Dynamic Competition and Expected Returns

Abstract

We build a dynamic model that highlights two separate effects of product market competition on factor betas. Within an industry, competition increases dynamically with the underlying demand and is responsible for an inverse U-shaped relation between systematic risk and profitability. Conditional on profitability, industries with lower adjustment costs are more competitive and less risky. Our empirical approach exploits changes in oil prices to capture the dynamic effect in the oil sector and uses a measure of trade flows between economic sectors to capture the cross-industry effect. Our methodology improves on previous studies that use one-dimensional proxies such as industry concentration to measure competition.