Investor Protection and the Demand for Equity

Investor Protection and the Demand for Equity

Mariassunta Giannetti, Yrjö Koskinen

Series number :

Serial Number: 
064/2004

Date posted :

April 01 2004

Last revised :

SSRN Share

Keywords

  • investor protection • 
  • private benefits of control • 
  • Portfolio Choice • 
  • Home Equity Bias • 
  • Limited Participation

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.

Published in

Published in: 
Publication Title: 
Journal of Financial and Quantitative Analysis
Description: 
Volume 45, Issue 1, pp. 135-168

Authors

Real name:
Yrjö Koskinen