CEO stock-option compensation and the use of credit default swaps in relation to European bank risk

This thesis investigates two main aspects related to the use of credit default swaps (CDS) by European banks. The first area of investigation focuses on the relationship between the CEOs’ risk-taking incentives generated by stock option compensation and the usage of CDS by banks. This thesis contributes to the existing literature in risk management with derivatives, which initially assumes that the use of derivatives is intended to reduce firm risk, by distinguishing between CDS use for hedging purposes and CDS use for trading purposes. The relationship between CEOs’ risk-taking incentives and CDS use in banks, and the influence of CDS use on bank’s risk are investigated based on the purpose of CDS use. This thesis utilises the estimates of the Black-Scholes sensitivity of executives’ stock option portfolios to stock return volatility (vega) to test the relationship between CEOs’ risk-taking incentives and CDS use. In addition, this thesis distinguishes between the effect of risk-taking incentives on CDS use for hedging purposes, and the effect of risk-taking incentives on CDS use for trading (speculating) purposes. The second key aspect of this thesis is to examine the effect of CDS use on bank risk by distinguishing between the effect of CDS use for hedging purposes and CDS use for trading purposes. The purpose of CDS use that depends upon the managers’ risk-taking incentives and the use of CDS can have different implications to the risk profile of the bank. Data for the period of 2006 – 2011 were hand collected from the annual reports of sixty European banks. The sample comprises publicly listed banks from European stock market indices and premier indices of the European Union countries (EU-27). In conducting the empirical testing, the two stages regression approach was used to adjust for the potential endogeneity that could arise between the risk-taking incentives of stock option compensation (vega), and CDS use. The results show a significantly positive relationship between CEOs’ risk-taking incentives generated by stock option compensations and CDS use in banks for trading purposes. This implies that higher risk-taking incentives (vega) are associated with greater CDS use for trading purposes. Furthermore, there is a negative linkage between CEOs’ risk-taking incentives and CDS use for hedging purposes at weak levels of statistical significance. The results also show strong evidence of a positive linkage between CDS use for trading purposes and bank risk. CDS use for trading purposes is associated with a higher bank’s beta and lower distance to default. Further, the results show a positive and significant relationship between CDS use for hedging purposes and bank risk. CDS use for hedging purposes is also associated with a higher beta of a bank and lower distance to default. These results are consistent with the theoretical predictions of Smith and Stulz (1985), who suggest that stock options can influence managers’ decisions to use derivatives and lead to greater alignment between the interests of managers and shareholders by mitigating managerial risk aversion. Thus, stock options provide managers with incentives to take on risk. Overall, the evidence presented in this thesis suggests that CEOs’ risk-taking incentives derived from stock options compensation is a key determinant of CDS use in banks. Moreover, banks’ CDS use increases bank risk regardless of the purpose of its use. Both hedging and speculating CDS activities are associated with a bank’s higher risk. This thesis provides an integrated understanding and builds a comprehensive picture of how CEOs’ stock option compensation can affect the purpose of CDS use, and how this use influences bank risk. It primarily extends previous empirical literature, which initially looked at derivatives as a risk reduction instrument, by distinguishing between CDS use for hedging purposes from CDS use for trading purposes.