Negative Hedging: Performance Sensitive Debt and CEOs’ Equity Incentives

Alexei Tchistyi
University of Illinois at Urbana-Champaign – Department of Finance

David Yermack
New York University (NYU) – Stern School of Business

Hayong Yun
Michigan State University – Department of Finance

September 18, 2009

NYU Working Paper No. FIN-07-043


We examine the relation between CEOs equity incentives and their use of performance-sensitive debt contracts. These contracts require higher or lower interest payments when the borrower’s performance deteriorates or improves, thereby increasing expected costs of financial distresswhile also making a firm riskier to the benefit of option holders. We find that managers whose compensation is more sensitive to stock price volatility choose steeper and more convex performance pricing schedules, while those with high delta incentives choose flatter, less convex pricing schedules. Performance pricing contracts therefore seem to provide a channel for managers to increase firms financial risk to gain private benefits.

Negative Hedging- Performance Sensitive Debt and CEOs’ Equity Incentives

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