Pricing Credit Risk in Buyer-Supplier Networks
50 Pages Posted: 25 Mar 2008 Last revised: 15 May 2008
Date Written: May, 13 2008
We investigate how buyer-supplier firm-specific relationships affect security prices. We propose a structural model of firm dependence in a vertically connected network of firms based on cash flow transfers between buyers and suppliers.
We prove that financial market completeness in a closed network economy depends only on the topology of the network. We develop analytical formulas for corporate debt, credit default swaps and collateralized debt obligations. The market prices of buy risks are determined globally in the economy and induce contagion effects. The empirical test of the model on the subcontractors' network of the SwissAir Group gives the yield spread average relative prediction error of 18% compared to the 89% error of the Merton model.
Keywords: Asset pricing, network dependence models, contagion, buyer-supplier networks, credit risk.
JEL Classification: C02, C16, C65, G12, G13.
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