Explanation:
A deep out-of-the-money (OTM) call option has an asymmetric and convex payoff. It gains value when volatility increases because a higher volatility increases the probability that the option will end up in-the-money. This gives managers a strong incentive to take on excessive risk (effectively reducing their incentive to manage risk) in an attempt to massively boost the stock price and make the deep OTM options valuable. Conversely, long stock positions or deep in-the-money options closely track the underlying asset price and encourage preserving value rather than taking excessive risks.
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Q.11 A wealth management firm is contemplating motivational measures in an attempt to align the interests of managers and shareholders. To this end, the board has plans to grant managers securities that are tied to the firm’s stock. Even as it ponders such a move, the board is wary of managerial incentives that could negatively affect risk management at the firm. Which of the following securities provides the best example of rewards likely to reduce managerial incentives to manage risk?
A
A long position in the firm’s stock
B
A deep out-of-the-money call option on the firm’s stock
C
At-the-money call option on the firm’s stock
D
A deep in-the-money call option on the firm’s stock
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