Winner
of the 2005 FAME Research Prize Authors Li
JIN, Harvard Business School Stewart C. MYERS, MIT Sloan School of Management
Date February
2004
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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.
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