Investor Protection and Asset Pricing∗

Corporations in most countries are run by controlling shareholders, who have substantially smaller cash flow rights than their control rights in the firm. This separation of ownership and control allows the controlling shareholders to pursue private benefits at the cost of outside minority investors by diverting resources away from the firm and distorting corporate investment and payout policies. We develop a dynamic stochastic general equilibrium asset pricing model that acknowledges the implications of agency conflicts through imperfect investor protection on security prices. We show that countries with weaker investor protection have lower market to book equity values, larger expected equity returns and return volatility, and higher interest rates. These predictions are consistent with empirical findings. We develop a new prediction that for relative risk aversion larger than unity countries with weaker investor protection have larger dividend yields. Finally, the utility cost of weak investor protection is shown to be economically large. JEL Classification: G12, G31, G32, G34.