Stock Comovement and Financial Flexibility

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 variation in return correlation. We test the implications of the model with firm-level data in two separate empirical analyses using: (i) an instrumental variable approach based on shocks to the value of collateralizable corporate assets and (ii) 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 that are 50 percentiles apart.