Question

Firms commonly incentivize their management to increase the firm’s value by granting man- agers securities tied to the firm’ stock. Some securities, however, can reduce managerial incentives to manage risk within the firm. Which is likely the best example of this type of security?

(a) Deep out-of-the-money call option on the firm’s stock

(b) Deep-in-the-money call option on the firm’s stock

(c) At-the-money call option on the firm’s stock

(d) Long position in the firm’s stock

Answer 1

(A) Deep out of the money call option.

Explanation : Assume that the stock price is currently 20, and manager has a call option of 30. Now to make the call option profitable, the manager will have to increase the value of stock by 10/20 = 50%. This will lead to managers taking risky decisions to gain 50%.

In the money or at the money options will be profitable either already or with minimal effort, thus it won't entail much risky decision. Similarly, holding long position is like keeping a stock in hand, not very risky decision will follow becasue of it.