Stock options and credit default swaps in risk management
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.