Corporate Governance and the Variability of Stock Returns

Abstract

Purpose - The purpose of this paper is to analyze the impact of firm level corporate governance practices on the riskiness of a firm’s stock returns. Design/methodology/approach - We construct an index of governance quality incorporating best practices stipulated by regulators. We employ regression analysis.

Findings - Our empirical evidence, using an index of corporate governance, shows that well-governed New Zealand firms experience lower levels of risk, ceteris paribus. In particular, our results indicate that corporate governance aspects such as board composition, shareholder rights, and disclosure practices are associated with lower levels of risk.

Research limitations/implications - A limitation of our study is that the corporate governance index constructed is somewhat arbitrary and due to limitation of data availability we may have excluded some factors such as share trading policy of directors and policies regarding provision of non-auditing services by auditors.

Our research supports the view that institutional context could have an impact on governance outcomes. Our work has three implications for managers, investors and policy makers. Firstly, our results imply that well-governed firms have lower idiosyncratic risk and that this reduction is most likely due to the reduction in agency costs and information risk. Secondly, in the absence of features like an active corporate control market and stock option based managerial compensation, managers have little incentives to take on risky projects that increase firm value. Thirdly, our results suggest that the managers of well governed firms are not more risk averse with respect to investment decisions compared to poorly governed firms.

Practical implications - Our work has practical implications for managers, investors and policy makers. Well-governed firms face lower variability in stock returns compared to poorly governed firms. Firms that have independent boards that protect its shareholders’ rights and disclose its governance related policies experience lower firm-level risk, other things being equal.

Originality/value - Our study is the first one to examine the impact of a composite measure of corporate governance quality on stock return variability in a non-US setting. Our results suggest that firms can use specific corporate governance provisions to mitigate firm level risk. The findings of our paper are therefore relevant and useful to corporate managers, investors and policy makers.

Keywords: Corporate governance, Stock return variability, New Zealand