Credit Default Swaps and Risk-taking Incentives in CEO Compensation

Abstract

What is the role of creditors in shaping the design of risk-taking incentives in managerial compensation? This paper provides empirical evidence by investigating how the trading of credit default swaps (CDS) shapes the design of CDS-referenced firm’s managerial compen- sation, especially its risk-taking incentives. We find that CEO compensation vega increases significantly when a firm has CDS referring its debt, and the causal relationship is verified by a set of endogeneity tests. The CDS effect is stronger for firms with larger risk-shifting agency conflict and lower bankruptcy risk, consistent with the view that the alleviation of creditors’ risk concerns is the main mechanism driving this effect.

Keywords: Credit Default Swaps, CEO Compensation, Vega, Managerial Risk Taking, Debtholder-Shareholder Conflict

JEL Classification: G34, J33, M52