Executive compensation, bankruptcy risk, and managerial risk taking

Abstract

Compensation studies suggest that equity-based compensation can align the interests of shareholders and managers in terms of managerial risk taking choices. This study extends the literature by examining whether equity-based compensation is used to incorporate the interests of bondholders with those of managers and shareholders in terms of managerial risk taking. In particular, it hypothesizes that equity-based compensation induced managerial risk taking is different for firms with and without high bankruptcy risk. Samples are partitioned according to measure of ex ante bankruptcy risk. The results show that the sensitivity of CEO wealth to stock returns volatility (Vega) has a lower impact on managerial risk taking for firms with higher bankruptcy risk than those with lower bankruptcy risk, while the sensitivity of CEO wealth to stock price (Delta) has a higher impact on managerial risk taking for firms with higher bankruptcy risk than those with lower bankruptcy risk, even after controlling for the effects of firm's size, firm's cash flow, and firm's investment opportunities.