Credit ratings and CEO risk-taking incentives

Abstract

This study examines the sophistication of rating agencies in incorporating managerial risk-taking incentives into their credit risk evaluation. We measure risk-taking incentives using two proxies: the sensitivity of managerial wealth to stock return volatility (vega) and the sensitivity of managerial wealth to stock price (delta). We find that rating agencies impound managerial risk-taking incentives in their credit risk assessments. Assuming other things equal, a one standard deviation increase in vega (delta) will lead to an approximately one-notch (two-notch) rating downgrade. In addition, we evaluate the significance of credit ratings in the design of CEO compensation. Our findings sugge..