Question

True or false with justification:

1. Financial Derivatives can be traded in the future markets. They include futures, options and bills.

2. Government bonds are issued by governments to finance the budget deficit, they are short term and less risky than stocks and corporate bonds.

3. The agency problem results from a manager’s concerns about corporate goals and can only be solved through stock options

Answer 1

1) False

Financial Derivative types are options and futures majorly and they also include others like forwards and swaps. Normal futures and futures on other derivative types can be traded in futures market. But bills is a simple financial instrument but not the derivative instrument.

2) True

Government bonds will be issued by the federal government. Since they are issued by the government the returns are assured and guaranteed by the government. So they considered to be less riskier than stocks which trade on secondary market and corporate bonds whose returns depends on company's performance. Government bonds will be issued by the government as a debt financing during budget deficit to help the economy

3) False

Agency problem is usually quoted as the conflict of interest between company's managers and its stake holders. Stake holders always concentrate on the long term profits and increase in stock prices where as managers shows their interest in short term gains so that they get additional monetary rewards in the near term.

Issuing stock options to the managers helps in making managers conscious about long term stock performance as well and so matching their expectations with that of stake holders. This resolves the agency problem.

But this is not the only method to reduce the agency problem. Changing the compensation structure, Bonus and Incentives based on long term performance, taking back the incentives based on the performance in the long term will also be used to solve the same