DP6310 Credit Constraints and Stock Price Volatility

Author(s):	Galina B Hale, Assaf Razin, Hui Tong
Publication Date:	May 2007
Keyword(s):	binding credit constraints, liquidity crises, Tobin-q investment model
JEL(s):	E4, F3, G0
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=6310

This paper addresses how creditor protection affects the volatility of stock market prices. Credit protection reduces the probability of oscillations between binding and non-binding states of the credit constraint; thereby lowering the rate of return variance. We test this prediction of a Tobin?s q model, by using cross-country panel regression on stock price volatility in 40 countries over the period from 1984 to 2004. Estimated probabilities of a liquidity crisis are used as a proxy for the probability that credit constraints are binding. We find support for the hypothesis that institutions that help reduce the probability of oscillations between binding and non-binding states of the credit constraint also reduce asset price volatility.