Leverage Choice and Credit Spread Dynamics When Managers Risk Shift

68 Pages Posted: 17 Mar 2006 Last revised: 14 Oct 2008

See all articles by Murray Carlson

Murray Carlson

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

Ali Lazrak

University of British Columbia Sauder School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: September 27, 2007

Abstract

We provide new insights that link compensation terms to credit spreads and leverage by structurally modeling the financial and operating decisions of a risk-averse manager paid with cash and stock. Optimal debt balances tax benefits with the utility cost resulting from ex-post asset substitution. When cash-stock ratios are low (high), initial leverage is high and debt is safe (risky), while moderate cash-stock ratios are associated with low initial leverage. High credit spreads can be generated even when leverage and equity volatility are low. Using a large cross-section of 646 US based corporate credit default swaps (CDS) covering 2001-2006, we find strong evidence that the flexibility provided by the compensation terms is important for explaining CDS rates. With parameters estimated to match moments based on stock volatility and CDS rates, our model outperforms a similarly calibrated version of the Merton (1974) model, explaining an additional 10% of the variation in CDS rates and reducing average bias by over 50%.

Keywords: Capital structure, credit spreads, managerial compensation

JEL Classification: G32

Suggested Citation

Carlson, Murray D. and Lazrak, Ali, Leverage Choice and Credit Spread Dynamics When Managers Risk Shift (September 27, 2007). Sauder School of Business Working Paper; AFA 2007 Chicago Meetings Paper; Paris December 2007 Finance International Meeting AFFI-EUROFIDAI Paper. Available at SSRN: https://ssrn.com/abstract=891427 or http://dx.doi.org/10.2139/ssrn.891427

Murray D. Carlson (Contact Author)

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

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

Ali Lazrak

University of British Columbia Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822 9481 (Phone)
604-822 4695 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
389
Abstract Views
2,000
rank
43,821
PlumX Metrics