Aggregation of Idiosyncratic Shocks in the Customer-Supplier Network

Abstract

Using customer-supplier networks, we document a strong increase in stock return comovement between customer and supplier after the establishment of their relationship. This increase in comovement is mainly associated with cash flow news and firm-specific information. We find that the idiosyncratic shocks to customers diffuse through the customer-supplier network and aggregate into a systematic risk, which affects suppliers' expected returns. Using a long-short portfolio based on exposure to aggregated customer risk, we realize annual excess returns of 3.1% (value-weighted) and 6.11% (equal-weighted), respectively. The customer risk factor cannot be explained by market, size, book-to-market, or momentum factor. Consistently, we also find a positive relationship between exposure to the customer risk factor and cost of equity capital.