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Counterparty risk in material supply contracts

Author

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  • Nina Boyarchenko
  • Anna M. Costello

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.

Suggested Citation

  • Nina Boyarchenko & Anna M. Costello, 2014. "Counterparty risk in material supply contracts," Staff Reports 694, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:694
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    References listed on IDEAS

    as
    1. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 473-494.
    2. Hertzel, Michael G. & Li, Zhi & Officer, Micah S. & Rodgers, Kimberly J., 2008. "Inter-firm linkages and the wealth effects of financial distress along the supply chain," Journal of Financial Economics, Elsevier, vol. 87(2), pages 374-387, February.
    3. Costello, Anna M., 2013. "Mitigating incentive conflicts in inter-firm relationships: Evidence from long-term supply contracts," Journal of Accounting and Economics, Elsevier, vol. 56(1), pages 19-39.
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    Cited by:

    1. Rahaman, Mohammad M. & Rau, P. Raghavendra & Zaman, Ashraf Al, 2020. "The effect of supply chain power on bank financing," Journal of Banking & Finance, Elsevier, vol. 114(C).

    More about this item

    Keywords

    supply contracts; counterparty risk premia; financial covenants;

    JEL classification:

    • G19 - Financial Economics - - General Financial Markets - - - Other
    • L00 - Industrial Organization - - General - - - General
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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