Navigating default risk in supply chain finance: Guidelines based on trade credit and equity vendor financing

Abstract

Controlling default risks and mitigating the negative impacts of risk aversion behaviors are crucial in supply chain financial activities. However, limited academic research exists on how firms should behave under default risk controls and how to improve channel efficiency using equity vendor financing. In this study, we focus on a supply chain consisting of a default risk-controlling supplier and a capital-constrained retailer controlling the risk of losing money. First, we explore the two firms’ decisions in trade credit financing when the default or losing money probabilities are controlled. Our findings show that the retailer reduces its risk by ordering fewer products; the supplier can reduce its risk by increasing the wholesale price or interest rate, where the former maximizes its expected profit while the latter helps distribute more products than the former. However, all these measures decrease supply chain efficiency. Second, to alleviate the negative impact of risk controls, we propose a portfolio by combining debt vendor financing (i.e., trade credit) with equity vendor financing, where a portion of trade credit financing is converted into equity financing. This portfolio can achieve win-win situations and channel coordination, while also meeting each firm’s risk management objectives. Additionally, by extending our model to a case where the wholesale price is determined exogenously, we find that the main conclusions still hold and obtain some complementary results. Finally, considering long-tail demand, we find that firms can also mitigate the impact of risk control by influencing the demand distribution through promotions.