Risky debt contracts with fluctuating interest rates, payments that rise and fall...

Author: Carol Newswriting

Chief executive officers whose compensation packages include large stock options are more likely to choose bank credit lines with fluctuating interest rates than those who don’t, says Finance Professor Hayong Yun.

In the study, “ Negative Hedging: Performance-Sensitive Debt and CEOs’ Equity Incentives , ” Professor Yun and research colleagues examined the relationship between CEO stock option incentives and performance-sensitive debt contracts, where interest payments rise or fall automatically depending on some measure of the borrower’s performance, such as a company credit rating.

“These variable debt contracts increase firm risk,” says Professor Yun, “and tend to lower equity value by accelerating the path to financial distress. Once you start having trouble, you have to pay more and more, and just get that much faster into default.”

On the other hand, he explains, CEOs with stock options can receive significant short-term financial gains from the contracts. This is because cash flow volatility can contribute to large option payouts during high performance periods without incurring losses during low performance periods.

“Performance-pricing contracts seem to provide a channel for CEOs to gain private benefits while increasing financial risk to firms,” Yun continues. “These contracts are growing in popularity. Investors and boards should take note.”

Professor Yun, who holds Ph.D.s in both finance and mechanical engineering, also studies corporate governance, corporate finance and bankruptcy. To learn more about the research of Professor Yun, visit business.nd.edu/hayongyun