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R2 Around the World: New Theory and New Tests

Author

Listed:
  • Li JIN

    (Harvard Business School)

  • Stewart C. MYERS

    (MIT Sloan School of Management)

Abstract

Morck, Yeung and Yu (MYY, 2000) show that R2 and other measures of stock market synchronicity are higher in countries with less developed financial systems and poorer corporate governance. MYY and Campbell, Lettau, Malkiel and Xu (2001) also find a secular decline in R2 in the United States over the last century. We develop a model that explains these results and generates additional testable hypotheses. The model shows how control rights and information affect the division of risk-bearing between inside managers and outside investors. Insiders capture part of the firm’s operating cash flows. The limits to capture are based on outside investors’ perception of the value of the firm. The firm is not completely transparent, however. Lack of transparency shifts firm-specific risk to insiders and reduces the amount of firm-specific risk absorbed by outside investors. Our model also predicts that “opaque” stocks are more likely to crash, that is, to deliver large negative returns. Crashes occur when insiders have to absorb too much firm-specific bad news and decide to "give up.". We test these predictions using stock returns from all major stock markets from 1990 to 2001. We find strong positive relationships between R2 and several measures of opaqueness. These measures also explain the frequency of large negative returns.

Suggested Citation

  • Li JIN & Stewart C. MYERS, 2004. "R2 Around the World: New Theory and New Tests," FAME Research Paper Series rp158, International Center for Financial Asset Management and Engineering.
  • Handle: RePEc:fam:rpseri:rp158
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    File URL: http://www.swissfinanceinstitute.ch/rp158.pdf
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    References listed on IDEAS

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    Cited by:

    1. Ding, Yuan & Hope, Ole-Kristian & Jeanjean, Thomas & Stolowy, Herve, 2007. "Differences between domestic accounting standards and IAS: Measurement, determinants and implications," Journal of Accounting and Public Policy, Elsevier, vol. 26(1), pages 1-38.
    2. Shen, Chung-Hua & Chih, Hsiang-Lin, 2005. "Investor protection, prospect theory, and earnings management: An international comparison of the banking industry," Journal of Banking & Finance, Elsevier, vol. 29(10), pages 2675-2697, October.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • N20 - Economic History - - Financial Markets and Institutions - - - General, International, or Comparative

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