Agency Conflicts, Macroeconomic Risk, and Asset Prices

Abstract

This paper studies the implications of changes in the balance of power between insiders and outside investors on the cost of equity. Agency costs generated can be inferred from governance decisions, and powerful insiders are viewed as costly. Outside investors dislike firms that give more power to insiders in bad times because it amplifies stock volatility at the business cycle frequency. To show this, I propose a consumption-based corporate finance model with time-varying governance policies and, using U.S. firms from 1990-2006, empirically test it with commonly used measures of corporate governance. A portfolio that buys firms with the highest differences and shorts firms with the lowest differences in governance quality in bad versus good times generates an annualized abnormal return of more than 6%. Causal analysis and out-of-sample tests consolidate this finding.