Asset Prices with Investor Protection in the Cross-Sectional Economy

In this study, we examine a dynamic asset pricing model in an economy with investor protection and cross-sectional stock returns of two firms. Our model takes into account the influence of a controlling shareholder who can divert a fraction of output in one firm with imperfect protection for minority shareholders, but is unable to do so in the other firm. Through analyzing the consumption-portfolio choices of shareholders and the asset price dynamics, our model highlights the joint effects of investor protection and cross-section. Our numerical results align with existing empirical evidence. With regards to investor protection, the cross-sectional economy yields positive investor protection premiums relative to the controlling shareholder’s stock holdings and stock volatilities, and comparison with perfect protection reveals that poorer protection tends to result in an increase in the controlling shareholder’s stock holdings in the firm with imperfect protection and a simultaneous decrease in the other firm, and an increase in stock volatilities in the firm with imperfect protection and a simultaneous decrease in the other firm, as well as a decrease in interest rates. On the other hand, comparison with independent correlation between two firms shows that positive (resp. negative) correlation produces higher (resp. lower) premiums relative to the controlling shareholder’s stock holdings and stock volatilities, and tends to reduce the protection of minority shareholders, increase the controlling shareholder’s stock holdings in the firm with imperfect protection and simultaneously decrease (resp. increase) his stock holdings in the other firm, increase stock volatilities in the firm with imperfect protection and simultaneously decrease (resp. increase) stock volatilities in the other firm, and decrease (resp. increase) interest rates.