Stock Options and Credit Default Swaps in Risk Management

Abstract

The use of stock options and credit default swaps (CDS) in banks is not uncommon. Stock options can induce risk-taking incentives, while CDS can be used to hedge against credit risk. Building on the existing literature on executive compensation and risk management, our study contributes novel empirical support for the role of stock options in restraining the use of CDS for hedging purposes. Based on data of CEO stock options and CDS held by 60 European banks during the period 2006-2011, we find a negative relationship between option-induced risk-taking incentives (vega) and the proportion of CDS held for hedging. However, the extent of CDS held for hedging is found to be positively related to default risk in the period leading to the financial crisis that erupted in 2007. The findings imply that restraining the use of stock options can incentivize hedging with CDS, but this risk management strategy will not necessarily produce lower default risk in times of systemic credit crisis.