Pay Me Later: Inside Debt and Its Role in Managerial Compensation

Inside debt, such as pensions and deferred compensation, constitutes a widely-used form of executive compensation, yet the valuation and incentive effects of these instruments have been almost entirely overlooked by prior work. Our paper initiates this line of research by studying CEO pension arrangements in a sample of 237 large capitalization firms. Among our findings are that CEO compensation in most large cap firms exhibits a balance between debt- and equity-based incentives, with the balance shifting systematically away from equity and toward debt as CEOs growolder; that annual increases in pension entitlements represent about 10% of overall compensation for the CEOs in our sample, and about 15% for CEOs aged 61 to 65; that CEOs with high debt-based incentives manage their firms conservatively to reduce default risk; and that pension plan compensation strongly influences patterns of CEO turnover and CEO cash compensation.CEO pensions; inside debt; deferred compensation

CDS Credit-Event Auctions

Credit-event auctions were introduced in 2005 to facilitate cash settlement in the credit default swap market following a credit event. They have a novel two-stage structure that makes them distinct from other auction forms. This paper studies outcomes in credit-event auctions over the period 2008-10. Our analysis is in three parts. In the rst part, we look at the ecacy of price discovery in the auction. We nd that the auction price has a signicant bias relative to the pre- and post-auction market prices for the same instruments, and that volatility of market prices often increases after the auction; nonetheless, we find that information generated in the auction is very valuable for post-auction market price formation. In the second part of the analysis, we look at behavior within and across auctions and the factors that in uence it. We find, among other things, that \winner's curse" concerns play a central role, affecting liquidity provision in the auction, the pricing bias, and bidders' within-auction updating of their private information. In the nal part of the paper, under some simplifying assumptions, we carry out a structural estimation to recover the underlying distribution of signals. Using these estimates, we find that the alternative auction formats could reduce the amount of bias in the auction final price

A Direct Approach to Arbitrage-Free Pricing of Credit Derivatives1

This paper develops a framework for modelling risky debt and valuing credit derivatives that is exible and simple to implement, and that is, to the maximum extent possible, based on observables. Our approach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. We do not follow the procedure of implying out the behavior of spreads from assumptions concerning the default process, instead working directly with the evolution of spreads. We show that risk-neutral drifts in the resulting model possess a recursive representation that particularly facilitates implementation and makes it possible to handle path-dependence and early exercise features without difficulty. The framework permits embedding a variety of specifications for default; we present an empirical example of a default structure which provides promising calibration results

Switching Costs and the Gittins Index

The Theorem of Gittins and Jones (1974) is, perhaps, the single most powerful result in the literature on Bandit problems. This result establishes that in independent-armed Bandit problems with geometric discounting over an infinite horizon, all optimal strategies may be obtained by solving a family of simple optimal stopping problems that associate with each arm an index known as the dynamic allocation index or, more popularly, as the Gittins index. Importantly, the Gittins index of an arm depends solely on the characteristics of that arm and the rate of discounting, and is otherwise completely independent of the problem under consideration. These features simplify significantly the task of characterizing optimal strategies in this class of problems

Denumerable-Armed Bandits

This paper studies the class of denumerable-armed (i.e. finite- or countably infinitearmed) bandit problems with independent arms and geometric discounting over an infinite horizon, in which each arm generates rewards according to one of a finite number of distributions, or "types." The number of types in the support of an arm, as also the types themselves, are allowed to vary across the arms. We derive certain continuity and curvature properties of the dynamic allocation (or Gittins) index of Gittins and Jones (1974), and provide necessary and sufficient conditions under which the Gittins-Jones result identifying all optimal strategies for finite-armed bandits may be extended to infinite-armed bandits. We then establish our central result: at each point in time, the arm selected by an optimal strategy will, with strictly positive probability, remain an optimal selection forever. More specifically, for every such arm, there exists (at least) one type of that arm such that, when conditioned on that type being the arm's "true" type, the arm will survive forever and continuously with nonzero probability. When the reward distributions of an arm satisfy the monotone likelihood ratio property (MLRP), the survival prospects of an arm improve when conditioned on types generating higher expected rewards; however, we show how this need not be the case in the absence of MLRP. Implications of these results are derived for the theories of job search and matching, as well as other applications of the bandit paradigm

A Class of Bandit Problems Yielding Myopic Optimal Strategies

We consider the class of bandit problems in which each of the n ≧ 2 independent arms generates rewards according to one of the same two reward distributions, and discounting is geometric over an infinite horizon. We show that the dynamic allocation index of Gittins and Jones (1974) in this context is strictly increasing in the probability that an arm is the better of the two distributions. It follows as an immediate consequence that myopic strategies are the uniquely optimal strategies in this class of bandit problems, regardless of the value of the discount parameter or the shape of the reward distributions. Some implications of this result for bandits with Bernoulli reward distributions are given

A Simple Model for Pricing Securities with Equity, Interest-Rate, and Default Risk

We develop a model for pricing derivative and hybrid securities whose value may depend on different sources of risk, namely, equity, interest-rate, and default risks. In addition to valuing such securities the framework is also useful for extracting probabilities of default (PD) functions from market data. Our model is not based on the stochastic process for the value of the firm [which is unobservable], but on the stochastic process for interest rates and the equity price, which are observable. The model comprises a risk-neutral setting in which the joint process of interest rates and equity are modeled together with the default conditions for security payoffs. The model is embedded on a recombining lattice which makes implementation of the pricing scheme feasible with polynomial complexity. We present a simple approach to calibration of the model to market observable data. The framework is shown to nest many familiar models as special cases. The model is extensible to handling correlated default risk and may be used to value distressed convertible bonds, debt-equity swaps, and credit portfolio products such as CDOs. We present several numerical and calibration examples to demonstrate the applicability and implementation of our approach

Pay Me Later: Inside Debt and Its Role in Managerial Compensation

Many companies pay their executives using inside debt, such as pensions and deferred compensation. Though these instruments are widely used, their valuation and incentive effects for managers have been almost entirely overlooked by prior research. CEO compensation in most firms exhibits a balance between debt and equity based incentives, and the balance systematically shifts away from equity and toward debt as CEOs grow older. CEOs with high debt-based incentives manage their firms conservatively to reduce default risk. Pension plan compensation strongly influences patterns of CEO turnover and CEO cash compensation

Pay Me Later: Inside Debt and Its Role in Managerial Compensation

Inside debt, such as pensions and deferred compensation, constitutes a widely-used form of executive compensation, yet the the valuation and incentive effects of these instruments have been almost entirely overlooked by prior work. Our paper initiates this line of research. Among our findings are that pensions constitute a significant component of overall compensation; that CEO compensation in most firms exhibits a balance between debtand equity-based incentives, with the balance shifting systematically away from equity and toward debt as CEOs grow older; that CEOs with high debt-based incentives manage their firms conservatively to reduce default risk; and that pension plan compensation strongly influences patterns of CEO turnover and CEO cash compensation