Market Exposure and Endogenous Firm Volatility over the Business Cycle

Abstract: We propose a theory of endogenous firm-level risk over the business cycle based on endogenous market exposure. Firms that reach a larger number of markets diversify market-specific demand shocks at a cost. The model is driven only by total factor productivity shocks and captures the observed countercyclity of firm-level risk.  Using a panel of U.S. firms (Compustat) matched to Compustat's Segment data and the U.S. Census Bureau's Longitudinal Business Database (LBD) we show that, consistent with our model, measures of market reach are procyclical, and the countercyclicality of firm-level risk is driven mostly by those firms that adjust the number of markets to which they are exposed which on average are larger than those that do not.  This finding is explained by the negative elasticity between various measures of market exposure and firm-level idiosyncratic risk we uncover.