Managerial Incentives and Changes in Corporate Investments Following the Inception of Credit Default Swap Trade

56 Pages Posted: 24 May 2017 Last revised: 20 Mar 2018

See all articles by Hyun A. Hong

Hyun A. Hong

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management

Ji Woo Ryou

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American)

Anup Srivastava

Dartmouth College - Tuck School of Business; University of Calgary - Haskayne School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2018

Abstract

A credit default swap (CDS) enables a lender to hedge its risk exposure on a loan given to reference client. The lender then reduces the monitoring of the client’s activities as well as aiding the distressed client. Two contrasting predictions can be made about how the borrower would respond to the altered lender-borrower relationship. (1) The borrower reduces risky investments to lower its vulnerability to financial distress. (2) The borrower pursues volatility-enhancing projects to increase the value of call options built into its shareholder investments. We find that a borrower shifts to a more conservative policy when its managers have low portfolio sensitivity to stock volatility (vega). A borrower with high managerial vega, however, seeks volatility-enhancing projects. Shareholders then increase vega incentives for managers to maintain investments in risky, positive NPV projects at pre CDS levels. This action, however, also results in higher bankruptcy risk. Our study shows a unique interaction between the manager-shareholder and lender-shareholder conflicts arising from CDS inception, which alters the course of the borrower’s operating policy.

Keywords: Credit default swap (CDS); Agency conflict; Managerial compensation; Operating risks; Investment policy; Bankruptcy

JEL Classification: G32, G33, M41, M48

Suggested Citation

Hong, Hyun A. and Ryou, Ji Woo and Srivastava, Anup, Managerial Incentives and Changes in Corporate Investments Following the Inception of Credit Default Swap Trade (March 15, 2018). Tuck School of Business Working Paper No. 2973275. Available at SSRN: https://ssrn.com/abstract=2973275 or http://dx.doi.org/10.2139/ssrn.2973275

Hyun A. Hong

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management ( email )

Riverside, CA 92521
United States

Ji Woo Ryou

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American) ( email )

1201 W. University Dr.
BUSA 220
Edinburg, TX 78539
United States
956-665-8073 (Phone)

Anup Srivastava (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

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