Executive Equity Risk-Taking Incentives and Firm's Choice of Debt Structure

Abstract

We examine the impact of executive equity risk-taking incentives on U.S. firms’ choices of debt structure. Firms with higher sensitivity of executive compensation to stock volatility (vega) rely less on bank debt and more on public debt. The effect of vega is amplified for firms with greater asset substitution risk and more opaque financial information, while mitigated for firms with less scope to increase equity risk. Multiple identification tests confirm causality. We conclude that, by encouraging risk-taking, higher vega increases firms’ reliance on public debt in order to avoid more stringent bank monitoring.

Keywords: Executive equity incentives; Vega; Bank debt; Public debt

JEL Classification: G21, G32, J33, J41