Creditor Protection and Stock Price Volatility

This paper analyzes the effect of creditor protection on the volatility of stock market returns. Our application of the Tobin’s q model predicts that credit protection reduces the probability of oscillations between binding and nonbinding states of the credit constraint, which result from liquidity crises and their aftermath. In this way creditor protection regulation reduces the stock market price volatility. We test this prediction by using cross-country panel regressions of the stock return volatility, in 40 countries, over the period from 1984 to 2004. Estimated probabilities of big shocks to liquidity are used as a forecast of a switch from a credit–unconstrained to a credit-constrained regime. We find support for the hypothesis that creditor protection institutions reduce the probability of oscillations between binding and nonbinding states of the credit constraint and thereby help reduce the asset price volatility.