Research Article: Asset pricing implications of good governance

Date Published: April 5, 2019

Publisher: Public Library of Science

Author(s): Thorsten Lehnert, Stefan Cristian Gherghina.

http://doi.org/10.1371/journal.pone.0214930

Abstract

In this paper, I aim to explore the effect of good governance on equity returns, and empirically investigate if governance at the country level has asset pricing implications and contributes to the idiosyncrasy of price jumps. Jumps are found to be far less systematic than the smooth (non-jump) component of country price indexes. Hence, if jumps are more idiosyncratic, governance should primarily affect the jump risk component. This is good news for international investors, because diversification provides insurance against jumps. Relying on an equilibrium asset-pricing model in an economy under jump diffusion, I decompose the moments of the returns of international stock markets into a diffusive (systematic) risk and a (idiosyncratic) jump risk part. For a balanced panel of 52 countries, my results suggest that governance is an important determinant of (idiosyncratic) jump risk. Stock markets in poorly governed countries are characterized by higher volatility and more negative return asymmetry, primarily driven by the higher jump risk. Regulatory quality, the government effectiveness and the control of corruption appear to be most important. Results are robust to the inclusion of various controls for other country- or market-specific characteristics.

Partial Text

The work of La Porta et al. [1–3] suggest that the legal environment, as described by both legal rules and their enforcement, matters for the size and extent of a country’s capital markets. Because a good legal environment protects the potential financiers against expropriation by entrepreneurs, it raises their willingness to surrender funds in exchange for securities, and hence expands the scope of capital markets and contributes positively to the development of financial markets. Johnson and Shleifer [4] illustrate the centrality of law enforcement in making financial markets work, and the possible role of regulators in law enforcement. Lombardo and Pagano [5] investigate whether international differences in the quality of government institutions also help explain the international cross-section of expected stock returns. They find that total stock market returns are positively correlated with overall measures of the quality of institutions, such as judicial efficiency and rule of law. They 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. Aggarwal et al. [6] find that fund managers invest less in countries with poor legal environments and low governance standards. Furthermore, Lombardo and Pagano [7] argue that the existence of this superior risk-return relationship for countries with better institutions is supported under international market segmentation providing diversification benefits. Rodríguez-Pose and Garcilazo [8] examine the impact of the quality of local and regional governments on the returns of investment. Their findings suggest that the quality of government is an important determinant of economic growth, but also a key factor determining the returns of public investment. Regions that receive structural funds only experience an improvement in economic growth when the quality of government is significantly enhanced. The findings of Hooper et al. [9] suggest that countries with better-developed governance systems have stock markets with higher returns on equity and lower levels of risk. Hail and Leuz [10] investigate international differences in firms cost of equity capital and analyze whether the effectiveness of a country’s legal institutions and securities regulation is systematically related to cross-country differences in the cost of equity capital. They find that countries with extensive securities regulation and strong enforcement mechanisms exhibit lower levels of cost of capital than countries with weak legal institutions.

In order to decompose stock price risk into a diffusive part and a jump risk part, I rely on the jump-diffusion model in a production economy of Zhang et al. [25]. The price of an asset St (the market portfolio) can be assumed to follow the following process:
dStSt=(rf+ϕ)dt+σdBt+(ex−1)(dNt−λdt)
where rf is the risk-free rate, ϕ represents the excess market return, σ denotes volatility of stock prices, Bt is a standard Brownian motion in R (and dBt the increment), Nt is a Poisson process with constant intensity λ (and dNt the increment) and jump size x. The arrival of jumps follows a Poisson process, which has E(dNt) = λdt with arrival intensity λ≥0. (ex−1) is the relative jump size of the rare event.

In my empirical analysis, I aim to investigate the relationship between governance and diffusive/jump risk in international stock markets. Based on daily data, the model parameters (μ,σ,λ,x) are estimated for each country and for each year, separately. Hence, I construct a measure of total return volatility (TOTALRISK) for country i’s stock market in year t, that is a combination of diffusive risk and jump risk
TOTALRISKi,t=σi,t2+λi,txi,t2

Governance or the management of government institutions varies substantially across countries. The literature suggests that good governance has a positive effect on the development of financial markets and equity returns, in particular; it lowers equity volatility and, therefore, the costs of equity financing. However, previous literature provides little guidance about asset pricing implications of governance. Additionally, the international nature of price jumps in stock markets and its relationship with country characteristics is not well understood. Price jumps are prevalent in stock markets all over the world, but jumps are found to be far less systematic than the smooth (non-jump) component of country price indexes. Hence, if jumps are more idiosyncratic, governance should primarily affect the jump risk component of stock market volatility. This is good news for international investors, because diversification provides insurance against jumps. Relying on an equilibrium asset-pricing model in an economy under jump diffusion, I decompose the moments of the returns of international stock markets into a diffusive (systematic) risk and a (idiosyncratic) jump risk part. Using stock market data for a balanced panel of 52 countries, my results suggest that the regulatory quality, the government effectiveness and the control of corruption are important determinant of (idiosyncratic) jump risk. Stock markets in poorly governed countries are characterized by higher volatility and more negative return asymmetry, primarily driven by the higher jump risk. Results are robust to the inclusion of various controls for other country- or market-specific characteristics. Therefore, my results lend further support for the view that a precondition for financial market development is the improvement of the government institutions.

 

Source:

http://doi.org/10.1371/journal.pone.0214930

 

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