This website uses cookies to help us give you the best experience when you visit our website. By continuing to use this website, you consent to our use of these cookies.
Read more
Anecdotal evidence suggests that investor protection affects the demand for equity, but existing theories emphasize only the effect of investor protection on the supply of equity. We build a model showing that the demand for equity is important in explaining stock market development.
If the level of investor protection is low, wealthy investors have an incentive to become controlling shareholders, because they can earn additional benefits by expropriating outside shareholders. In equilibrium, since the market price reflects the demand from both controlling and outside shareholders, the stock price of weak corporate governance stocks is not low enough to fully discount the extraction of private benefits. This generates the following empirical implications. First, stocks have lower expected return when investor protection is weak. Second, differences in stock market participation rates across countries, home equity bias and flow of foreign direct investment depend on investor protection. Finally, we uncover a good country bias in investment decisions as portfolio investors from countries with low level of investor protection hold relatively more foreign equity. We provide novel international evidence on stock market participation rates, and on holdings of domestic and foreign stocks consistent with the predictions of the model.
Better access to debt markets mitigates the effects of uncertainty on corporate policies. We establish this result using the staggered introduction of...