Law and Equity Markets: A Simple Model

We analyze how the law and its enforcement affect equity market equilibrium. Improvements in the legal system, while invariably associated with broader equity markets, have different effects on equity returns depending on the institutional change considered and on the degree of international stock market segmentation. The model is useful to interpret the results of recent empirical work, such as La Porta et al. (1997) and Lombardo and Pagano (2000). In particular, it can rationalize the observed cross-country pattern, whereby better institutions are associated both with broader equity markets and higher risk-adjusted returns on equity.