Risk-taking incentives and firm credit risk11The authors thank Kristine W. Hankins (editor), the anonymous associate editor and two anonymous reviewers, workshop participants at Lehigh University, Northwestern University, Southern Methodist University, and the University of Florida; conference participants at the Temple University Accounting 100th Anniversary Conference and the Hawaii Accounting Research Conference; Ray Ball, Sam Bonsall, Brian Cadman, Rachel Hayes, Marcus Kirk, Zawadi Lemayian, Karl Muller, Gans Narayanamoorthy, Matthew Ringgenberg, David Sovich, and Liz Tashjian, and Wei Wang (discussant) for helpful comments. We thank Catherine Blowe and Tian (Terri) Xu for research assistance, and Kai Chen for sharing his executive compensation code. Koharki thanks the Krannert School of Management, and Watson thanks the Villanova School of Business for financial support. All errors are our own. ©2016–2025 Kevin Koharki and Luke Watson

Theoretically, increased risk-taking incentives should disproportionately benefit equity holders at the expense of creditors. However, we find that increases in CEO risk-taking incentives (vega) are associated with better outcomes for creditors. Specifically, credit ratings and credit default swaps both improve following increases in vega. This effect is magnified for firms close to default. Within the Merton (1974) framework, our findings suggest that increased risk-taking incentives induce managers to take on more positive net present value projects. Consequently, while higher vega increases the risk of the firm, our results imply that it also increases the expected value of the firm, reducing its credit risk.