R-Squared Around the World: New Theory and New Tests

Stewart C. Myers, Li Jin
2005 Social Science Research Network  
Morck, Yeung and Yu (2000) show that R 2 and other measures of stock market synchronicity are higher in countries with less developed financial systems and poorer corporate governance. We develop a model that explains these results and generates additional testable hypotheses. The model shows how control rights and information affect the division of risk bearing between inside managers and outside investors. Insiders capture part of the firm's operating cash flows. The limits to capture are
more » ... to capture are based on outside investors' perception of the value of the firm. The firm is not completely transparent, however. Lack of transparency shifts firm-specific risk to insiders and reduces the amount of firm-specific risk absorbed by outside investors. Our model also predicts that "opaque" stocks are more likely to crash, that is, to deliver large negative returns. Crashes occur when insiders have to absorb too much firm-specific bad news and decide to give up. We test these predictions using stock returns from 40 stock markets from 1990 to 2001. We find strong positive relations between R 2 and several measures of opaqueness. These measures also explain the frequency and magnitude of large negative returns. JEL classification: G12, G14, G15, G38, N20
doi:10.2139/ssrn.531263 fatcat:67wsybyuajcvla673txajjjeze