Question

Risk Preference Exercises—Compensation

1. Given what you know about risk preferences and what propels individuals to take risk evaluate, using what you know about the business model of each firm and from the perspective of the shareholder of the firm:

1. The use of trading limits by an investment bank’s proprietary trading desk. E.g., $2 mil in losses per trader per day and an aggregate limit of the trading desk = $40 mil per day. Evaluate the traders’ behavior in terms of risk taken and possibility for returns generated.

2. The effectiveness of a “Deals Committee” used by a private equity firm in which deal teams present the merits of the deals they want to close. The merits would include expected profitability and risk metrics.

3. An executive compensation plan in which the senior executive’s plan includes: $3 mil annual salary, fully vested pension and 100,000 warrants granted per year with a strike price of $75 (company shares are currently trading at $50).

Answer 1

A. Investment Banks Prop Trading Desk usually has a risk in terms of VaR(Value at Risk) which is assigned to the whole of the trading desk. So if risk limit is 40m for a trading desk with 20 traders, each trader will have 2m VaR allocation to himself. Traders then want to curtail excessive volatility so they generally opt for a derivative instrument to reduce the risk of their portfolio. Also, Traders look for the relatively stable market when they assume to be in high leverage positions so that in adverse conditions, their losses can be kept at a minimum level. This is in line with the shareholder perspective as these risk allocations keep traders in check.

B. Deal Committee asses the business and financial merits of a new investment opportunity. That generally includes "Why we are doing this deal?", "What would be the profitability/synergies/EPS after deal?", "Management Overview in terms of cultural fit", "Provide cost-cutting opportunities by deal". It also states the business of the company, their recent developments, and if there is any conflict of interest between the acquirer and target. On the risk side, Deal Committee assigns a probability to this acquisition going through and the proposed Deal Close Value to acquire the target. So Deals Committee is pretty much effective in assessing all the profitability and risk metrics in scenarios of before and after the deal in an M&A.

C. The executive has 3m in basic salary, fully vested pension( employee has met the threshold number of years of employment) as well as 100,000 warrants (right to purchase 100,000 stocks at 75$). It will not be profitable for him to use warrants no as he can himself buy stocks from the market at 50$ instead of 75$ through warrants. Also, executive risk profile looks like he wants to save for retirement as well as some portion of current salary in fixed investment (like property) and some portion in markets for gaining through capital appreciation.