Investor Protection and Asset Prices

Abstract

Empirical evidence suggests that investor protection significantly affects ownership concentration and asset prices. We develop a dynamic asset pricing model to address the empirical regularities and uncover some of the underlying mechanisms at play. Our model features a controlling shareholder that endogenously accumulates control over a firm, and diverts a fraction of its output. Better investor protection decreases stock holdings of controlling shareholders, increases stock mean returns, and increases stock return volatilities when ownership concentration is sufficiently high, consistent with the related empirical evidence. The model also predicts that better protection increases interest rates and decreases the controlling shareholder’s leverage. Received August 14, 2017; editorial decision January 15, 2019 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Asset Prices with Investor Protection and Survival Analysis of Shareholders in the Cross-Sectional Economy

“…Controlling shareholders who dominate corporations in many countries can benefit from diverting resources, and hence it is of much significance to protect minority shareholders and study the effect of such investor protection on ownership concentration and asset prices. In [6], Basak et al develop a dynamic continuous-time model where a controlling shareholder dominates a firm and diverts a fraction of its output and where shareholders' consumption-portfolio choice and equilibrium asset prices are derived with myopic preferences. Their theory features the effect of investor protection on the firm ownership concentration, stock returns and volatilities, interest rates and so on.…”

“…Their theory features the effect of investor protection on the firm ownership concentration, stock returns and volatilities, interest rates and so on. As for the economy with an additional firm and different levels of investor protection, their research adopts a simpler, one-period model because of "additional hedging demands in shareholder portfolios, nonlinear differential equations for value functions, and the non-convexity of the controlling shareholder's portfolio optimization" (see Subsection 5.3 in [6]). As is showed in the empirical evidence (see, for instance, [14]), the effect of investor protection on firm stock returns is largely cross-sectional.…”

“…They find in equilibrium that the relation between the stock price and investor protection is nonmonotonic and that with same wealth distribution, the country with better investor protection has less concentrated ownership and higher security returns (i.e., stock returns and interest rates). Basak et al [6] solve both the controlling shareholder's and the minority shareholder's consumption-portfolio problems in equilibrium, and draw a conclusion that better investor protection results in lower stock holdings of controlling shareholders, higher stock returns and volatilities, and higher interest rates. For more literature related to investor protection, one can refer to [7,18,31] for static models and [19,25] for dynamic models.…”

“…The equilibria are Markovian in two state variables including consumption shares, and the analysis of equilibrium shows that consumption shares would affect stock return correlations and volatilities, but the effect is complex and differs from conditions. For more related literature, one can also refer to [6,12,13]. For another, since there exist different firms in the cross-sectional economy, empirical evidence shows that firm stocks differ from market capitalization of firms.…”

“…From above researches, not only is investor protection theoretically studied and empirically examined in corporate finance, but the cross-sectional economy with multiple stocks are also adopted in investors' consumption-portfolio problems. Therefore, just like the economy with a single firm in [6], it is of significance to establish a dynamic continuous-time model for a cross-sectional economy (where the word "cross-sectional" is adopted form [6,21]) and then address the related effect of investor protection and cross-section. In order to establish an economy which accounts for investor protection and cross-section, we develop a dynamic continuous-time model based on the model used in [6].…”