Institutional Weakness and Stock Price Volatility

We establish an empirical regularity that a weak creditor protection index is associated with high stock price volatility. Using a standard Tobin Q model we demonstrate two distinct mechanisms that are responsible for increased volatility: credit guarantees and weak creditor protection that tightens credit constraints. In a panel of OECD and non OECD countries we attempt to identify the effects of these distinct mechanisms on stock price volatility while taking explicit account of events of financial crises. We find that both mechanisms are responsible for the stock price volatility in the data.