Lakhasly

Corporate diversification has been the subject of ongoing debate among investors and
academics. Investors who wish to diversify their portfolios within a market or across markets can
choose to diversify directly by creating a portfolio of firms from different industries or markets
(homemade diversification) or diversify indirectly by investing instead in firms that are already
diversified. Barriers to investment, including imperfectly integrated capital markets, transaction
costs, and limited access to information, can impose impediments on homemade diversification,
making it more efficient for investors to invest directly in diversified firms (Mathur & Hanagan,
1983). Studies suggest that corporate diversification should lower investment risk at a fraction of
the cost incurred by individual investors (Agmon & Lessard, 1977; Doukas & Travlos, 1988;
Harris & Ravenscraft, 1991; Sanders & Carpenter, 1998).
Scholars have investigated the impact of corporate diversification on various aspects of firm
risk exposure. Rugman (1976), Brewer (1981), Fatemi (1984), Thompson (1984), Shaked
(1986), Lubatkin and Chatterjee (1994), Goldberg and Helfin (1995), Reeb et al. (1998), Stulz
(1999), Olibe et al. (2008), and Hann et al. (2013) measure the variance of stock returns and
systematic risk (U.S. beta). Mitton and Vorkink (2010) measure the skewness of stock returns.
Hund et al. (2010) and Lee and Li (2012) examine the volatility of firm profitability and ROE.
While some studies document that corporate diversification reduces systematic risk (Fatemi,
1984; Hann et al., 2013; Lubatkin & Chatterjee, 1994; Shaked, 1986; Stulz, 1999), other studies
show that diversified firms have a higher systematic risk (Krapl, 2015; Olibe et al., 2008; Reeb et
al., 1998), a higher idiosyncratic risk, and a higher volatility of cash flows and earnings (Krapl,
2015).3
In this paper, we investigate the impact of corporate diversification on firms’ risk exposure
from 1998 to 2016. While previous studies either bundle industrial and global diversification or
focus on only one of the two, this study disentangles the impacts of industrial and global
diversification on firm risk exposure. In addition to systematic risk, we include idiosyncratic risk
in our analysis to shed more light on various aspects of firm risk exposure. To estimate
idiosyncratic and systematic risks of the sample firms, we employ a modified version of the
Fama-French three-factor model instead of the one-factor market model and incorporate world
returns (from the MSCI World Excluding U.S. index) as a fourth factor to circumvent the issue
of incomplete modeling. We follow Heckman (1979) to address the potential endogeneity of the
diversification decision (Campa & Kedia, 2002) through various self-selection models. Lastly,
we check the results before, during, and after the financial crisis of 2007–2009.
The remainder of the paper is organized as follows. In Section 2, we summarize the existing
literature on the effects of diversification on firm risk and develop our hypotheses. In Section 3,
we describe the data and elaborate the methods. In Section 4, we report the empirical findings
and their implications. In Section 5, we check the robustness of the results before, during, and
after the financial crisis of 2007–2009. We conclude the paper in Section 6