Lecture 10 Flashcards
(3 cards)
1
Q
What are the two uses of financial derivatives?
A
- To hedge against the risk of loss and default (4 main types of risk).
- To speculate on the economic variables (interest rates, etc.) to change and most of the time to increase the risk and consequently the return.
*Difference betwen hedging and speculation is that speculation you aim to make a profit but also taking more risk whereas hedging you want to minimise risk and you don’t make a profit
1
Q
What are the advantages of using options as a payment method?
A
- Align executives’ interests to that of the shareholders.
- Lower the executive’s base pay.
- Executive’s pay at risk, rather than guaranteeing it regardless of the performance of the firm. This gives the manager/executive the incentive to work harder.
2
Q
What are the disadvantages of using options as a payment method?
A
- Align executives’ interests to that of ONLY the shareholders, and not other stakeholders.
- Increase the upper limit of the executive’s pay, and may encourage risk-taking behaviors of the executives.
- Executive’s pay at risk, rather than guaranteeing it regardless of the performance of the firm. This gives incentives to the managers to manipulate earnings or stock prices.
