Production Networks and Stock Returns: The Role of Vertical Creative Destruction

We study the relation between firms’ risk and their upstreamness in a production
network. Empirically, firms’ average stock returns and productivity exposures
increase monotonically with their upstreamness. We quantitatively explain
these novel facts using a multi-layer general equilibrium model. These patterns
arise from vertical creative destruction — innovations by suppliers devalue customers’
assets-in-place. We confirm several model predictions, and document
additional new facts consistent with vertical creative destruction: a diminished
value premium among downstream firms and a negative relation between downstream
firms’ returns and their suppliers’ competitiveness. Overall, vertical creative
destruction has a sizable effect on cross-sectional risk premia.