New Perspectives on the Modern Corporation series
Edited by Per-Olof Bjuggren and Dennis C. Mueller
Chapter 8: The Cost of Legal Uncertainty: The Impact of Insecure Property Rights on Cost of Capital
Per-Olof Bjuggren and Johan E. Eklund* INTRODUCTION 1. In the required rate of return on investments a special risk premium labeled institutional risk should be included. Different countries represent institutional risks for investors. It is various risk factors tied to the institutional framework that give the rules of the game facing investors. The rules can be of a supportive nature or make long-term investments hazardous due to the lack of secure property rights. It is more or less evident that investors must use a higher discount rate in evaluations of investments in countries where property rights are weakly protected. How to account for the political risk has not received much attention in the finance literature, even though the concept ‘political risk’ is sometimes mentioned. However, a formal treatment is not offered. An exception is Faure and Skogh (2003), who have shown how ‘political risk’ can be incorporated in investment analysis. It is their approach that has inspired this chapter. But it is one thing to propose the necessity to add an ‘institutional risk premium’ and another thing to prove the existence of such risk premiums and estimate their size. One reason why few attempts have been made so far is the difficulty of empirically quantifying and pricing institutional risk. The purpose of this chapter is to show the existence of property risk premiums and measure their magnitude. As measures of institutional risk we use two indexes; one on property right protection provided by the Heritage Foundation, and one on investor...
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