Market Exposure and Endogenous Firm Volatility Over the Business Cycle

Abstract

We propose a theory of endogenous firm-level volatility over the business cycle based on endogenous market exposure. Firms that reach a larger number of markets diversify market-specific demand risk at a cost. The model is driven only by total factor productivity shocks and captures the business cycle properties of firm-level volatility. Using a panel of U.S. firms (Compustat), we empirically document the countercyclical nature of firm-level volatility. We then match this panel to Compustat’s Segment data and the U.S. Census’s Longitudinal Business Database (LBD) to show that, consistent with our model, measures of market reach are procyclical, and the countercyclicality of firm-level volatility is driven mostly by those firms that adjust the number of markets to which they are exposed. This finding is explained by the negative elasticity between various measures of market exposure and firm-level idiosyncratic volatility we uncover using Compustat, the LBD, and the Kauffman Firm Survey.