Counterparty Risk in Material Supply Contracts
48 Pages Posted: 11 Oct 2014 Last revised: 15 Jan 2015
Date Written: January 13, 2015
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: Suggested Citation