Working Paper: CEPR ID: DP2275
Authors: Davide Lombardo; Marco Pagano
Abstract: Recent work documents that better legal institutions are associated with broader equity markets. We investigate whether international differences in legal institutions also help explain the international cross-section of expected stock returns. We document three main regularities. First, total stock market returns are positively correlated with overall measures of the quality of institutions, such as judicial efficiency and rule of law, but have no relationship with measures of shareholder rights, controlling for risk. Second, dividend yields and earning-price ratios also correlate positively with judicial efficiency and rule of law, but negatively with shareholder rights' protection, controlling for risk and expected earnings growth. Thirdly, the excess return on new issues is negatively associated with the quality of accounting standards. We interpret the positive effect of the overall quality of institutions on equity returns as capturing the resulting curtailment of private benefits and increase of profitability, under imperfect international integration of stock markets. The negative impact of shareholders' legal protection and of accounting standards can instead be seen as resulting from the implied reduction in shareholders' auditing and monitoring costs.
Keywords: law enforcement; shareholder protection; corporate governance; return on equity
JEL Codes: G12; K22; K42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| judicial efficiency (K41) | stock returns (G12) |
| rule of law (K15) | stock returns (G12) |
| judicial efficiency (K41) | dividend yields (G35) |
| judicial efficiency (K41) | earnings-price ratios (G12) |
| shareholder rights protection (G38) | dividend yields (G35) |
| shareholder rights protection (G38) | earnings-price ratios (G12) |
| quality of accounting standards (M48) | excess return on new issues (G12) |