A dysfunctional effect of basing CEO incentives on stock price is to encourage excessive risk taking. Such risk taking affects not only the creditors of the company but also other stakeholders including taxpayers and potentially the financial system as a whole.

Credit Default Swaps (CDS) offer creditors an opportunity to get default insurance. The issuer of the CDS (typically a financial institution) provides the buyer with compensation in case of default by company that issued the loan or bond (called the reference obligation). For this, the CDS issuer receives premiums from the buyer.

CDSs are derivatives, i.e. financial instruments whose value depends on the riskiness of the reference obligation. The value of the CDS is measured in the form of its spread. A CDS spread indicates the premium that is required to insure $100 of the reference obligation.

As the riskiness of the underlying reference obligation increases, the value of the CDS increases. As such, CDSs are actively traded and are often bought by investors who do not own the underlying loan or bond.

a) Explain why companies base some part CEO compensation on stock price when this will likely result in excessive risk taking (3 marks)

b) Explain whether you expect the degree of CEO risk taking to be higher or lower for a company that is highly levered, i.e. with a large amount of debt (2 marks).

c) Buying a CDS without owning the underlying reference obligation amounts to short selling the reference obligation. Briefly explain the concept of short selling and why investors would wish to buy the CDS in order to short a company's bonds (2 marks)

d) Identify and briefly explain one benefit that CDSs provide to securities markets (2 marks)

e) Assume that a company ties a part of the CEO's compensation to its CDS spread. What effect, if any, do you expect this will have on the CEO's risk taking behavior? Explain briefly (2 marks)

f) CEOs of companies listed in Fortune magazine's ranking of America's most admired companies earn, on average, 8% less than others. Explain briefly why (2 marks)

g) What reaction do you expect from securities markets to a proposed regulation that seeks to limit executive compensation by making shareholders' "say on pay" binding? Explain briefly (2 marks)

Answer rating: 100% (QA)

a Companies base some part of CEO compensation on stock price because it aligns the interests of the CEO with those of shareholders When CEOs are ince... View the full answer