Stock Market Returns and CorporateGovernance in Capital MarketEquilibrium

Why does capital market competition among rms not eliminate control benets by inducing them to adopt more shareholder friendly governance provisions? What determines the heterogeneity of the governance provisions among companies? To address these questions we propose a model that endogenizes the determination of corporate governance quality in the asset pricing framework of the CAPM. The main insight is that if weak governance gives owner/managers some discretionary power it may be optimal for the controlling shareholder to choose a weak governance despite the fact that the market penalizes the stock price of rms that allow for the inecient extraction of control benets. Our model predicts that it is not always optimal to choose tough corporate governance rules and that governance is weaker when stocks have a lower and a lower idiosyncratic risk. We test these propositions on a sample of U.S. companies and nd that higher control benets as measured by the index of Gompers, Ishii, and Metrick (2003) are indeed higher in companies with lower and with lower idiosyncratic volatility.