Why Does Investor Protection Matter for the Cost of Equity?

Abstract

Investor protection matters for the cost of equity because it affects the redistribution of wealth from investors to other agents in the economy. This wealth redistribution shifts systematic risk to investors, which can not be eliminated by portfolio diversification or risk sharing through trade. Other country specific factors that affect output can be shared by international trade, which provides justification for the emphasis of the literature on investor protection in explaining cross-country differences in the cost of equity. The theory predicts that the effect of redistribution on the cost of equity is stronger in countries with larger GDP and higher GDP growth volatility. The empirical evidence shows that the effect of redistribution on the cost of equity is economically significant even across developed countries that are relatively well integrated to world markets. In addition, redistribution theory connects several seemingly unrelated international finance puzzles.