Offshore Activities and Global Consumption Risk

We use 10-K filings to construct novel text-based measures of the extent to which publicly traded U.S. firms are exposed to three types of offshore activities: the sale of output, the purchase of input, and the ownership of assets that produce input. Our framework has three advantages: we comprehensively account for activities in all nations, we assess returns in a single market which avoids market segmentation bias, and we use direct text-based measures of risk exposures to reduce error in variables. We find that global consumption risk is significantly priced in the U.S. equity market through exposure to offshore sales. In contrast, offshore purchasing of inputs serves as a hedge. We report country-level consumption risk premia, which are higher in Europe and Africa, and lower in Asia. The question of whether consumption risk demands a risk premium has a long history in Financial Economics. Yet, as we discuss in Section 1, evidence on this prediction remains elusive. This is at least in part due to econometric challenges including error in variables, market segmentation bias, and ambiguity regarding which measure of consumption growth (local or worldwide) should be priced. We use text analytics of U.S. firm 10-Ks to directly measure firm-level exposures to offshore activities across nations with heterogeneous risk exposures. This framework mitigates the aforementioned econometric challenges, allowing us to conduct a more powerful test of the consumption risk hypothesis. We find strong evidence that global consumption risk is priced in the cross-section of U.S. equities. Our framework is based on the simple idea that a U.S. firm that sells its output to a given nation is likely exposed to the risks inherent to consumption in that nation in general. This idea relies in part on the assumption that this output is likely consumed by citizens of the given nation either directly or indirectly through intermediate inputs being transformed to more sophisticated goods. Hence, a firm that sells output to high risk nations should face a higher cost of capital and its equity should earn a risk premium. With this hypothesis in mind, we identify statements in each firm’s 10-K from 1997 to 2011 in which each firm mentions any nation by name alongside a keyword that associates the discussion with the sale of output. In all, we identify a complete time varying network identifying all of the nations each publicly traded U.S. firm sells its output to. We then separately score each nation based on how its domestic consumption growth comoves with aggregate world consumption growth. This then allows us to score each firm based on the extent to which it sells output to nations with higher consumption risk. We extend this simple framework to include not only offshore output, but also offshore input (the act of purchasing key inputs to production from offshore sources). The central idea underlying this extension is that offshore input from high risk nations should serve as a hedge to global consumption risk. Consistent with this assumption, this hedging relationship is predicted by the production-based equilibrium in Tuzel and Zhang (2013), who also find This work dates back to seminal work by Rubinstein (1976), Lucas (1978), and Breeden (1979). This is related to the well-known Roll (1977) critique.