The Hidden Cost of Managerial Incentives: Evidence from the Bond and Stock Markets

38 Pages Posted: 2 Nov 2004

See all articles by Naveen D. Daniel

Naveen D. Daniel

Drexel University - Department of Finance

J. Spencer Martin

University of Melbourne - Faculty of Business and Economics; Financial Research Network (FIRN)

Lalitha Naveen

Temple University - Department of Finance

Date Written: September 2004

Abstract

We examine how incentives embedded in managerial compensation contracts are priced by the bond and stock markets. Specifically, the incentives we consider are the sensitivity of CEO wealth to stock price (delta) and the sensitivity of CEO wealth to stock-return volatility (vega). Controlling for other determinants, we find that higher levels of both vega and delta are associated with higher bond credit spreads and higher expected stock returns. In addition to having a direct effect on credit spreads and expected stock returns, higher incentives are also associated with lower average cash flows, higher volatility of cash flows, and higher volatility of stock returns (all of which increase credit spreads), and higher systematic risk (which increases expected stock return). Thus, higher incentives have a cascading effect on credit spreads and expected stock returns. Also, a portfolio of high-incentive firms significantly underperforms a portfolio of low-incentive firms on a risk-adjusted basis; thus, on average shareholders appear to be harmed ex post as a result of incentive provision.

Keywords: Managerial incentives, executive compensation, credit spreads, expected stock returns

JEL Classification: G12, G34

Suggested Citation

Daniel, Naveen D. and Martin, J. Spencer and Naveen, Lalitha, The Hidden Cost of Managerial Incentives: Evidence from the Bond and Stock Markets (September 2004). Available at SSRN: https://ssrn.com/abstract=612921 or http://dx.doi.org/10.2139/ssrn.612921

Naveen D. Daniel (Contact Author)

Drexel University - Department of Finance ( email )

LeBow College of Business
Philadelphia, PA 19104
United States
215-895-5858 (Phone)
215-895-2955 (Fax)

HOME PAGE: http://lebow.drexel.edu/Faculty/DanielN

J. Spencer Martin

University of Melbourne - Faculty of Business and Economics ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Lalitha Naveen

Temple University - Department of Finance ( email )

Fox School of Business and Management
Philadelphia, PA 19122
United States
215-204-6435 (Phone)

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