The Network Foundations of Credit Counterparty Risk: Theory and Evidence
Abstract
Wedevelopastructuralmodelofcreditcounterpartyriskinwhichcontagionarisesfromaninter-firm production network. We then propose a parsimonious empirical approach that directly incorporates networktopologytopredictcreditspreads. Wefindthatincorporatingnetworkedgefeaturesinducesan averagecredit-spreadchangeofapproximately21.8%andyieldsanincremental𝐿2of0.56inexplaining creditspreads. Ourresultsshowthatnetwork-basedcounterpartyriskisstronglypricedandplaysafirst- order role in shaping credit spreads, particularly during periods when production networks experience severedisruption,reorganization,orrewiring. Networke!ectsareespeciallyimportantforfirmsoperating in industries that occupy intermediate positions within supply chains, rely heavily on distribution and logistics,andfacelowsubstitutabilityofinputs.