The Oligopoly Lucas Tree: Consumption Risk and Industry-Level Risk Exposure

70 Pages Posted: 26 May 2020 Last revised: 3 Jun 2020

See all articles by Winston Dou

Winston Dou

The Wharton School, University of Pennsylvania

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Wei Wu

Texas A&M University

Date Written: June 3rd, 2020

Abstract

We develop a novel quantitative asset pricing framework with concentrated industries, consumer inertia, and strategic competition, in which competition intensity endogenously intensifies as the expected growth declines or the discount rate rises, because firms compete more aggressively for current cash flows by undercutting each other as the present value of future cooperation decreases. We quantitatively decompose the beta of stock returns with the consumption risk into two components, reflecting news about the expected growth and discount rate. In equilibrium, more profitable industries have higher exposure to the discount-rate component of consumption risk because of higher consumer inertia, while value industries have higher exposure to the expected-growth component. More important, after controlling for the book-to-market ratio, the gross profitability premium becomes more pronounced. Finally, we exploit exogenous variation in market structures and growth loadings, such as large tariff cuts and natural disasters, to test the core competition and growth mechanisms directly.

Keywords: Product market friction, Imperfect substitutable consumption, Discount rates, Expected growth, Consumption risk

JEL Classification: G12, L13, O33, C73

Suggested Citation

Dou, Winston and Ji, Yan and Wu, Wei, The Oligopoly Lucas Tree: Consumption Risk and Industry-Level Risk Exposure (June 3rd, 2020). Available at SSRN: https://ssrn.com/abstract=3604841 or http://dx.doi.org/10.2139/ssrn.3604841

Winston Dou (Contact Author)

The Wharton School, University of Pennsylvania ( email )

2318 Steinberg Hall - Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Yan Ji

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

Wei Wu

Texas A&M University ( email )

360M Wehner
College Station, TX 77843-4218
United States
979-862-8092 (Phone)

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