International Journal of Managerial Finance

Corporate governance and the variability of stock returns

Hardjo Koerniadi Chandrasekhar Krishnamurti Alireza Tourani-Rad

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Article information:
To cite this document:
Hardjo Koerniadi Chandrasekhar Krishnamurti Alireza Tourani-Rad , (2014),"Corporate governance and the
variability of stock returns", International Journal of Managerial Finance, Vol. 10 Iss 4 pp. 494 - 510
Permanent link to this document:
http://dx.doi.org/10.1108/IJMF-08-2012-0090
Downloaded on: 02 May 2016, At: 00:12 (PT)
References: this document contains references to 47 other documents.
To copy this document: permissions@emeraldinsight.com
The fulltext of this document has been downloaded 1260 times since 2014*

Users who downloaded this article also downloaded:

(2014),"The relationship between ownership structure, capital structure and corporate governance practices:
A case study of co-operatives and mutuals in New Zealand", International Journal of Managerial Finance,
Vol. 10 Iss 4 pp. 511-536 http://dx.doi.org/10.1108/IJMF-12-2012-0130
(2014),"The impact of cash conversion cycle on firm profitability: An empirical study based on Swedish
data", International Journal of Managerial Finance, Vol. 10 Iss 4 pp. 442-452 http://dx.doi.org/10.1108/
IJMF-12-2013-0137
(2014),"Portfolio revision and optimal diversification strategy choices", International Journal of Managerial
Finance, Vol. 10 Iss 4 pp. 537-564 http://dx.doi.org/10.1108/IJMF-07-2012-0085

Access to this document was granted through an Emerald subscription provided by emerald-srm:551360 []

For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for
Authors service information about how to choose which publication to write for and submission guidelines
are available for all. Please visit www.emeraldinsight.com/authors for more information.

About Emerald www.emeraldinsight.com

Emerald is a global publisher linking research and practice to the benefit of society. The company
manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as
providing an extensive range of online products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee
on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive
preservation.
*Related content and download information correct at time of download.

The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1743-9132.htm

IJMF
10,4

Corporate governance and the

variability of stock returns

494

Finance Department, Auckland University of Technology,

Auckland, New Zealand

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Hardjo Koerniadi
Received 7 August 2012
Revised 27 February 2013
22 May 2013
5 August 2013
3 September 2013
2 October 2013
Accepted 11 October 2013

Chandrasekhar Krishnamurti
Finance Discipline, University of Southern Queensland, Toowoomba,
Australia, and

Alireza Tourani-Rad
Finance Department, Auckland University of Technology, Auckland,
New Zealand
Abstract
Purpose The purpose of this paper is to analyze the impact of firm-level corporate governance
practices on the riskiness of a firms stock returns.
Design/methodology/approach The authors constructed an index of governance quality
incorporating best practices stipulated by regulators. The authors employed regression analysis.
Findings The empirical evidence, using an index of corporate governance, shows that well-governed
New Zealand firms experience lower levels of risk, ceteris paribus. In particular, the results indicate that
corporate governance aspects such as board composition, shareholder rights, and disclosure practices are
associated with lower levels of risk.
Research limitations/implications A limitation of the study is that the corporate governance
index constructed is somewhat arbitrary and due to limitation of data availability the authors may
have excluded some factors such as share trading policy of directors and policies regarding provision
of non-auditing services by auditors. The research supports the view that institutional context could
have an impact on governance outcomes. The work has three implications for managers, investors,
and policy makers. First, the results imply that well-governed firms have lower idiosyncratic risk and
that this reduction is most likely due to the reduction in agency costs and information risk. Second, in
the absence of features like an active corporate control market and stock option based managerial
compensation, managers have little incentives to take on risky projects that increase firm value.
Third, the results suggest that the managers of well-governed firms are not more risk averse with
respect to investment decisions compared to poorly governed firms.
Practical implications The work has practical implications for managers, investors, and policy
makers. Well-governed firms face lower variability in stock returns compared to poorly governed
firms. Firms that have independent boards that protect its shareholders rights and disclose its
governance-related policies experience lower firm-level risk, other things being equal.
Originality/value This study is the first one to examine the impact of a composite measure of
corporate governance quality on stock return variability in a non-US setting. The results suggest that
firms can use specific corporate governance provisions to mitigate firm-level risk. The findings of the
paper are therefore relevant and useful to corporate managers, investors, and policy makers.
Keywords Corporate governance, New Zealand, Stock return variability
Paper type Research paper

International Journal of Managerial

Finance
Vol. 10 No. 4, 2014
pp. 494-510
r Emerald Group Publishing Limited
1743-9132
DOI 10.1108/IJMF-08-2012-0090

JEL Classifications G30, G32

The authors would like to thank the participants at the 2010 Corporate Governance and
Finance Conference, Melbourne, Australia, and the 2010 Annual Conference on PBFEAM, Beijing,
China for their helpful comments and suggestions. Any remaining errors are of the authors.

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

1. Introduction
Extant research is of the view that firm-specific risk has a positive impact on a firms
stock returns (Fu, 2009; Goyal and Santa-Clara, 2003). Thus managers must take on
more risk, albeit in a measured way, in order to maximize firm value. However,
oftentimes managerial risk aversion precludes managers from an optimal level of risk
taking. In the absence of incentives, managers tend to behave in a risk-averse manner
foregoing risky projects that potentially increase the value of the firm. Amihud and
Lev (1981) provide another example of managerial risk aversion where managers
mitigate their employment risk by engaging in conglomerate mergers that reduce the
risk of the firm, at the cost of lowering the total value of combined firms.
Managerial compensation and an active market for corporate control have been
shown to provide the incentives for managerial risk taking. Smith and Stulz (1985)
posit that if managerial compensation is a convex function of the value of the firm, then
managers are incentivized to take risk as they will be better off if the firm does not
hedge. Low (2009) finds that managers responded to the regime shift that provided
greater protection from takeovers by lowering the risk of the firm. Furthermore,
the increase in managerial risk aversion is particularly severe in firms with lower CEO
vega values implying that option-like features in managerial compensation can
alleviate managerial risk aversion.
In addition to firm-specific managerial incentives, institutional factors have been
shown to be associated with higher risk taking. John et al. (2008) document a positive
linkage between investor protection and corporate risk taking. Furthermore, they show
that good governance at the firm level is associated with higher risk taking among US
firms. Thus it appears that good governance can mitigate managerial risk aversion.
While one strand of literature ( John et al., 2008; Ferreira and Laux, 2007) emphasizes
the positive aspects of risk taking, another strand emphasizes the existence of agency
costs such as the misuse of free cash flows, managerial opportunism, excessive managerial
compensation, and opaqueness in governance structures (Jensen and Meckling, 1976;
Dechow and Sloan, 1991) which have an adverse effect on a firms value. Bhojraj and
Sengupta (2003) show that firms with stronger governance practices are associated with
superior bond ratings and lower yield, ostensibly due to reduced agency risk.
Thus good governance, in the presence of conducive institutional features, can
enhance managerial risk-taking behavior and increase firm value akin to the good
cholesterol situation prevailing in the medical sciences. Good governance can also
reduce the bad cholesterol aspect of risk, namely, agency costs. We argue that these
costs and therefore bad risks may be minimized by a firm that adopts good
governance. The positive association between corporate governance quality and risk
documented by John et al. (2008) and Ferreira and Laux (2007) indicate that the good
cholesterol effect dominates the bad cholesterol effect in the USA.
In this paper, we extend the literature by examining the association between
corporate governance and risk taking in New Zealand, a country with major
institutional differences with the USA where most current studies have so far been
conducted. The New Zealand capital market is less developed and its corporations
have very high ownership concentration. There hardly exists an active market for
corporate control in New Zealand and executive compensation, with the exception of
a few larger and cross-listed firms, is far less performance based compared to countries
like the USA and the UK. We believe these specific institutional and corporate structures
in New Zealand would have considerable bearing on managerial risk-taking incentives,
weakening the good cholesterol effect. Therefore, we expect the bad cholesterol effect

Variability of
stock returns

495

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

496

to dominate. In other words, firms with good corporate governance will have lower
risk, ceteris paribus.
We therefore examine the impact of corporate governance features on the variability
of stock returns as a measure of risk taking. Specifically, we score each firm in our
sample on four components of corporate governance: board composition, shareholding
and compensation issues, shareholder rights issues, and corporate disclosure issues.
We aggregate these component scores to obtain an overall rating for each firm.
Our empirical results show that sub-indices based on board composition, shareholder
rights, and disclosure policy, significantly negatively influence risk, measured by
the standard deviation of monthly market-adjusted returns. There is no relationship
between shareholding and the compensation component of governance on a firms risk.
On balance, we show that in contrast to the USA, the bad cholesterol effect dominates
the good cholesterol effect in New Zealand.
We believe that our study is relevant to academicians and practitioners for the
following reasons. Idiosyncratic risk is not necessarily bad. In fact, shareholders
benefit when managers take deliberate risks when they make investment decisions.
However, governance risk stemming from agency costs detracts from stockholder
wealth maximization. A well-governed firm has a safety net in place for the protection
of minority shareholders. As such, the directors of well-governed firms should be
comfortable with their managers taking more considered risks, other things being equal.
On the other hand, it is possible that managers view current best corporate governance
practice recommendations as unduly restrictive and become more risk averse. Thus the
critical empirical issue is which of these effects is dominant. The insight from our
empirical work is that good governance is associated with lower risk, ostensibly due to
a reduction in agency costs. There is no evidence to indicate that good governance makes
managers more risk averse in the context of investment decisions.
The rest of the paper is organized as follows. In Section 2, we describe the theoretical
underpinnings that drive the relationship between specific corporate governance features
and risk. Based on these, we develop a set of testable hypotheses that form the basis of
our empirical analysis. In Section 3, we describe our Data and Methodology. Our empirical
results are contained in Section 4. Our conclusions are provided in the final section.
2. Corporate governance and risk: theoretical underpinnings and
measurement
2.1 Theoretical underpinnings
Recent work by financial economists explicitly recognizes the benefits of firm-specific
risk. Goyal and Santa-Clara (2003) assert that idiosyncratic risk is a good predictor of
future stock returns. Other researchers find an association between idiosyncratic risk
and growth (Campbell et al., 2001; Xu and Malkiel, 2003). Another effect of idiosyncratic
risk is that it provides firm-specific information that contributes to an improvement in
the allocation of resources across firms. Durnev et al. (2004) show that idiosyncratic
volatility is positively associated with more efficient capital budgeting, implying that it
also enhances the efficacy of allocation of resources within the firm. Using US data,
John et al. (2008) find that good governance at the firm level is associated with greater
risk taking.
Extant research supports the view that two firm-level features incentivize firm-level
risk taking. First, Ferreira and Laux (2007) find that firms with fewer anti-takeover
provisions display higher levels of idiosyncratic risk. They also report that trading
interest by institutions, especially those active in merger arbitrage, strengthens the

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

association between governance and idiosyncratic risk. Furthermore, their results

indicate that openness to the market for corporate control leads to more informative stock
prices by encouraging collection of and trading on private information. Second, several
studies find evidence suggesting that managers equity-based compensation component
influences their risk-taking behavior (Coles et al., 2006; Guay, 1999). For instance, Coles
et al. (2006) show that CEOs, whose compensation is highly sensitive to the volatility of
their stock prices have greater risk-taking incentives than other firms. Low (2009)
investigates the impact of equity-based compensation on managers risk-taking behavior
by using exogenous changes in the Delaware takeover regime that occurred during the
mid-1990s. She finds that managerial risk aversion is a serious agency problem, resulting
in managers reducing firm risk at the expense of shareholder wealth. She reports that
managers reacted to the greater takeover protection provided by the regime shift by
decreasing firm risk. The reduction is concentrated among firms with fewer option-based
managerial compensation (low CEO vega).
When compared to countries such as UK, and the USA, the threat of takeovers is
virtually non-existent in New Zealand. The studies by Ferreira and Laux (2007) and
John et al. (2008) use anti-takeover provisions as their measure of firm-level corporate
governance. It is therefore possible that the existence of an efficient market for
corporate control is a prerequisite for incentivizing managers to take risk. This view is
also supported by Low (2009). Recent work by Marshall and Anderson (2009) indicates
that a regulatory increase in protection from takeovers has occurred in New Zealand
following the introduction of the 2001 Takeovers Code. Their empirical analysis
suggests that there are fewer bids being launched as regulation increases implying that
the corporate discipline function of takeovers may have weakened in recent periods.
In New Zealand the usage of stock options in compensating the top managers of the
firm is less prevalent. Boyle et al. (2006) report that very few New Zealand firms use
stock options to compensate their top managers.
Due to these significant differences in the New Zealand institutional set up, such as
an active takeover market, and the widespread usage of option-based compensation,
managers are not incentivized to take risk and so the impact of good governance on
risk-taking will be considerably weaker in New Zealand firms. Although, we expect the
good cholesterol effect to be considerably weaker in New Zealand compared to other
markets such as the USA and UK, we argue that the bad cholesterol effect will be
strong. Since we expect the bad cholesterol effect to dominate, we posit that firms with
good corporate governance will have lower risk, ceteris paribus.
2.2 Measurement of corporate governance quality
Our methodology for constructing firm-level corporate governance scores closely
follows the system of McFarland (2002) and used by Klein et al. (2005) and Adjaoud
et al. (2007). Our overall corporate governance index (CGI) scoring system takes into
account a wide range of governance aspects of a firm and encompasses four categories:
board composition, shareholding and compensation policies, shareholder rights
and policies, and disclosure policies. We elaborate our motivation for using these
components and the predicted impacts on risk below.
First, we construct the board composition sub-index to capture board autonomy,
structure, and effectiveness. Board composition is a key governance feature (Fama and
Jensen, 1983). The main duty of the board is to monitor managers performance
and reduce agency costs. Autonomy is measured by board independence, and by the
independence of audit, compensation, and nominating committees. This sub-index also

Variability of
stock returns

497

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

498

contains measures of board effectiveness, number of meetings, and the separation of

CEO/chairperson positions.
Corporate boards have the fiduciary duty of monitoring the performance of managers
and protecting the interest of minority shareholders. Since independent directors bear
a reputation cost for poor performance, they have incentives to monitor management
actions more carefully than inside directors (Cadbury Report, 1992; Jensen, 1993; Fama,
1980; Baysinger and Hoskisson, 1990). Independent/outsider dominated boards perform
several valuable functions such as removing poorly performing CEOs (Weisbach, 1988),
engaging less in earnings management (Klein, 2002), reduce the likelihood of fraud
(Sharma, 2004), demand higher quality external audit (Carcello et al., 2002), and invest
more in enterprise risk management (Desender and Lafuente, 2009).
A generally accepted governance feature is audit committee independence. New York
Stock Exchange (NYSE) and NASDAQ established new standards for more independent
audit committees in December 1999. Klein (2002) finds that earnings management is
higher for firms whose audit committees do not have a majority of independent directors.
CEO duality increases the power of CEOs and is a potential source of governance risk
(Dayton, 1984). Furthermore, the variability of firm performance increases with CEO
duality perhaps due to increased risk from judgmental errors (Adams et al., 2005).
The independence of nomination committee is another important characteristic of board
effectiveness and monitoring ability (Williamson, 1985). Interlocking directorships create
conflicts of interest (Fich and White, 2005) and is another source of governance risk.
Based on these discussions, we give maximum weight to board independence, followed
by audit committee independence, CEO duality, compensation committee independence,
and nominating committee independence.
Since a key function of the board is to review and guide a firms risk management
policy (Kirkpatrick, 2009), we argue that an effective board will prevent a firm from
engaging in extremely risky investment and financial policies that jeopardize the
future prospects of the firm. Furthermore, more than 60 percent of surveyed
New Zealand company directors felt that recent governance regulations cause board
attention to focus on preventing downside risk (Anderson et al., 2007). Our view is that
a powerful board serves as an internal governance mechanism, but may be less
effective than external governance devices such as the market for corporate control in
incentivizing managers to take on risky projects. Thus an effective board may
minimize bad risk arising from agency costs but may not increase good risk.
We therefore hypothesize the following:
H1. Firms that have a higher score on the board composition sub-index will be
associated with a lower level of unsystematic risk of the firms stock returns,
ceteris paribus.
Second, we compute the sub-index of shareholding and compensation policies to
measure the extent to which manager and the board members have incentives that
align their interests with those of shareholders. Companies where the CEO and
directors are required to take equity positions are given higher scores in constructing
this sub-index. Companies that give subsidized loans to managers are scored lower in
this sub-index. Empirical research supports the view that equity holdings by directors
provide them with incentives to rigorously monitor managerial performance (Kren and
Kerr, 1997) and for deeper strategic involvement with the firm (Chatterjee, 2008).
Bhagat et al. (1999) find an association between director stock holdings and heightened

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

corporate performance as well as an association between director stock ownership and

subsequent CEO turnover. Overall, the weight of empirical evidence supports the view
that board equity ownership results in better monitoring of management.
CEOs whose wealth is highly sensitive to stock price (high delta) tend to become
risk averse and adopt policies that minimize firm risk (Coles et al., 2006). However, if
CEO wealth is highly sensitive to stock price volatility (high vega), then managers
have incentives to implement policies such as higher R&D expenditures, lower capital
expenditure in plant, property and equipment, greater firm focus, and higher leverage
which increase the riskiness of the firm. Overall, extant research supports the view that
option packages increase the vega of CEOs and provides them with incentives to engage
in high-risk investments in hopes of getting high returns. In New Zealand, the vegas of
CEOs are likely to be low, but their deltas may be high if they have high-stock ownership.
On balance, the resultant impact of shareholding and compensation policies on risk is an
empirical issue. We therefore, do not posit an explicit hypothesis for this sub-index.
Third, we measure shareholder rights based on the re-election of directors, existence of
dilutive employee stock options and the presence of subordinate shares. These features
reduce shareholder rights vis-a`-vis managers. As such, firms with high scores on this
sub-index are deemed to be investor friendly. The negative effects of the existence of
dilutive stock options and subordinate shares will exacerbate the poor performance
of firms under conditions of economic stress (Martin and Thomas, 2005). Firms with
strong shareholder rights are able to use their power to force managers to pay higher
dividends instead of using them for private benefit (Adjaoud and Ben-Amar, 2010).
Thus containing managers opportunistic behavior is likely to make the firm less risky,
by reducing bad risk associated with managerial misbehavior, ceteris paribus. A firm
with strong shareholder rights in itself does not provide incentives to managers to take
on good risk. We therefore hypothesize the following:
H2. Firms that have a higher score on the shareholder rights sub-index will be
associated with a lower level of unsystematic risk of the firms stock returns,
ceteris paribus.
The final sub-index deals with disclosure policies. Companies that comply with the
best practices stipulated by the regulatory bodies in terms of disclosing their corporate
governance practices, other relevant details of their directors, auditor compensation,
list of other boards on which directors sit, and attendance records of board members
score higher on this sub-index. Good disclosure policies attenuate the information risk
faced by investors. Using a cross-country sample of 15 countries, Krishnamurti et al.
(2005) show that firms with better disclosure have lower adverse selection component
of spreads, ceteris paribus. Therefore, we posit the following hypothesis:
H3. Firms that have a higher score on disclosure policies sub-index will have
a lower level of unsystematic risk of the firms stock returns, ceteris paribus.
We use the theoretical predictions developed in this section to conduct empirical
analysis, the results of which are reported and discussed in Section 4.
3. Data and methodology
3.1 Data
We collect financial data and corporate governance information from annual reports of
firms listed in New Zealand from the NZX Deep Archive database for the 2004-2008

Variability of
stock returns

499

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

500

period. We describe the detailed scoring scheme of our corporate governance indices in
the Appendix. Price data is sourced from DataStream. After deleting firms for which
there were no financial data, the final sample consists of 385 firm year observations.
We provide descriptive statistics for selected variables in Table I. We use 385 firm
year observations covering 88 sample firms. The effects of outliers have been mitigated
by trimming the sample at first and 99th percentiles. Firm-level risk is the dependent
variable and following Cheng (2008) and Adams et al. (2005) is measured in two
ways standard deviation of monthly raw and market-adjusted returns. The market
index used was NZX all index. SD_Raw was calculated as the standard deviation of
monthly stock return from July in a given year to June next year. Adj_SD was
calculated as the standard deviation of market-adjusted monthly stock return.
The mean standard deviation of monthly raw stock return (SD_Raw) is 0.10.
The other dependent variable, standard deviation of monthly market-adjusted return
(Adj_SD) also has a mean of 0.10. The mean standard deviation of monthly market
return (Mkt_SD) is 0.04. The mean return on assets (ROA) is 0.33. The mean of
lagged ROA is 0.32. The average leverage is 1.39 for our sample firms. The average
market-to-book ratio (M/B) of the sample is 2.47. The average market capitalization of
our sample firms is NZ$391.71 million. The average age of our sample firms is 11.63
years. These statistics are similar to other those of comparable New Zealand studies
such as Koerniadi and Tourani-Rad (2012). The average aggregate CGI of our sample
firms is 65.40 out of a maximum 100 marks. The average board composition sub-index
score (BOARD) is 21.55 out of a possible 40 marks. The average shareholding and
compensation sub-index score (COMP) is 12.65 out of a possible 23 marks. The average
shareholder rights sub-index score (RIGHTS) is 19.44 out of a possible 22 marks.
The average disclosure policy sub-index score (DISC) is 11.76 out of a possible 15 marks.

Adj_SD
SD_Raw
Mkt_SD
ROA
LEV
M/B
Size (millions)
AGEa
ROA1
CGI
BOARD
COMP
RIGHTS
DISC

Table I.
Descriptive statistics

Mean

SD

Min

25th

Median

75th

Max

0.10
0.10
0.04
0.33
1.39
2.47
391.71
11.63
0.32
65.40
21.55
12.65
19.44
11.76

0.07
0.07
0.01
5.02
3.54
6.26
1,177.51
11.44
5.01
10.07
7.55
3.34
1.38
2.59

0.02
0.00
0.03
90.50
5.39
24.14
0.19
0.21
90.50
41.00
1.00
2.00
14.00
2.00

0.05
0.05
0.04
0.02
0.42
0.91
26.60
4.34
0.02
58.00
16.00
10.00
20.00
10.00

0.08
0.08
0.04
0.05
0.72
1.40
71.39
8.26
0.05
65.00
20.00
13.00
20.00
12.00

0.11
0.11
0.04
0.08
1.49
2.66
261.79
13.99
0.09
72.00
27.00
15.00
20.00
14.00

0.50
0.49
0.06
1.09
58.67
97.49
11,699.17
61.79
1.09
88.00
40.00
19.00
20.00
15.00

Notes: Adj_SD is standard deviation of monthly market-adjusted return; SD_Raw is standard

deviation of monthly raw return; Mkt_SD is standard deviation of monthly market return; ROA is
return on assets; ROA1 is lagged ROA; LEV is total debt/total equity; M/B is market-to-book ratio;
Size is the market equity capital; Age is the number of years listed; CGI is the aggregate corporate
governance index; BOARD is board composition index; COMP is compensation policy index; RIGHTS
is shareholder rights index; DISC is disclosure index. aAGE was calculated as the number of years
a firm was listed on the exchange. One firm was listed in 2004. Since this firm was listed in 2004 for
77 days the age for this firm was recorded as 0.21 year (77/365)

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Our descriptive statistics indicate that there is a wide range of variation in the dependent
and key independent variables across firms.
The distribution of our sample across industrial sectors is shown in Table II. With the
exception of the consumer sector which contains about a quarter of our sample, there is no
concentration across other industry sectors. In Table III, we present correlation matrix
for aggregate corporate governance and its components as well as other key variables.
The correlation matrix indicates high correlation between the aggregate index and its
components. The components display low correlation between themselves (with the
exception of board and disclosure sub-indices). Thus we are assured that the components
of corporate governance computed assess different aspects of corporate governance
and do not cause serious measurement problems. As expected there is very high
correlation between our dependent variables standard deviation of monthly raw
return and standard deviation of monthly market-adjusted returns (0.98). The correlation
matrix indicates few cases of high correlation with the exception of 0.85 between leverage
and M/B.

Variability of
stock returns

501

3.2 Methodology
We conduct panel data regressions using standard deviation of monthly raw and
market-adjusted returns as dependent variables and corporate governance measures
described in the previous section as independent variables. Following Black et al.
(2006) and Klein et al. (2005), we also include a number of control variables such as
standard deviation of monthly market returns, ROA, leverage, M/B, size, and age.
In addition to these control variables we also use dummy variables to control for the effect
of industry affiliation. These control variables capture the potential impact of profitability,
growth potential, leverage, and size on riskiness of the firm. Thus the impact of corporate
governance on risk may be measured after controlling for other factors which could have
an impact on the riskiness of the firm. Our empirical models are as follows:
SD Raw a b1 Corporate Governancei;t b2 Mkt SDt b3 ROAi;t b4 LEVi;t
1
b5 M =Bi;t b6 SIZEi;t b7 AGEi;t b8 ROAi;t1 ei;t

Adj SD a b1 Corporate Governancei;t b2 ROAi;t b3 LEVi;t b4 M =Bi;t

b5 SIZEi;t b6 AGEi;t b7 ROAi;t1 ei;t
Industry
Agriculture and fishing
Forestry
Consumer
Food
Textiles and apparel
Intermed and durables
Ports
Leisure and tourism
Media and comms
Transport
Property
Total

Number of firms
10
2
21
6
3
11
5
5
11
4
10
88

Table II.
Industry affiliation
of sample firms

Table III.
Correlation matrices

0.98
0.18
0.22
0.32
0.27
0.45
0.03
0.13
0.15
0.02
0.03
0.31
0.12

0.18
0.20
0.31
0.27
0.41
0.01
0.13
0.12
0.03
0.04
0.27
0.10

SD_Raw

0.04
0.06
0.01
0.01
0.10
0.10
0.12
0.06
0.14
0.11
0.16

Mkt_SD

0.09
0.24
0.20
0.07
0.46
0.17
0.19
0.05
0.26
0.03

ROA

0.85
0.00
0.14
0.07
0.05
0.07
0.03
0.02
0.02

LEV

0.10
0.15
0.09
0.07
0.06
0.02
0.01
0.01

M/B

0.18
0.13
0.38
0.07
0.26
0.60
0.44

SIZE

0.07
0.01
0.18
0.02
0.13
0.05

AGE

0.17
0.22
0.07
0.27
0.05

ROA1

0.19
0.29
0.40
0.69

BOARD

0.29
0.23
0.48

COMP

502
0.33
0.75

RIGHTS

0.59

DISC

Notes: SD_Raw is standard deviation of monthly raw return; Adj_SD is standard deviation of monthly market-adjusted return; Mkt_SD is standard deviation
of monthly market return; ROA is return on assets; ROA1 is lagged ROA; LEV is total debt/total equity; M/B is market-to-book ratio; SIZE is the natural
logarithm of market equity capital; AGE is the number of years listed; BOARD is the log of board composition index; COMP is the log of compensation policy
index; RIGHTS is the log of shareholder rights index; DISC is the log of disclosure index; CGI is the log of aggregate corporate governance index

SD_Raw
Mkt_SD
ROA
LEV
M/B
SIZE
AGE
ROA1
BOARD
COMP
RIGHTS
DISC
CGI

Adj_SD

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

IJMF
10,4

The equations below show the components of the two risk measures used:
SD Raw VarRi 1=2 Varai bi Rm ei 1=2 b2i VarRm Varei 1=2 3

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Adj SD VarRi  Rm 1=2 b2i VarRm  VarRm Varei 1=2

Variability of
stock returns

503

We use Rm to denote market rate of return, Ri to denote rate of return of firm i, bi to

denote systematic risk of firm i and ei to denote error term in a market model
specification. The variable of interest is Var(ei) and represents a measure of
idiosyncratic risk. Since the variance of raw return contains the extra term b2i Var(Rm),
we use Mkt_SD as an additional independent variable to control for market risk.
When we use Adj_SD as dependent variable, it is equivalent to [Var(ei)]1/2 for a firm
with b 1.0. Therefore, we do not control for market risk in Equation (2).
4. Empirical results
Our main empirical results are presented in Tables IV and V. In Table IV, the standard
deviation of monthly raw returns is regressed on corporate governance variable(s)
and control variables. Firm-level risk is positively related to market risk (Mkt_SD) and
growth but negatively related to profitability and size. The aggregate CGI has
a negative impact on risk and is highly statistically significant at conventional levels.
A one standard deviation increase in the CGI reduces standard deviation of returns by
around 1.3 percent.
Next, we examine the impact of specific sub-indices of corporate governance on risk.
We replace CGI in the above models (Equations (1) and (2)) with its components board

Model 1

Model 2

Model 3

Model 4

Model 5

CGI
0.130 (0.007)

BOARD

0.039 (0.006)
COMP

0.007 (0.301)
RIGHTS

0.193 (0.023)
DISC

0.096 (0.002)
Mkt_SD
1.396 (0.000)
1.414 (0.000)
1.317 (0.000)
1.317 (0.000)
1.367 (0.000)
ROA
0.005 (0.000) 0.005 (0.000) 0.005 (0.000) 0.005 (0.000) 0.004 (0.000)
LEV
0.001 (0.360)
0.001 (0.622)
0.001 (0.266)
0.001 (0.541)
0.002 (0.143)
M/B
0.002 (0.034)
0.002 (0.014)
0.001 (0.053)
0.002 (0.017)
0.001 (0.178)
SIZE
0.015 (0.000) 0.016 (0.000) 0.017 (0.000) 0.017 (0.000) 0.013 (0.000)
AGE
0.000 (0.314)
0.000 (0.275)
0.000 (0.453)
0.000 (0.443)
0.000 (0.348)
ROA1
0.003 (0.000) 0.003 (0.000) 0.003 (0.000) 0.003 (0.000) 0.003 (0.000)
Intercept
0.446 (0.000)
0.271 (0.000)
0.243 (0.000)
0.489 (0.000)
0.296 (0.000)
Industry Effect
Yes
Yes
Yes
Yes
Yes
Adjusted R2
46.31%
46.33%
45.39%
46.00%
46.66%
Notes: CGI is the log of aggregate corporate governance index; BOARD is the log of board
composition index; COMP is the log of compensation policy index; RIGHTS is the log of shareholder
rights index; DISC is the log of disclosure index; Mkt_SD is standard deviation of monthly market
return; ROA is return on assets; LEV is total debt/total equity; M/B is market to book ratio; SIZE is the
natural logarithm of market equity capital; AGE is the number of years listed;. ROA1 is lagged ROA.
p-values are in parentheses

Table IV.
The association between
standard deviation of
monthly raw returns and
corporate governance
components

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

504

Table V.
The association between
standard deviation of
market-adjusted monthly
returns and corporate
governance components

Model 1

Model 2

Model 3

Model 4

Model 5

CGI
0.102 (0.028)

BOARD

0.030 (0.034)
COMP

0.006 (0.379)
RIGHTS

0.158 (0.055)
DISC

0.092 (0.002)
ROA
0.005 (0.000) 0.005 (0.000) 0.005 (0.000) 0.005 (0.000) 0.004 (0.000)
LEV
0.001 (0.293)
0.001 (0.468)
0.001 (0.229)
0.001 (0.437)
0.002 (0.115)
M/B
0.001 (0.054)
0.002 (0.029)
0.001 (0.073)
0.002 (0.030)
0.001 (0.241)
SIZE
0.018 (0.000) 0.019 (0.000) 0.020 (0.000) 0.020 (0.000) 0.016 (0.000)
AGE
0.000 (0.641)
0.000 (0.602)
0.000 (0.779)
0.000 (0.769)
0.000 (0.662)
ROA1
0.003 (0.000) 0.003 (0.000) 0.003 (0.000) 0.003 (0.000) 0.003 (0.000)
Intercept
0.485 (0.000)
0.347 (0.000)
0.322 (0.000)
0.524 (0.000)
0.376 (0.000)
Industry Effect
Yes
Yes
Yes
Yes
Yes
Adjusted R2
47.23%
47.18%
46.65%
47.07%
47.91%
Notes: CGI is the log of aggregate corporate governance index; BOARD is the log of board
composition index; COMP is the log of compensation policy index; RIGHTS is the log of shareholder
rights index; DISC is the log of disclosure index; ROA is return on assets; LEV is total debt/total equity;
M/B is market to book ratio; SIZE is the natural logarithm of market equity capital; AGE is the number
of years listed; ROA1 is lagged ROA. p-values are in parentheses

composition (BOARD), compensation policy (COMP), shareholder rights (RIGHTS), and

disclosure policy (DISC) using them one at a time. We do not use all sub-indices at the
same time to prevent the effects of multicollinearity from clouding our results. We observe
that board composition has a negative and statistically significant impact on riskiness.
This result indicates that autonomous boards reduce the risk of the firm. Our results
support H1 which states that firms that have a higher score on the board composition
sub-index will be associated with a lower level of unsystematic risk of the firms stock
returns, ceteris paribus.
Shareholder rights also have a negative and significant impact on risk. When
shareholder rights are well protected and managers are not unduly compensated at the
expense of shareholders, firms tend to become less risky, other things being equal.
Our findings validate H2 which posits that firms which have a higher score on the
shareholder rights sub-index will be associated with a lower level of unsystematic risk
of the firms stock returns, ceteris paribus.
Finally, we obtain a similar result for the disclosure policy sub-index as well, supporting
H3, which conjectures that firms which have a higher score on disclosure policies sub-index
will have a lower level of unsystematic risk of the firms stock returns, ceteris paribus.
The sub-index of shareholding and compensation does not have a significant impact on risk.
We check the robustness of our results by using standard deviation of market-adjusted
monthly returns as the dependent variable and report the results in Table V. As before,
we regress on corporate governance measures and other control variables. The overall
measure, CGI, has a negative and significant impact on risk. The sub-indices of board,
rights, and disclosure have significant negative impacts on the level of risk. However, with
the exception of rights, the significance levels of corporate governance variables are lower
compared to Table IV. As for control variables, we observe that risk is positively related to
growth (M/B) but negatively related to size and profitability.
While our discussions suggest a causal link from board composition to idiosyncratic
risk, our findings could also be consistent with reverse causation as prior work has

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

documented that corporate boards are endogenously determined (Hermalin and

Weisbach, 1998, 2003). Following Cheng (2008), to mitigate the possibility of reverse
causality, we measured our independent variables including board composition with
one-period lag, i.e. at time t1, while the dependent variable is measured at t. Furthermore,
we use two different versions of board composition. The first version measures board
composition sub-index with a scoring procedure given in the Appendix. The second
version is a nave score which gives one mark per board feature that a firm satisfies. If we
get qualitatively similar results, this would imply that endogeneity is not a serious issue.
We recalculate the overall CGI and each of the sub-indices by giving one mark per
attribute if the firm maximally satisfies the criterion stated in the Appendix. A score of
zero mark is given if a firm does not maximally comply with a particular stipulation.
Using these alternate sub-indices and overall CG score, we reran all the regressions
and report the results in Table VI. The overall CGI is negative and significant at the
10 percent level. Board composition sub-index is significant at the 10 percent level with
a negative coefficient. As before, shareholding and compensation sub-index is not
significant. Shareholder rights sub-index which was significant at the 10 percent level
is no longer significant. The disclosure sub-index continues to have a negative
coefficient and is highly significant ( p 0.011). Taken as a whole, our main results are
still valid, although statistical significance is lower compared to the previous results.
Given that we have now used a cruder measure, the drop in significance is not at all
surprising. Since, we get qualitatively similar results with both measures, we conclude
that endogeneity is not a serious problem in our study.
Overall, our results are consistent with the view that firms with independent boards
that protect its shareholders rights and disclose their governance-related policies
experience lower firm-level risk, other things being equal. Our findings regarding the
impact of board composition, shareholder rights, and disclosure policy are as per our
hypotheses outlined in Section 2. In the New Zealand context, the bad cholesterol effect
dominates the good cholesterol effect. In other words, good governance reduces risk

CGI
BOARD
COMP
RIGHTS
DISC
ROA
LEV
M/B
SIZE
AGE
ROA1
Intercept
Industry effect
Adjusted R2

Model 1

Model 2

Model 3

Model 4

Model 5

0.061 (0.081)

0.004 (0.000)
0.001 (0.248)
0.001 (0.070)
0.018 (0.000)
0.000 (0.609)
0.003 (0.000)
0.368 (0.000)
Yes
47.0%

0.023 (0.071)

0.004 (0.000)
0.001 (0.336)
0.001 (0.039)
0.019 (0.000)
0.000 (0.620)
0.003 (0.000)
0.321 (0.000)
Yes
47.0%

0.013 (0.465)

0.005 (0.000)
0.001 (0.245)
0.001 (0.064)
0.020 (0.000)
0.000 (0.771)
0.003 (0.000)
0.323 (0.000)
Yes
46.09%

0.008 (0.850)

0.005 (0.000)
0.001 (0.313)
0.001 (0.057)
0.020 (0.000)
0.000 (0.743)
0.003 (0.000)
0.322 (0.000)
Yes
46.64%

0.046 (0.011)
0.004 (0.000)
0.002 (0.142)
0.001 (0.20)
0.017 (0.000)
0.000 (0.599)
0.003 (0.000)
0.307 (0.000)
Yes
46.63%

Notes: CGI is the log of aggregate corporate governance index; BOARD is the log of board
composition index; COMP is the log of compensation policy index; RIGHTS is the log of shareholder
rights index; DISC is the log of disclosure index; ROA is return on assets; LEV is total debt/total equity;
M/B is market to book ratio; SIZE is the natural logarithm of market equity capital; AGE is the number
of years listed; ROA1 is lagged ROA. p-values are in parentheses

Variability of
stock returns

505

Table VI.
The association between
standard deviation of
market-adjusted monthly
returns using an alternate
measure of corporate
governance index
and its components

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

506

attributable to agency costs and information risk. Due to the relatively inactive
corporate control market and the infrequent usage of stock options in managerial
compensation, it appears that managers are not incentivized to take good risk that
enhances stockholder value.
In order to assess the relationship between governance and good risk, we compared
the level of investments in capital expenditures as percentage of book capital between
strong (top 33 percent in overall CG measure) and weak governance (bottom 33 percent)
firms. There was no significant difference. Furthermore, strong governance firms have
significantly higher cash earnings (measured as the sum of income before extraordinary
items interest and deferred taxes and depreciation depreciation expenses divided by
book value of capital) compared to weak governance firms. Thus our results are consistent
with the view that, in the New Zealand set up, managers are not incentivized to take on
risky projects that increase shareholder value. Overall, we are able to conclude that the
lower risk faced by well-governed firms is most likely due to reduction in agency and
information costs and not due to increased risk averseness of managers with respect to
investment decisions.
5. Conclusions
Our empirical results based on 385 firm years show that the aggregate measure of
corporate governance has a negative impact on the risk of a firm. Our empirical results
show that a one standard deviation increase in the CGI reduces standard deviation of
returns by around 1.3 percent. Furthermore, sub-indices based on board composition,
shareholder rights, and disclosure policy have a significant and negative influence on risk.
Our contribution to the literature on the impact of corporate governance on risk is
twofold. First, our research supports the view that institutional context essentially
determines governance outcomes. In the governance-risk-taking relationship, two
features that are prevalent in the USA are largely absent in New Zealand. These are an
active corporate control market and stock option based managerial compensation.
In the absence of these features, it appears that, managers have little incentives to take
on risky projects that increase firm value. Second, our work highlights the importance
of the interplay of regulatory aspects of corporate governance with the functioning
of corporate control market. While prior work has recognized the importance of
institutionalized investor protection features in influencing governance outcomes our
work shows that markets play a significant role and works in tandem with regulation.
Our work has implications for managers, investors, and policy makers. Since
managerial risk taking is a desirable characteristic from the investors point of view, it
appears that regulators and policy makers should consider steps to effectively develop the
market for corporate control. Also, encouragement of stock option oriented managerial
compensation is another measure that policy makers and regulators should consider.
References
Adams, R., Almeida, H. and Ferreira, D. (2005), Powerful CEOs and their impact on corporate
performance, Review of Financial Studies, Vol. 18 No. 4, pp. 1403-1432.
Adjaoud, F. and Ben-Amar, W. (2010), Corporate governance and dividend policy: shareholders
protection or expropriation?, Journal of Business Finance and Accounting, Vol. 37 No. 5,
pp. 648-667.
Adjaoud, F., Zeghal, D. and Andaleeb, S. (2007), The effect of boards quality on performance: a
study of Canadian firms, Corporate Governance: An International Review, Vol. 15 No. 4,
pp. 623-635.

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Amihud, Y. and Lev, B. (1981), Risk reduction as a managerial motive for conglomerate
mergers, Bell Journal of Economics, Vol. 12 No. 2, pp. 605-617.
Anderson, D.W., Melanson, S.J. and Maly, J. (2007), The evolution of corporate governance:
power redistribution brings boards to life, Corporate Governance: An International
Review, Vol. 15 No. 5, pp. 780-797.
Baysinger, B. and Hoskisson, R.E. (1990), The composition of board of directors and
strategic control: effects on corporate strategy, Academy of Management Review, Vol. 15
No. 5, pp. 72-87.
Bhagat, S., Carey, D.C. and Elson, C.M. (1999), Director ownership, corporate performance and
management turnover, The Business Lawyer, Vol. 54 No. 5, pp. 885-919.
Bhojraj, S. and Sengupta, P. (2003), Effect of corporate governance on bond ratings and yields:
the role of institutional investors and outside directors, The Journal of Business, Vol. 76
No. 3, pp. 455-475.
Black, B.S., Jang, H. and Kim, W. (2006), Does corporate governance predict firms market
values? Evidence from Korea, Journal of Law, Economics, and Organization, Vol. 22 No. 2,
pp. 366-413.
Boyle, G., Clyne, S. and Roberts, H. (2006), Valuing employee stock options: implications for the
implementation of NZ IFRS 2 , Pacific Accounting Review, Vol. 18 No. 1, pp. 3-20.
Cadbury Report (1992), Report of the Committee on the Financial Aspects of Corporate
Governance, Gee & Co., London.
Campbell, J., Lettau, M., Malkiel, B. and Xu, Y. (2001), Have individual stocks become more
volatile? An empirical exploration of idiosyncratic risk, Journal of Finance, Vol. 56
No. 1, pp. 1-43.
Carcello, J.V., Hermanson, D.R., Neal, T.L. and Riley, R.R. Jr. (2002), Board characteristics and
audit fees, Contemporary Accounting Research, Vol. 19 No. 3, pp. 365-384.
Chatterjee, S. (2008), Does increased equity ownership lead to more strategically involved
boards?, Journal of Business Ethics, Vol. 87 No. S1, pp. 267-277.
Cheng, S. (2008), Board size and the variability of corporate performance, Journal of Financial
Economics, Vol. 87 No. 1, pp. 157-176.
Coles, J.L., Daniel, N.D. and Naveen, L. (2006), Managerial incentives and risk taking, Journal of
Financial Economics, Vol. 79 No. 2, pp. 431-468.
Dayton, K. (1984), Corporate governance: the other side of the coin, Harvard Business Review,
Vol. 62 No. 1, pp. 34-37.
Dechow, P. and Sloan, R. (1991), Executive incentives and the horizon problem: an empirical
investigation, Journal of Accounting and Economics, Vol. 14 No. 1, pp. 51-89.
Desender, K. and Lafuente, E. (2009), The influence of board composition, audit fees and
ownership concentration on enterprise risk management, working paper, Universitat
Auto`noma de Barcelona, Barcelona.
Durnev, A., Morck, R. and Yeung, B. (2004), Value-enhancing capital budgeting and firm-specific
stock return variation, Journal of Finance, Vol. 59 No. 1, pp. 65-105.
Fama, E. (1980), Agency problems and the theory of the firm, Journal of Political Economy,
Vol. 88 No. 2, pp. 288-307.
Fama, E. and Jensen, M.C. (1983), Separation of ownership and control, Journal of Law and
Economics, Vol. 26 No. 2, pp. 301-325.
Ferreira, M.A. and Laux, P.A. (2007), Corporate governance, idiosyncratic risk, and information
flow, Journal of Finance, Vol. 62 No. 2, pp. 951-989.
Fich, E.M. and White, L.J. (2005), Why do CEOs reciprocally sit on each others boards?, Journal
of Corporate Finance, Vol. 11 Nos 1/2, pp. 175-195.

Variability of
stock returns

507

IJMF
10,4

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

508

Fu, F. (2009), Idiosyncratic risk and the cross-section of expected stock return, Journal of
Financial Economics, Vol. 91 No. 1, pp. 24-37.
Goyal, A. and Santa-Clara, P. (2003), Idiosyncratic risk matters!, Journal of Finance, Vol. 58
No. 3, pp. 975-1008.
Guay, W. (1999), The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and
determinants, Journal of Financial Economics, Vol. 53 No. 1, pp. 43-71.
Hermalin, B.E. and Weisbach, M.S. (1998), Endogenously chosen boards of directors and their
monitoring of the CEO, American Economic Review, Vol. 88 No. 1, pp. 96-118.
Hermalin, B.E. and Weisbach, M.S. (2003), Board of directors as an endogenously determined
institution: a survey of the economics literature, Economic Policy Review, Federal Reserve
Bank of New York, Vol. 9 No. 1, pp. 7-26.
Jensen, M.C. (1993), The modern industrial revolution, exit and the failure of internal control
systems, Journal of Finance, Vol. 48 No. 3, pp. 831-880.
Jensen, M.C. and Meckling, W.H. (1976), Theory of the firm: Managerial behavior, agency costs
and ownership structure, Journal of Financial Economics, Vol. 3 No. 4, pp. 305-360.
John, K., Litov, L. and Yeung, B. (2008), Corporate governance and risk-taking, Journal of
Finance, Vol. 63 No. 4, pp. 1679-1728.
Kirkpatrick, G. (2009), Corporate governance and the financial crisis, OECD, Financiial Market
Trends, Vol. 96 No. 1, pp. 1-30.
Klein, A. (2002), Audit committee, board of director characteristics, and earnings management:
an empirical investigation, Journal of Accounting and Economics, Vol. 33 No. 1, pp. 51-89.
Klein, P., Shapiro, D. and Young, J. (2005), Corporate governance, family ownership and firm value: the
Canadian evidence, Corporate Governance: An International Review, Vol. 13 No. 6, pp. 769-784.
Koerniadi, H. and Tourani-Rad, A. (2012), Does board independence matter? Evidence from
New Zealand, Australasian Accounting Business and Finance Journal, Vol. 6 No. 2, pp. 3-18.
Kren, L. and Kerr, J.L. (1997), The effects of outside directors and board shareholdings on the
relation between chief executive compensation and firm performance, Accounting and
Business Research, Vol. 27 No. 4, pp. 297-309.
Krishnamurti, C., Sevic, A. and Sevic, Z. (2005), Voluntary disclosure, transparency, and market
quality: evidence from emerging market ADRs, Journal of Multinational Financial
Management, Vol. 15 Nos 4-5, pp. 435-454.
Low, A. (2009), Managerial risk-taking behavior and equity-based compensation, Journal of
Financial Economics, Vol. 92 No. 3, pp. 470-490.
McFarland, J. (2002), How ROB created the rating system, The Globe and Mail, October 7, p. B6.
Marshall, B.R. and Anderson, H.D. (2009), Regulation and target takeover returns: is there
a link?, Pacific-Basin Finance Journal, Vol. 17 No. 4, pp. 395-412.
Martin, K.J. and Thomas, R.S. (2005), When is enough, enough? Market reaction to highly
dilutive stock option plans and the subsequent impact on CEO compensation, Journal of
Corporate Finance, Vol. 11 Nos 1/2, pp. 61-83.
Sharma, V.D. (2004), Board of director characteristics, institutional ownership, and fraud: evidence
from Australia, Auditing: A Journal of Practice and Theory, Vol. 23 No. 2, pp. 107-119.
Smith, C.W. and Stulz, R.M. (1985), The determinants of firms hedging policies, Journal of
Financial and Quantitative Analysis, Vol. 20 No. 4, pp. 391-405.
Weisbach, M. (1988), Outside directors and CEO turnover, Journal of Financial Economics,
Vol. 20 No. January-March, pp. 431-460.
Williamson, O.E. (1985), The Economics Institutions of Capitalism, Free Press, New York, NY.
Xu, Y. and Malkiel, B. (2003), Investigating the behavior of idiosyncratic volatility, Journal of
Business, Vol. 76 No. 4, pp. 613-644.

Variability of
stock returns

Appendix

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Sub-index 1: board composition

Independent

Maximum marks: 40 marks

8 marks for boards with at least 66% independent
directors
4 marks if 50% or more are independent
0 mark if o50% are independent
Audit committee
6 marks if the committee is fully independent
2 if there are one or more related directors
0 if a member of management is on the committee
Compensation committee
4 marks if the committee is fully independent
2 if there are one or more related directors
0 if a member of management is on the committee
Nominating committee
3 marks if the committee is fully independent
2 if there are one or more related directors
0 if a member of management is on the committee
0 if there is no nominating committee
Duality
5 marks if the jobs are split
2 marks if the chairman is also a related director
3 marks if the jobs are not split, but there is an
independent lead director
Relationship among directors
Start with 5 marks
Minus 3 if marks if the CEO swaps board with the
CEO of another company
Minus 2 marks if 3 or more directors are together on
the board of another public company
Minus 2 marks if any director who is on more than
8 other for-profit corporate boards (score can go
below zero)
CEO commitment
2 marks if the CEO sits on 3 or fewer other boards
of public company
0 mark if more than 3
Formal system of board performance
2 marks if any
0 if there is no such system
Board meeting without management present 2 marks if yes, 0 mark if no
Number of board meetings
3 marks if the information is disclosed and both the
board and audit committee meets at least 4 times
1 mark if they meet less often, or if only partial
number information about the number of meeting
0 mark if this information is not disclosed
Sub-index 2: shareholding and compensation Maximum marks: 23 marks
issues
Directors required to own stock (stock
4 marks if share ownership is mandatory an equals at
option do not count)
least 3 times the annual retainer paid to directors
2 marks if mandatory but ownership is lower
0 mark if ownership is not mandatory
Director own stock
Start with 4 marks
Minus 1 mark if each director has o1,000 shares
after sitting on the board for at least a year (can go
below zero)
CEO required to own stock (stock options
3 marks if required, or if the CEO is the controlling
do not count)
shareholder of the firm

(continued)

509

Table AI.
Components of corporate
governance index

IJMF
10,4

CEO own shares

Directors in their own separate option plan

Loans to directors

510
Sub-index 3: shareholder rights policy
Re-election of directors

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

Stock option dilutive

Option re-priced, exercise date extended or
exchanged for lower priced option
Voting shares

Sub-index 4: disclosure policy

Full statement of corporate governance
practices

Information on related directors

Payment for auditors
Board member biographies
Information on other boards the company
directors sit on
Attendance records of directors
Table AI.

3 marks if the CEO owns more than 50,000 shares after

2 years on the job
2 marks if more than 20,000 shares
0 mark if o20,000 shares
3 marks if yes or if directors do not get stock options
6 marks if there are no loans or company makes loans
with interest payable
0 mark if loans are interest free
Maximum marks: 22 marks
2 marks for annual election of all directors
0 mark for staggered boards
8 marks if dilution is o5% of outstanding shares
6 marks if dilution is between 5 and 10%
0 mark if dilution is more than 10%
4 marks if no
0 marks if yes
8 marks if there are no non-voting or subordinate
voting shares
0 mark if voting control is 5 times greater than the
ownership stake
Maximum marks: 15 marks
3 marks if the company fully addresses all topics
required by New Zealand Securities Commission
1 mark if the company gives partial answer or chooses
to discuss some of the requirements
0 mark if there is no statement on governance
practices
4 marks for full disclosure or relationship
2 marks if information is missing
4 marks for disclosure
1 mark for disclosure
1 mark for disclosure
2 marks for full disclosure, but minus 1 mark for poor
disclosure

Corresponding author
Dr Chandrasekhar Krishnamurti can be contacted at: chandrasekhar.krishnamurti@usq.edu.au

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

Or visit our web site for further details: www.emeraldinsight.com/reprints

This article has been cited by:

Downloaded by UNIVERSITAS TRISAKTI, User Usakti At 00:12 02 May 2016 (PT)

1. Shoeyb Rostami, Zeynab Rostami, Samin Kohansal. 2016. The Effect of Corporate Governance
Components on Return on Assets and Stock Return of Companies Listed in Tehran Stock Exchange.
Procedia Economics and Finance 36, 137-146. [CrossRef]