Professor of Finance
JOURNAL ARTICLE | Journal of Business | 79 | November 2006
Idiosyncratic Volatility and Product Market Competition
This paper investigates the relation between a firm's competitive position and the idiosyncratic volatility of its stock price.The authors focus on two particular aspects of competitive conditions: the firm's market power, interpreted as its ability to price above marginal cost, and the firm's investment in innovation, proxied by the amount spent on research and development (R&D). The authors test the prediction that greater market power provides a firm with a natural hedge against idiosyncratic shocks. The empirical results show that firms with higher market power exhibit a lower absolute level of idiosyncratic volatility and also a higher ratio of systematic to total volatility.These findings are further supported by Granger causality tests, where the authors show that an increase in market power reduces idiosyncratic volatility, but not the reverse. The authors also produce evidence that investments in innovation make the firm more opaque to outside investors by showing that R&D spending increases idiosyncratic volatility but do not change the ratio of systematic to total risk.Overall these results contribute to the understanding of recent empirical trends of idiosyncratic volatility, and confirm the important link between stock market performance and the competitive environment of firms.