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Direct and Indirect Risk-taking Incentives of Inside Debt

We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about the relation between credit spreads and different compensation components. First, we show that credit spreads are decreasing in inside debt only if it is unsecured. Second, the relation between credit spreads and equity incentives varies depending on the features of inside debt.

16. June 2016

Authors Stefano Colonnello Giuliano Curatola Ngoc Giang Hoang

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Direct and Indirect Risk-taking Incentives of Inside Debt

Stefano Colonnello Giuliano Curatola Ngoc Giang Hoang

in: Journal of Corporate Finance, August 2017

Abstract

We develop a model of compensation structure and asset risk choice, where a risk-averse manager is compensated with salary, equity and inside debt. We seek to understand the joint implications of this compensation package for managerial risk-taking incentives and credit spreads. We show that the size and seniority of inside debt not only are crucial for the relation between inside debt and credit spreads but also play an important role in shaping the relation between equity compensation and credit spreads. Using a sample of U.S. public firms with traded credit default swap contracts, we provide evidence supportive of the model's predictions.

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