Investor Protection and Value Impact of Stock Liquidity

Abstract

Despite recent theories on the link between financial market efficiency and real economic efficiency, not much evidence exists in international finance that addresses how investor protection strengthens the connection between the two efficiencies. Our study examines this important issue on a broad sample of firms from 41 countries for the period 1996-2010. We demonstrate that better investor protection is associated with greater value impact of stock liquidity. The observed relationship is mainly driven by the effect of investor protection on the growth of future cash flows rather than the reduction in the cost of capital. We use the enforcement of Market Abuse Directive (MAD) among European member countries as an exogenous shock to country-level investor protection and find that value impact of stock liquidity tends to be stronger after the MAD enforcement. Further analysis explores the many explanations for the role of investor protection. We find evidence consistent with strong investor protection inducing low levels of managerial entrenchment, high levels of informed trading and strong linkage of executive pay with performance. Finally, our analysis suggests that financial market integration attenuates the importance of country-specific investor protection to the firm value sensitivity to liquidity.