Legal institutions and international equity markets

Recent empirical work by La Porta, Lopez-de-Silanes, Shleifer and Vishny emphasizes that key determinants of the size of a country's capital markets are its legal rules and the effectiveness of their enforcement. This dissertation investigates whether the law and finance approach to corporate governance can also help improve our understanding of international stock returns, a goal that has so far proved elusive for the Capital Asset Pricing Model (CAPM). A theoretical framework is first introduced that departs from the perfect-markets assumption of the classical CAPM to analyze the effects of the efficiency of the judicial system or the legal protection of investors' property rights on the equilibrium of the equity market. These institutions influence the supply of equity (to the extent that they affect the costs that shareholders must bear to monitor and audit management and enforce their claims through the courts). They also affect firms' demand for equity financing, as more efficient institutions boost the marginal productivity of physical capital.; We then investigate whether the observed risk-adjusted return differentials across countries—usually taken as prima facie evidence for equity markets' segmentation—can be explained with different enforcement costs for minority shareholders resulting from different legal and judicial institutions. We document that countries with more investor-friendly institutional environments have higher (as opposed to lower) risk-adjusted expected rates of return. We interpret this finding as strong evidence that the causes for segmentation among national equity markets are not confined to differences in the degree of protection of shareholders' rights.; Finally, we use a panel of industry-level data to identify econometrically the effect of institutions on the risk-adjusted expected return on equity, controlling for unexplained country effects and industry effects. We document that investors demand a significantly lower expected return following improvements in the quality of the institutional environment.