Why Has Firm-Specific Risk Increased Over Time?

Abstract:     
Firm-specific risk climbed steadily between 1962 and 1999, but fell sharply between 2000 and 2003. We hypothesize that changes in the composition of the market, rather than fundamental changes in the economy or return-generating process, drive these changes in aggregate firm-specific risk over time. Specifically, we posit that three factors are primarily responsible for observed changes in firm-specific risk: changes in the market weights of "riskier" industries, changes in the relative role of small stocks in the market, and measurement error associated with changes in within-industry concentration. Our empirical tests reveal that each of these factors contribute to changes in firm-specific risk. Moreover, our analysis demonstrates that, combined, these three factors largely explain changes in firm-specific risk over the past 40 years.

Number of Pages in PDF File: 29

Keywords: Firm-specific risk, volatility

JEL Classification: G10, G11, G14

working papers series