Credit Default Swaps, Agency Problems, and Management Incentives

Jongsub Lee, Junho Oh, David Yermack

NBER Working Paper No. 24064
Issued in November 2017
NBER Program(s):Asset Pricing, Corporate Finance, Law and Economics

We show in a theoretical model that credit default swaps induce managerial agency problems through two channels: reducing the opportunity for managers to transfer value to equityholders from creditors via strategic default, and reducing the intensity of monitoring by creditors, which leads to greater CEO diversion of assets as perquisites. We further show that boards can use compensation awards that increase managerial performance incentives (delta) and risk-taking incentives (vega) in order to mitigate these two agency problems, with increases in managerial vega being particularly useful to alleviate the strategic default-related agency problem. We study equity compensation awards to CEOs of S&P 1500 companies during 2001–2015 and find that they occur in patterns consistent with these predictions.

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Document Object Identifier (DOI): 10.3386/w24064

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