Executive compensation influences managerial risk preferences through executives' portfolio sensitivities to changes in stock prices (delta) and stock return volatility (vega).Large deltas discourage managerial risk-taking, while large vegas encourage risk-taking.Theory suggests that short-maturity debt mitigates agency costs of debt by constraining managerial risk preferences. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and short-maturity debt. We also find that shortmaturity debt mitigates the influence of vega-and delta-related incentives on bond yields.Overall, our empirical evidence shows that short-term debt mitigates agency costs of debt arising from compensation risk.
JEL:G30; G32 Keywords: Executive compensation; Agency costs; Debt maturity * Lehigh University, Washington University, and University of Nebraska. The authors thank an anonymous referee and associate editor, the editor (Campbell R. Harvey), and co-editor (John R. Graham) for their suggestions and comments during the revision process. The authors also thank Mary McGarvey, James Schmidt and seminar participants at Washington University, University of Missouri, Texas Christian University, and University of Texas-Dallas for their comments.
Forthcoming in THE JOURNAL OF FINANCE
2The use of stock-and option-based executive compensation has increased dramatically during the past few decades. The median exposure of CEO wealth to stock prices tripled between 1980 and 1994(Hall and Liebman (1998), and then doubled again between 1994and 2000 (Bergstresser and Philippon (2006). Such changes in executive compensation have a direct impact on the manager's exposure to risk, thus altering both incentives and behavior. Carpenter (2000) and Lambert, Larcker, and Verrecchia (1991) discuss two effects of compensation on managerial incentives. One effect is caused by the sensitivity of compensation to stock prices (delta). A second effect is caused by the sensitivity of compensation to stock return volatility (vega). The higher the compensation package's sensitivity to stock prices, the weaker will be the manager's appetite for risk (Knopf, Nam, and Thornton (2002)). In contrast, the higher the compensation package's sensitivity to stock return volatility, the stronger will be the manager's appetite for risk (Knopf, Nam, and Thornton (2002), Coles, Daniel, and Naveen (2006)). By altering managerial risk preferences, stock-based compensation also influences third-party (e.g., creditors, suppliers, customers) perceptions of those risk preferences. The primary objective of this study is to investigate the role of short-term debt in reducing agency costs of debt arising from executive incentive contracts. Specifically, we examine the effect of the two portfolio sensitivities on the maturity structure of corporate debt. In addition, we analyze the effect of debt maturity on the relation between portfolio sensitivities and bond yields. The empirical results provide a consistent picture that short-term...
