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  • Our paper also contributes to the large but hitherto inconcl

    2022-01-14

    Our paper also contributes to the large, but hitherto inconclusive literature that studies the effects of option-based compensation or convexity in compensation on corporate risk-taking policies. On the one hand, some studies document a positive relationship by showing that convexity increases leverage, firm volatility, and investment risk (Low, 2009; Chava and Purnanandam, 2010; Armstrong and Vashishtha, 2012; Gormley et al., 2013; Bakke et al., 2016). On the other hand, some other studies do not find a positive link by documenting option compensation reduces debt financing or results in less risky investment policies (Lewellen, 2006; Hayes et al., 2012; Tosun, 2016). Our paper contributes to the above debate by arguing that the inconclusive result between managerial compensation risk-taking incentives and financial policies is likely due to the negligence of one potential mechanism, i.e., the creditor channel. In Praziquantel receptor to the manager Praziquantel receptor channel, the creditor channel has an opposite prediction on how the convexity of managerial compensation affects some financial policies, e.g., leverage and net debt issuances. The literature mainly focuses on the manager channel, while ignoring the role of creditors in determining the financial policies when they face less risk-promoting managerial compensation. The consideration of the creditor channel helps reconcile why some studies, e.g., Lewellen (2006) and Hayes et al. (2012), find that managers acting with greater risk-taking incentives induced by option compensation reduce rather than increase leverage. The remainder of the paper is organized as follows. Section 2 discusses the theoretical background. Section 3 explains our identification strategy. Section 4 presents the hypotheses. Section 5 presents our main data and variables. Section 6 describes our main empirical analysis. Section 7 investigates the underlying mechanisms and Section 8 concludes.
    Theoretical background A fundamental principle of finance is that managers should take financing and investment decisions to maximize shareholder value. However, in reality, risk-averse and under-diversified managers are likely to make conservative decisions and take less than the optimal level of risks for shareholders. The agency conflict between managers and shareholders regarding risk taking arises because shareholders are well diversified but managers' human capital and wealth are largely locked inside the firm, both of which can be jeopardized by firm risk (Amihud and Lev, 1981; Smith and Stulz, 1985). As argued by Jensen and Meckling (1976), Haugen and Senbet (1981), Smith and Stulz (1985) and Guay (1999), option compensation is the major component contributing to the managerial risk-taking incentives because of its convex payoff structure. If managers are granted with more options, they will have greater incentives to take risks. Thus, risk-averse managers should be compensated with option compensation to adopt the risk level that shareholders demand. Guay (1999) and Core and Guay (2002) argue that the risk-taking incentives provided by option compensation can be measured by the sensitivity of option compensation to a percentage change in stock-return volatility (vega). Following this, a growing literature, e.g., Rajgopal and Shevlin (2002), Coles et al. (2006), Low (2009), Chava and Purnanandam (2010), Armstrong and Vashishtha (2012), Cohen et al. (2013), Gormley et al. (2013), Croci and Petmezas (2015), Francis et al. (2017) and Kim et al. (2017), documents that a manager, granted with greater risk-taking incentives through option compensation (higher vega), will be more willing to increase leverage, investment risk and firm volatility. In this paper, we are particularly interested in the relationship between compensation risk-taking incentives measured by vega and corporate debt maturity choices. The effect of compensation vega on debt maturity has received less attention. This might be due to the perception that debt maturity is a secondary source of financial risks compared with leverage. However, a recent growing literature emphasizes short-maturity as an important source of financial risks, which can even induce severe risk-amplifying consequences during credit rationing periods. Acharya et al. (2011) and He and Xiong (2012) show that short-term debt can exacerbate a firm's credit risks, and sometimes even lead to market freeze, in scenarios with a deterioration in debt market liquidity or a fall in collateral values. The collapses of Bear Stearns and Lehman Brothers are vivid examples indicating that overreliance on short-term debt can drive bankruptcy since firms are unable to roll over its debt during a credit rationing period (Gopalan et al., 2014). Therefore, the maturity of debt is also a very important aspect of financial risks, and managers' risk preferences should also matter for this financial decision. Specifically, managers with larger risk-taking incentives through options (higher vega) prefer riskier corporate policies, and would be more willing to borrow in short-term to pay lower interest expenses (due to the term structure) at an expense of higher rollover and liquidity risk. This underlying mechanism behind the relationship between the risk-taking incentives provided by options and debt maturity is called the manager channel. It predicts a negative relationship between compensation vega and corporate debt maturity.