  Economic models with input-output networks assume that firm or sector (unit)
growth is driven by a weighted sum of trade partners' growth and an
independently-drawn idiosyncratic shock. I show that the idiosyncratic risk
assumption in a broad class of network models implicitly generates restrictions
on the network weights which are unrealistic. When allowing for correlated
shocks, units are exposed to an additional risk term which captures the ability
to substitute away from supply and demand shocks propagating through the
network. I provide empirical evidence that changes in substitutability between
trade partners are inversely related to changes in the panel of realized
industry variance. Moreover, I find that supply-side (demand-side)
substitutability is closely related to technological (product) dispersion of a
unit's suppliers (customers). To synthesize these results, I propose a
production-based asset pricing model in which supply chain substitutability is
a function of dispersion in product/technology space and correlation in supply
and demand shocks is driven by shared customers and suppliers between firms.
The model predicts that assets which are positively exposed to average
propagation of upstream and downstream shocks are useful hedges and thus earn
lower average risk premia. Consistently, I find that estimated upstream
(downstream) propagation factors earn return spreads of -11.4% (-4.2%) and are
negatively associated with aggregate consumption, output, and dividend growth.
