8, 2023

Shifts in trade policy influence the structure of the economy, creating winners and losers. Trade policy clearly influences the financial performance of firms. Moreover, shifts in trade policy will have heterogeneous effects across such businesses. Some may benefit from a more globalised market via reduced input costs or more export opportunities, while others may benefit from the introduction of protectionist policies via a reduction in foreign competition. A measure that captures the impact of shifts in trade policy on firms is therefore a useful tool for financial market participants and researchers in finance or economics alike.

Measuring the impact of trade policy shifts

In recent research[1], we proposed such a firm-level measure of exposure to trade policy shifts. Our exposure measure is based on firm characteristics used in previous research. It combines the information captured by the tradability of the goods produced by a firm, the share of the output in the firm’s industry that is exported, and the attention given to trade policy in the firm’s official corporate risk disclosures.

Furthermore, we make use of stock market information when constructing the exposure measure. Each of the three characteristics is augmented with a covariance score that captures how similar a stock behaves compared to stocks with a high characteristic score. Adding covariances in the exposure measures allows us to extract information in stock returns that solely characteristics-based measures ignore.

This multi-dimensional exposure measure has the advantage that it is granular and available for all firms. Using a single characteristic to measure exposure would miss important information, because for many firms, characteristics are not available or are not able to discriminate between firms. International trade is complex, so we cannot expect a single data source to capture exposure to shifts in trade policy accurately. Combining characteristics and extracting information from stock returns has the potential to lead to a more reliable measure of exposure. Combining multiple metrics also reduces the impact of noise present in each of them individually.

Research shows reliability

Our research concludes that the measure reliably captures out-of-sample differences in exposure to trade policy shifts across firms.

First, we find that firms with a high exposure according to our measure have a more negative stock price reaction around tariff announcements than firms with a low exposure. This result is both statistically and economically significant, with a 140 bp difference during the week following the announcement, as shown in Figure 1.

Second, in times of rising trade tensions, high exposure firms discuss trade policy with a more negative sentiment than low exposure firms in their quarterly earnings calls. Supportive out-of-sample evidence based on two entirely different data sources strengthens our confidence in the validity of the measure. Moreover, we show that standard firm classifications by size and industry are insufficient to capture such heterogeneity in trade policy exposures and we present evidence both in US and international data.

Figure 1: Stock Price Reaction to Tariff Announcements

The table reports the stock price reaction during the week following tariff announcements for high and low trade policy exposure firms. T-statistics are indicated between brackets.

While the focus of our research is on the measure of exposure to trade policy shifts and its validation, we also discuss a variety of potential applications. The firm-level granularity and reliance on ex-ante available data makes the measure suitable for a wide range of applications. Among others, we expect the measure to be useful for investors who want to manage the trade policy risk exposure in their equity portfolio, or for researchers interested in the economic effects of international trade policy or asset pricing.