Knowledge Network and the Cross-Section of Expected Returns

I examine whether connected firms in the knowledge network also face additional types of risks while experiencing a net positive R&D spillover effect, as in Bloom, Schankerman, and Van Reenen (2013). Developing a measure of firm connectivity, I find that highly connected firms earn 6.6%-7.6% more than less connected firms after adjusting for the risk differential, proxied by the Fama-French three factors, during the 1981-2008 period. The risk-adjusted return premium may be due to the risk-based hypothesis, suggesting that connected firms are more exposed to innovative idea risk. Economy-wide innovative ideas enable connected firms to create new products and markets, and thus face less product market threat when innovative ideas are plentiful; however, they have the opposite effect when innovative ideas are scarce. I provide empirical support for this hypothesis. Innovative idea risk is priced in the cross-section of assets when I proxy innovative idea risk by the growth rate of IPO activities and that of venture capital investments. In addition, the product market threat of highly connected firms respond more in magnitude to innovative idea risk than do less connected firms