Is There a Cost to Poor Institutions?

This paper uses a data set of industry-level equity returns from both developed and emerging markets to investigate whether the quality of the institutional environment - recently shown to affect capital markets' size - also affects the expected return on equity. The paper documents that the required rate of return on equity is negatively associated with the enforceability of contracts and the impartiality and observance of the law, while it is positively associated with corruption and risk of expropriation. The paper also shows that institutions affect the expected return on equity independently of their impact on equity's financial risk, as measured by its covariance with the world market portfolio. The results are robust to important sources of model misspecification, like unexplained country-specific as well as industry-specific risk factors.