The impact of creditor protection on stock prices in the presence of credit crunches

A Tobin q model of investment is used to 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. ; The paper tests the predictions of the model by using cross–country panel regressions of stock market returns in 40 countries over the period from 1984 to 2004 at an annual frequency. We find broad empirical support for the prediction of the model that creditor protection increases the expected level of the stock market price level and reduces its volatility, both directly and indirectly, by lowering the probability of credit crunches.