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a banking relation with the original borrower. A b orrower’s shareholders could trade off the
increased value of their call options with the increased cost of bankruptcy risk. Finally, managers balance between enhancing their undiversified risks and the additional vega benefits.
The rest of the paper proceeds as follows. Section 2 summarizes the literature and presents the hypotheses. Section 3 describes the sample selection and the measurement of the variables.
Section 4 describes the tests of the hypotheses and Section 5 presents robustness tests. Section 6 presents concluding remarks.
2. Literature review and motivation of hypothesis.
The creation of CDS contracts is credited to J.P. Morgan, which sold the credit risk of Exxon Mobil in 1994 Tett, 2009. Initially, CDS contracts were used to hedge the credit risk of
bank loans. After the International Swaps and Derivatives Association ISDA standardized CDS contracts, other participants such as asset managers entered the CDS market. The notional amount
of outstanding CDS contracts peaked at 62.2 trillion by the end of 2007. After the financial crisis of 2008
–2009, the notional amount declined, but it remains at the double-digit trillion-dollar level. Third parties typically initiate CDS trades. Yet the creation of an active CDS market for a
company’s debt offers the lender an opportunity to change its counterparty risk to the one based on a more creditworthy CDS writer, which could significantly alter the debtor-creditor relation.
Buying CDS protection , partially or fully, separates the creditor’s control rights from its cash flow
rights Hu and Black, 2008; Bolton and Oehmke, 2011. An empty lender is then less likely to continuously monitor clients’ activities to protect the value of its claim Morrison, 2005; Ashcraft
and Santos, 2009; Subrahmanyam, Tang, and Wang, 2014; Martin and Roychowdhury, 2015.
3
3
Similar concerns arise when loans are subsequently sold securitized by the lender. However, agency conflicts arguably are stronger in the presence of CDSs because, with CDS contracts, banks obtain protection against their risk
exposure without transferring control rights Parlour and Winton, 2013.
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Furthermore, it would have a reduced interest in the continuation of the debtor, would be less flexible in negotiations upon any credit event, and could push the debtor into inefficient bankruptcy
or liquidation. Consistent with this idea, Subrahmanyam, Tang, and Wang 2014 find increases in bankruptcy risk with CDS trade inception and Li and Tang 2016 find more conservative
policies pursued by supply chain partners. Other benefits accrue to the lender upon hedging its risk after CDS inception. Its regulatory capital requirements are relaxed, allowing it to extend more
debt to other clients Shan, Tang, and Yan 2014. Another possible reason for the increased bankruptcy risk upon CDS inception
Subrahmanyam, Tang, and Wang 2014 besides lender inflexibility is that lenders continue to bear monitoring responsibilities but do not retain the same incentives to ensure a timely repayment
of loans. Thus, they can reduce their costly monitoring and vigilance efforts because these efforts provide no additional returns. Furthermore, such efforts would be spread over a larger number of
clients, given that lenders can expand their loan portfolios. This diluted vigilance on the part of lenders is likely to permit clients to alter operating strategies that were previously constrained by
lenders’ monitoring Campello and Matta, 2012. The equilibrium between rival lender and shareholder forces that determined the
borrower’s operating policies could shift toward shareholder interests.
In general, the value of residual claim holders can be viewed as a European call option on the firm’s assets with the face value of debt being the strike price. Shareholders keep all of the
upside in firm value beyond the face value of debt, but, given their limited liability, do not have to compensate lenders when the firm value declines below the face value of debt. Hence, asset
volatility improves the value of equity, even if it leaves the expected value of the firm’s future cash flow unchanged. Shareholders thus have a strong incentive to increase asset volatility. When
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the volatility value dominates the in-the-money value of call options held by shareholders, a volatility-enhancing project benefits shareholders even when it has a negative net present value.
However, increased volatility could adversely impact the value for creditors. For example, creditors suffer large losses when the firm fails. Lenders, which stand to lose when a firm shifts
from safe to risky assets, attempt to prevent such action through covenants and active monitoring Fama and Miller, 1972; Jensen and Meckling, 1976; Smith and Warner, 1979. One implication
of the options pricing theory is that any managerial action that increases the volatility of firm value enhances the value of the call option held by shareholders, yet decreases the value of fixed claims.
Consequently, lenders strive to prevent the substitution of safe firm assets with risky ones Jensen and Meckling, 1976. This leads to lender-shareholder conflict with regard to the preferred level
of operating risks. Any decline in lender monitoring could shift the equilibrium from lender- shareholder forces toward shareholder preference, that is, toward increased asset volatility
Campello and Matta, 2012. Thus, we expect asset substitution upon CDS inception, all else held equal. We test this proposition in H1.
H1. Firms shift a part of their safe assets to risky ones upon CDS inception.
H1 posits that firms shift their operating policy towards shareholder interest upon CDS inception. Nevertheless, why managers would facilitate or implement such shifts when doing so
could hurt their personal interests is unclear. Unlike shareholders, which can easily diversify their firm-
specific risks, managers’ monetary capital and human capital are disproportionately invested in their firms Aggarwal and Samwick, 1999. But, managers can neither sell their stock options
nor easily hedge the risks of decline in their options’ in-the-money values related to fluctuations
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in their own firms’ stock prices.
4
Therefore, unlike diversified investors, whose estimated option value increases with volatility, managers’ utility from holding in-the-money options can decline
with stock price volatility Pratt, 1964; Arrow, 1965; Carpenter, 2000. Managers holding a large amount of firm stock and in-the-money stock options can become highly risk averse Lambert,
Larcker, and Verrecchia, 1991; Wiseman and Gomez-Mejia, 1998. Unless managers hold compensation packages with convex payoffs, that is, unless their
wealth increases with asset volatility sufficient enough to make up for the nondiversifiability of firm risks, they would be reluctant to increase firm risks Berle and Means 1932; Jensen and
Meckling 1976. Absent convex payoffs, they act in the lender’s interest in so far as the selection of risky projects is concerned. However, shareholders could treat reduced lender monitoring, upon
CDS inception, as a unique opportunity to enhance their wealth at the expense of lenders. They can change managerial incentives to bring managers on board. We thus expect shareholders to
offer higher vega to managers to incentivize them to increase asset volatility post –CDS inception
Gormley, Matsa, and Milbourn 2013. We also expect shareholders to offer higher compensation to managers to benefit from asset volatility, but not too much to make them risk averse Knopf,
Nam, and Thornton, 2002. Managers could also demand more risk-taking incentives to take benefit from reduced lender monitoring. Our second hypothesis is stated as:
H2A. The total value and the vega of managerial compensation increase after CDS trade
inception. We also expect managers with the right compensation contracts that is, greater amount
and convexity of executive compensation, irrespective of whether those incentives were reached
4
Managers are not permitted to take short positions in firm securities against their option holdings [Section 16c of the Securities and Exchange Act of 1934]. See Bettis, Bizjak, and Kalpathy 2015 for avenues available to managers
for hedging their risks.
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before or after CDS inception, to undertake risky investment projects and increase asset volatility, shifting wealth from lenders to shareholders, when such opportunities arise from reduced lender
vigilance. Furthermore, because dividend payouts are the most direct way to transfer wealth from creditors to shareholders, we expect firms with incentives aligned with shareholder interests to pay
excessive dividends. Our second hypothesis is formulated as:
H2B. Asset substitution and excessive dividend payouts upon CDS inception increase with
managers’ vega and total compensation. Increases in operating risks post
–CDS inception, because of shifts in lender and shareholder forces, to the extent facilitated by managers’ vega incentives, should increase
bankruptcy risk by enhancing the high likelihood of both large payoffs and drastic failure. We thus triangulate the ideas tested in H2A and H2B to provide an additional explanation for the increases
in bankruptcy risk post –CDS inception.
H3. Increases in bankruptcy risk after CDS trade inception are
affected by managers’ incentives.
3. Sample selection and descriptive statistics
