Product Market Competition and Equity Returns
42 Pages Posted: 12 Mar 2012
Date Written: August 30, 2012
Abstract
We develop an analytically tractable equilibrium model to examine the link between competition in product markets and stock returns. Firms maximize pro fits from the sale of their products to consumers. Investors receive firm profi ts as investment returns. We characterize fi rms' optimal production plans and expected equity returns, and show that firm heterogeneity within an industry leads to differences in expected returns across firms. In particular, we demonstrate that the expected returns of firms with reliable products can decrease with competition. This is a distinguishing feature of our model with endogenous production which standard models of exogenous production will not deliver. We show empirically that the compensation for bearing cash flow risk resulting from competition in output markets is economically significant and that product market competition is associated with average returns in ways that are consistent with the model.
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