University of Illinois at Urbana-Champaign – Department of Finance
New York University (NYU) – Stern School of Business
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.