Reference no: EM133072463

A share trader works for a financial institution and has decision rights over which stocks he buys and sells using the financial institution's capital. The share trader's performance is measured as the profit or loss (P&L) from the trades he makes over a quarter.

The stock trader's quarterly P&L is the sum of the individual trade P&Ls. If during the quarter he buys 10,000 shares of a particular stock at $41 per share using the financial institutions capital and later sells the shares for $43 per share the P&L of the trade is ($43-$41)*(10,000) or $20,000. The P&L is a profit to the financial institution. If he sells the stock at $35, then the P&L is ($35-$41)*(10,000) or -$70,000.

Effort exerted by the stock trader to research the market will improve her P&L. Finally, note that some stocks have very volatile returns (the price can change a great deal in a short period of time) while other stocks have low return volatility (the price changes less than high return volatility stocks in a short period of time).

The standard incentive contract pays the employee a bonus equal to a percentage of performance, the trader's P&L in this case, above a target level of performance when measured performance exceeds the target level.

(A) While a standard incentive contract will reward research effort made by the share trader, how could the standard incentive contract induce the him to make choices that are not in the financial institutions best interests?

(B) How could the standard incentive contract be modified to reduce the stock trader's incentives to make choices that are not in the financial institutions best interests while still providing the stock trader and incentive to put forth effort to make more profitable trades?