DP13472 Investor Protection and Asset Prices
Empirical evidence suggests that investor protection has significant effects on 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 who 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.