Governance, Liquidity and Adverse Selection in Asset Pricing

Abstract

Gompers, Ishii and Metrick (2003) and other researchers found significant evidence for governance related premia explaining stock returns. We hypothesize bad governance leads to information asymmetry which in turn leads to illiquidity of stocks. Thus governance characteristics are just a proxy for information asymmetry that is better captured by the liquidity and adverse selection component of a company’s shares. Companies governed by managers who are not embracing shareholder rights will attract fewer investors and, hence, have less liquid stocks and more adverse selection costs. In a series of standard asset pricing tests we examine the joint effect of governance and liquidity on the asset pricing paradigm and we find that liquidity and information asymmetry premia dominate the governance effect. Hence, we show that governance characteristics are priced. But this holds only as long as liquidity and adverse selection factors are not taken into account. Our results are robust to different proxies for liquidity and governance.