R-squared around the world

NBER WORKING PAPER SERIES

R-SQUARED AROUND THE WORLD: NEW THEORY AND NEW TESTS Li Jin Stewart Myers Working Paper 10453 http://www.nber.org/papers/w10453 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 April 2004

We thank Toby Moskowitz, Rene Stulz, Robert Taggart and Sheridan Titman for helpful comments, and the Research Computing Services Group atHarvard Business School, especially James Zeilter, for help with obtaining and understanding the data used in this paper. Anna Yu and Alvaro Vivanco provided helpful research assistance. The views expressed herein are those of the author(s) and not necessarily those of the National Bureau of Economic Research. ©2004 by Li Jin and Stewart Myers. All rights reserved. Short sections of text, not to exceedtwo paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

R-Squared Around the World: New Theory and New Tests Li Jin and Stewart Myers NBER Working Paper No. 10453 April 2004 JEL No. G12, G14, G15, G38, N20 ABSTRACT Morck, Yeung and Yu (MYY, 2000) show that R2 and other measures of stock market synchronicity are higher incountries with less developed financial systems and poorer corporate governance. MYY and Campbell, Lettau, Malkiel and Xu (2001) also find a secular decline in R2 in the United States over the last century. 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 betweeninside managers and outside investors. Insiders capture part of the firm's operating cash flows. The limits 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 all major stock markets from 1990 to 2001. We find strong positive relationships between R2 and several measures of opaqueness. These measures also explain thefrequency of large negative returns. Li Jin Harvard Business School ljin@hbs.edu Stewart C. Myers Sloan School of Management MIT, Room E52-451 50 Memorial Drive Cambridge, MA 02142-1347 and NBER scmyers@mit.edu

1. Introduction Morck et al. 2000 show that R2 and other measures of stock-market synchronicity are higher in countries with relatively low per-capita GDP and less-developed financial systems.MYY and Campbell et al. 2001 also find a secular decline in R2s in the United States over the last century. These are intriguing and important results, which suggest that we may be able to learn about corporate finance and governance not just from the level of stock prices, or from short-term event studies, but also from the second or higher moments of stock returns. Of course there are manypossible explanations for the inverse relationship between financial development and R2s, explanations that have nothing to do with corporate finance or governance. The pattern of R2s could reflect higher macroeconomic risk or lack of diversification across industries in smaller, less-developed countries. MYY control for such effects assiduously. The cross-country pattern in R2s remains. MYY proposethat differences in protection for investors’ property rights could explain the connection between financial development and R2. MYY are on the right track, but it turns out that imperfect protection for investors does not affect R2 if the firm is completely transparent. Some degree of opaqueness (lack of transparency) is essential. We show how limited information affects the division of...