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Leverage Choice and Credit Spreads when Managers Risk Shift

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  • MURRAY CARLSON
  • ALI LAZRAK

Abstract

We model the debt and asset risk choice of a manager with performance‐insensitive pay (cash) and performance‐sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex‐post asset substitution and that credit spreads are increasing in the ratio of cash‐to‐stock. Using a large cross‐section of U.S.‐based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash‐to‐stock and CDS rates, and between cash‐to‐stock and leverage ratios.

Suggested Citation

  • Murray Carlson & Ali Lazrak, 2010. "Leverage Choice and Credit Spreads when Managers Risk Shift," Journal of Finance, American Finance Association, vol. 65(6), pages 2323-2362, December.
    • Handle: RePEc:bla:jfinan:v:65:y:2010:i:6:p:2323-2362
    DOI: 10.1111/j.1540-6261.2010.01617.x
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