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The Impact of Credit Protection on Stock Prices in the Presence of Credit Crunches

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Author Info
Galina Hale
Assaf Razin
Hui Tong

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Abstract

Data show that better creditor protection is correlated across countries with lower average stock market volatility. Moreover, countries with better creditor protection seem to have suffered lower decline in their stock market indexes during the current financial crisis. To explain this regularity, we use a Tobin q model of investment and show that stronger creditor protection increases the expected level and lowers the variance of stock prices in the presence of credit crunches. There are two main channels through which creditor protection enhances the performance of the stock market: (1) The credit-constrained stock price increases with better protection of creditors; (2) The probability of a credit crunch leading to a binding credit constraint falls with strong protection of creditors. These mechanisms are consistent with the patterns observed in the cross-country data. We find that except for OECD countries with low creditor protection, stock market return is negative in the crisis years and positive in non-crisis years.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15141.

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Date of creation: Jul 2009
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Handle: RePEc:nbr:nberwo:15141

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F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
G0 - Financial Economics - - General

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This page was last updated on 2009-11-25.

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