Competition, Markups and Predictable Returns
51 Pages Posted: 18 Jan 2015 Last revised: 9 Oct 2017
Date Written: October 9, 2017
When markups are high, new innovators can aggressively undercut incumbents to capture market share. Sensitivity to entry risk intensifies during times of high profit margins. We show that strategic interactions among firms in product markets provide a significant endogenous source of time-varying risks. Our general equilibrium production-based asset pricing model explains a sizable equity premium and predictable excess returns. Consistent with the data, the model predicts that higher markups are associated with higher expected returns.
Keywords: Production-based asset pricing, time-varying risk premia, stock return predictability, strategic interactions, recursive preferences
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