Credit Constraints and Stock Price Volatility

Galina Hale, Assaf Razin, Hui Tong

NBER Working Paper No. 13089
Issued in May 2007
NBER Program(s):   IFM

This paper addresses how creditor protection affects the volatility of stock market prices. Credit protection reduces the probability of oscillations between binding and non-binding states of the credit constraint; thereby lowering the rate of return variance. We test this prediction of a Tobin's q model, by using cross-country panel regression on stock price volatility in 40 countries over the period from 1984 to 2004. Estimated probabilities of a liquidity crisis are used as a proxy for the probability that credit constraints are binding. We find support for the hypothesis that institutions that help reduce the probability of oscillations between binding and non-binding states of the credit constraint also reduce asset price volatility.

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Acknowledgments

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