Stock Prices in the Presence of Liquidity Crises: The Effect of Creditor Protection

type="main" xml:id="ecca12072-abs-0001"> <p>We develop a model predicting two channels through which creditor protection affects stock prices: (1) the probability of a liquidity crisis leading to a binding investment-finance constraint falls with better creditor protection; (2) the stock prices under the investment-constrained regime increase with better creditor protection. We find evidence for both predictions using data on stock markets and creditor protection for 52 countries from 1980 to 2008. In particular, better creditor protection is correlated with lower stock market volatility and lower frequency of crises. Moreover, during crises, stock prices and investment fall more in countries with poor creditor protection.