Teng Huang, Anil Kumar, Stefano Sacchetto and Carles Vergara-Alert
We develop a dynamic model of corporate investment and financing, in which shocks to the value of collateralizable assets generate variation in firms’ debt capacity. We show that the degree of similarity among firms’ financial flexibility forecasts cross-sectional return correlation. We test the implications of the model using an instrumental variable approach based on shocks to collateralizable corporate assets and the outbreak of the COVID-19 crisis as an event study. We find that firms in the same percentile of the cross-sectional distribution of financial flexibility have 62% higher correlation in stock return residuals than firms 50 percentiles apart.