Asset pricing implications of good governance

Area of Science:

• Financial Economics
• International Finance
• Political Economy

Background:

• Country-level governance influences financial markets, but its impact on asset pricing, particularly jump risk, remains underexplored.
• Price jumps in stock markets are often idiosyncratic, suggesting that country-specific factors, like governance, may play a significant role.

Purpose of the Study:

• To investigate the effect of good governance on equity returns and asset pricing implications at the country level.
• To determine if country governance contributes to the idiosyncrasy of stock market price jumps.

Main Methods:

• An equilibrium asset-pricing model under jump diffusion is employed to decompose international stock market returns.
• The study analyzes a balanced panel of 52 countries, examining the relationship between governance indicators and return moments.
• Key governance metrics include regulatory quality, government effectiveness, and control of corruption.

Main Results:

• Good governance is a significant determinant of idiosyncratic jump risk in equity markets.
• Poorly governed countries exhibit higher stock market volatility and more negative return asymmetry, primarily due to elevated jump risk.
• Regulatory quality, government effectiveness, and control of corruption are identified as the most impactful governance factors.

Conclusions:

• Country-level governance has direct asset pricing implications, specifically influencing the idiosyncratic jump risk component of equity returns.
• International investors can benefit from diversification as insurance against jumps, particularly in markets with weaker governance.
• Strengthening governance, especially regulatory quality and corruption control, can enhance market stability and reduce idiosyncratic risk.