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Competition, No-Arbitrage, and Systematic Risk

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Abstract: We study how strategic interaction among firms affects their systematic risk. Competition effectively imposes bounds on profitability within each economic sector because competing firms simultaneously scale production up or down in response to common demand shocks. We show that no arbitrage implies that exposure to systematic risk factors must be zero at these bounds, leading to an inverse U-shaped relation between systematic risk and sector profitability. In general, competition reduces systematic risk and attenuates size related asset pricing anomalies. Using trade flows between economic sectors, we construct a new measure of competition based on each sector’s dependence on input factors and find broad empirical support for the theoretical predictions.

This talk is part of the Cambridge Finance Workshop Series series.

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