Credit default swaps and CEO compensation: a long-term perspective

In this paper, we examine whether the onset of credit default swaps (CDSs) affects a firm's executive compensation. The availability of CDSs allows lenders to transfer credit risk, but not control or monitoring rights, to CDS sellers. Hence, CDS-protected lenders' incentives to monitor borrowing firms are curtailed, which could exacerbate the managerial agency problem. To mitigate the concern about the increased agency problem, we postulate that shareholders are more likely to demand greater long-term compensation for CEOs to compensate for their reduced ability to delegate monitoring to CDS-protected lenders. Consistent with our hypothesis, we find a positive CDS-incentive horizon relationship. Moreover, the positive relationship is more pronounced for institutional investors who have stronger incentives for monitoring. This study contributes to the literature by examining the impact of CDSs on executive compensation design, which has been largely overlooked in prior research.