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Bankers Need Safety Nets Not Carrots To Take Risks

01 May 2004

Conventional wisdom says that if you offer traders stock options, which pay out if the firm performs well, they will take more risk in order to boost their performance and get paid more.

Conventional wisdom says that if you offer traders stock options, which pay out if the firm performs well, they will take more risk in order to boost their performance and get paid more. Stephen Ross, Franco Modigliani professor of finance and economics at the Sloan School at the Massachusetts Institute of Technology, however, argued, "To make agents more willing to take risks there should be more of a focus on offering downside protection than on offering them upside potential." But, he quipped, "Not so much that their best outcome is the firm goes belly up."

Ross said the high delta of call options means employees get nervous and become risk averse in order to protect their wealth. The put options still add convexity into employees' remuneration and therefore encourage outperformance, explained Ross.

One practitioner, however, said bankers rarely look at their options when calculating their net worth because they frequently leave the firm before the options vest. In addition, most staffers lack the ability to move a firm's share price, he added.

01 May 2004