Leverage Choice and Credit Spread Dynamics When Managers Risk Shift

68 Pages Posted: 17 Feb 2009

See all articles by Murray Carlson

Murray Carlson

University of British Columbia (UBC) - Sauder School of Business

Ali Lazrak

University of British Columbia (UBC) - Sauder School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: February 15, 2009

Abstract

We provide new insights that link compensation structure terms to credit spreads by modeling the dynamic risk choice of a risk-averse manager paid with performance insensitive pay (cash) and performance sensitive pay (stock). The model predicts that credit spreads are increasing in the ratio of cash-to-stock. When the manager has discretion to choose debt levels, a trade-off between tax benefits and utility cost from ex-post asset substitution arises. The resulting optimal initial leverage is high with safe (risky) debt when cash-to-stock ratios are low (high), while moderate cash-to-stock ratios are associated with low initial leverage. In an empirical exercise using a large cross-section of 608 US based corporate credit default swaps (CDS) covering 2001-2006, we find strong evidence that CDS rates are high for CEOs with high salaries relative to stock and option holdings.

Keywords: compensation structure, credit spread, CDS rates, leverage

JEL Classification: G32

Suggested Citation

Carlson, Murray D. and Lazrak, Ali, Leverage Choice and Credit Spread Dynamics When Managers Risk Shift (February 15, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1343725 or http://dx.doi.org/10.2139/ssrn.1343725

Murray D. Carlson

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8358 (Phone)

Ali Lazrak (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

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