CORPORATE GOVERNANCE QUALITY AND STOCK RETURN VOLATILITY: A REVIEW OF PAKISTANI CONTEXT

Abstract

While corporate governance is an important factor in explaining overall firm performance and capital market stability in emerging markets, the association between it and the volatility of stock returns has not been properly studied in Pakistan. This paper brings together the theoretical underpinning and empirical evidence of how the mechanisms of good governance affect the stock price movements and especially the institutional novelty of Pakistan. Based on the agency theory, information asymmetry theory, signaling theory and institutional theory, we construct a conceptual model linking the three dimensions of governance quality – board independence, audit committee effectiveness, ownership concentration, disclosure quality and managerial accountability to realized and idiosyncratic stock volatility. The Pakistani capital market has a unique environment in which governance and volatility relationships can be studied, as it is owned by the concentrated family, has poor minority shareholder protection, has weak regulatory development, is politically uncertain, and has information asymmetry. This paper highlights the need of critical research gaps, offers rigorous methodological framework (dynamic panel estimation and instrumental variables analysis to deal with the issue of endogeneity) as well as outlining practical implications for the Securities and Exchange Commission of Pakistan, Pakistan Stock Exchange, boards of directors, institutional investors and policymakers. A higher level of corporate governance quality should help lower the volatility of stock returns as a result of lowering the information asymmetry, increasing the transparency of disclosure, improving the monitoring mechanisms and communicating the firm's credibility to capital market participants. The paper provides a valuable addition to the burgeoning governance literature from the EMGs by critically combining governance theory with institutional analysis pertinent to the Pakistan context, to examine the potential and constraints of formal governance structures in weak enforcement environments. Future research should explore governance quality indices instead of governance mechanisms, explore ownership structure as a moderator and comparative South Asian analyses to build understanding of the effectiveness of governance in frontier markets.