Working Paper: CEPR ID: DP10392
Authors: Bruno Parigi; Loriana Pelizzon; Ernst-Ludwig von Thadden
Abstract: This paper analyzes why corporate governance matters for stock returns if the stock market prices the underlying managerial agency problem correctly. Our theory assumes that strict corporate governance prevents managers from diverting cash flows, but reduces incentives for managerial effort. In capital market equilibrium, this trade-off has implications for the firm's earnings, stock returns, and managerial ownership, because governance impacts the firm's risk-return structure. In particular, the strictness of corporate governance is negatively related to earnings and positively to ß;. Various empirical tests with U.S. data using the governance index of Gompers, Ishii, and Metrick (2003) yield results consistent with these predictions.
Keywords: beta; CAPM; cash flow; corporate governance; stock returns
JEL Codes: G32; G38; K22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Strict corporate governance (G38) | lower managerial ownership (G32) |
| Strict corporate governance (G38) | lower total cash flow (G32) |
| Strict corporate governance (G38) | increases public cash flows (H69) |
| Strict corporate governance (G38) | lower earnings (J31) |
| Increase in cash flow risk (F65) | stricter governance (G38) |
| Increase in cash flow risk (F65) | lower managerial ownership (G32) |