Counterparty Risk in Material Supply Contracts

48 Pages Posted: 11 Oct 2014 Last revised: 15 Jan 2015

See all articles by Nina Boyarchenko

Nina Boyarchenko

Federal Reserve Bank of New York

Anna M. Costello

University of Michigan, Stephen M. Ross School of Business

Date Written: January 13, 2015

Abstract

This paper explores the sources of counterparty risk in material supply relationships. Using long-term supply contracts collected from SEC filings, we test whether three sources of counterparty risk — financial exposure, product quality risk, and redeployability risk — are priced in the equity returns of linked firms. Our results show that equity holders require compensation for exposure to all three sources of risk. Specifically, offering trade credit to counterparties and investing in relationship-specific assets increase the firm’s exposure to counterparty risk. Further, we show that contracts with protective financial covenants and product warranties mitigate the transmission of risk. Overall, we provide evidence on the channels of supply-chain risk, and we show that shareholders recognize the role of contractual features in mitigating counterparty risk.

Keywords: supply contracts, finacial covenants, counterparty risk premia

JEL Classification: G14, G19, L00, L14

Suggested Citation

Boyarchenko, Nina and Costello, Anna M., Counterparty Risk in Material Supply Contracts (January 13, 2015). FRB of New York Staff Report No. 694, Available at SSRN: https://ssrn.com/abstract=2507991 or http://dx.doi.org/10.2139/ssrn.2507991

Nina Boyarchenko (Contact Author)

Federal Reserve Bank of New York ( email )

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Anna M. Costello

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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