Investor Protection And Asset Prices
London Business School; Centre for Economic Policy Research (CEPR)
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London School of Economics and Political Science
Purdue University – Krannert School of Management
March 6, 2016
There is substantial empirical evidence that investor protection affects stock returns, volatilities and interest rates. We develop a dynamic asset pricing model to shed light on the empirical regularities and underlying mechanisms at play. Our model features a controlling shareholder who can divert a fraction of the firm’s output. The controlling shareholder’s power over the firm is endogenous and interacts with investor protection in determining the level of expropriation. In equilibrium, imperfect investor protection implies higher stock holdings by controlling shareholders, lower stock returns, higher stock return volatilities and lower interest rates.
Investor Protection And Asset Prices – Introduction
The protection of minority shareholders against expropriation by controlling shareholders is argued to be an important economic factor affecting asset price dynamics. In particular, the empirical literature provides ample evidence that the level of investor protection has economically significant effects on stock mean-returns, stock return volatilities and interest rates, as elaborated below. However, there is continuing discussion on the direction of these effects and the economic mechanism through which investor protection in uences asset prices. The objective of this paper is to shed light on the effects of investor protection on asset prices and to provide theoretical guidance on the direction of these effects. Although there is some work towards that (discussed below), our paper is the first to incorporate investor protection into a dynamic asset pricing model with endogenous accumulation of control power by controlling shareholders (often taken as exogenous in the extant literature) and expropriation. This allows us to address the empirical regularities in asset return dynamics and to provide new predictions.
We consider a dynamic general equilibrium economy with a representative competitive firm that produces an exogenous stream of output. The firm’s stock is owned by two types of shareholders with identical constant relative risk aversion (CRRA) preferences, a minority shareholder and a controlling shareholder who can divert a fraction of the firm’s output for himself. The diverted fraction is constrained by investor protection in the economy. The investor protection constraint limits the scope of available diversion strategies. This constraint becomes tighter with better protection and looser with higher stock holdings that increase the controlling shareholder’s power over the firm. The diversion of output is further tempered by non-pecuniary costs of stealing.
We provide tractable expressions for the equilibrium processes that preserve the structure of their counterparts in the full protection benchmark economy, familiar from the asset pricing literature. However, these expressions additionally incorporate new terms that depend on the controlling shareholder’s stake in the firm and quantify the effects of investor protection. Our expressions are explicit up to the controlling shareholder’s stock holding, which solves a fixed point problem. The fixed-point problem arises because, on one hand, the controlling shareholder’s stake in the firm affects the equilibrium processes via the fraction of diverted output, and on the other hand, the stock holding is itself influenced by the equilibrium processes. We derive the dynamic equilibrium in terms of the minority shareholder’s share in aggregate consumption, which emerges as an endogenous time-varying state variable affecting the relation between investor protection and asset price dynamics by determining whether investor protection constraint binds or not. In general, the effects of investor protection tend to be stronger when the controlling shareholder has a low share of the aggregate consumption and the investor protection constraint binds.
A notable new feature of our model is that the endogenous accumulation of control power by the controlling shareholder makes the fraction of diverted output a hump-shaped function of the shares held by the controlling shareholder. In our model, a higher stock holding increases the control power over the firm which relaxes the investor protection constraint, and the controlling shareholder diverts more as his holding increases. On the other hand, the higher stock holding decreases his incentive to divert. After some point, the investor protection constraint no longer binds and the equilibrium amount of diverted output decreases with the stock holding.
We find that the controlling shareholder’s stock holding is larger in economies with imperfect investor protection than in economies with full protection, consistent with the empirical evidence (e.g., La Porta et al, 1999). Intuitively, poor protection expands the set of diversion strategies and increases the potential gains from higher control power over the firm, which induces buying more shares. However, the relationship between investor protection and optimal stock holdings is non-monotonic and depends on whether the investor protection constraint binds or not. This is because investor protection has two opposing effects on the controlling shareholder’s optimal portfolio decision. An increase in investor protection reduces the marginal benefit of control and hence reduces the incentive to acquire more shares, while on the other hand, makes the investor protection constraint relevant for a wider range of stock holdings thereby providing an incentive to acquire more shares to relax the constraint. The relative importance of these effects depends on the consumption share of the minority shareholder. We also show that the acquisition of shares is financed by leverage, and the leverage-stock price ratio is simply given by the controlling shareholder’s stock holding over and above his holding in the full protection economy.
We demonstrate that the stock mean-return decreases with poor investor protection in equilibrium. This is consistent with the empirical evidence on the relation between the realized stock returns and the degree of corporate governance, entrenchment and managerial perks (e.g., Gompers, Ishii and Metrick, 2003; Bebchuk, Cohen and Ferrell, 2009; Yermack, 2006, among others), although there is an ongoing discussion of the robustness of this relation (Core, Guay and Rusticus, 2006; Giroud and Mueller, 2011; Bebchuk, Cohen and Wang, 2013). We contribute to this discussion by providing a theoretical argument in favor of the positive relation between the stock mean-return and investor protection. Our intuition is that, in contrast to the minority shareholder, the controlling shareholder is compensated for holding risky assets not only by the risk premium but also by the fraction of the diverted output. Therefore, the controlling shareholder hoards shares even if the realized risk premium is low, which drives down the stock mean-return in equilibrium. Following this intuition, we show that the asset holdings of the controlling shareholder are determined by a previously unexplored quantity, which we refer to as the effective risk premium. We decompose the effective risk premium into a conventional risk premium implied by stock price dynamics and an additional term capturing the diverted output per share. In our decomposition the diverted output per share can be interpreted as an adjustment to the dividend that is received by the controlling shareholder.
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