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This study analyzes a time-varying relationship between corporate governance and expected stock returns. Based on an assumption that expected returns of portfolios sorted by the corporate governance rating are regime-dependent, my goal is to seek an optimal switching investment strategy that outperforms a simple buy-and-hold investment. The optimal investment strategy is further analyzed whether combing with value and momentum risk factors can improve the returns to investors. The motivation for this research stems from mixed results of the previous researches regarding the influence of the quality of firms’ corporate governance on operating performance and valuation. It’s intuitive to presume that good governance at a firm positively affects its operating profits and value creation to investors. This theory is in line with the conclusion of Gompers et al. (2003), Drobetz et al. (2004), Bebchuk et al. (2008), Ammann et al. (2011). On the contrary, Core et al. (2006) and Bhagat and Bolton (2008) claim that, while weak shareholder rights lead to a lower operating outcome, they do not cause poor stock returns and governance measures are not correlated with future stock returns. Core et al. (2006) argue that a positive relationship between corporate governance and stock performance is rather period-specific, which hints that expected returns from corporate governance are non-linear and a regime-switching model may be a better fit. The results of Bauer et al. (2003) also indicate that good corporate governance does not necessarily increase firm value, and depending on the tested year, the relationship can be negative. Time-varying returns are captured by Markov switching model, which the previous researches suggest its capability of fitting well-documented risk premiums such as size, value, and momentum. Markov switching model is hypothesized to be applicable for tracing the relationship between corporate governance and its expected returns. Unstable, or time-varying stock returns can be attributable to a change in a macroeconomic environment. Following Chen et al. (1986) who argue that stock returns are not captured by a standard CAPM but rather by macroeconomic variables, numerous studies attempt to find out whether the excess returns from the size, value, and momentum Abstract

Time-varying relationship between corporate governance and expected stock returns