Does Credit Default Swap Initiation Affect Executive Compensation?
40 Pages Posted: 24 Sep 2017 Last revised: 16 Oct 2017
Date Written: November 11, 2016
In this study, we examine whether the initiation of credit default swaps affects the reference entity’s executive compensation design. With both human capital and financial capital highly associated with the firm’s bankruptcy risk, risk averse managers prefer cash compensation over option compensation to hedge their individual exposure to the firm’s bankruptcy risk. Consistent with this notion, we find a significant increase (decrease) in the proportion of cash (option) compensation around the initiation of CDS trading. Such a finding survives a matching procedure, a falsification test employing a different CDS initiation time and an instrumental variable approach to address the endogeneity. Further, the effect of CDS trading on firms’ compensation design is more pronounced for firms with higher distress risk and for managers who are more powerful.
Keywords: credit default swap, executive compensation, human capital, financial distress
JEL Classification: G32, G33, M12
Suggested Citation: Suggested Citation