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Financial Risk Management > Topic 8: Agency Risk > Flashcards

Topic 8: Agency Risk Flashcards

1
Q

Agent vs Principal

conflict / agency theory

A

Agent: acts for or on behalf of principal
Principal: engages/hires/employs the agent

Note Agency theory - conflict between agent acting in own interests vs on behalf of client
Agent may have more information than the principal

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2
Q

examples agent / principal & potential conflict

A
  • real estate agent acts on behalf of principals for sale & purchase
  • head hunters
  • shareholders elect board of directors for publicly listed company
  • investors - fund managers
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3
Q

Incentive conflicts

A

Neoclassical framework: assume individuals maximise utility. Stakeholders may not be aligned.

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4
Q

Owner/manager conflicts (examples) (7)

A
  1. choice of effort (mgr vs owner)
  2. perquisite taking (perks)
  3. differential risk exposure (owners have diversification so are tolerant)
  4. differential horizons
  5. entrenchment (protect own position to detriment of shareholders)
  6. consensus provision risk (YES MAN problem)
  7. extravagant investment
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5
Q

controlling incentive problems with contracts

Effectiveness is reduced by (4)

A

contracts may attempt to control agency risk, eg to package up perks as part of overall salary package.
Effectiveness reduced by:
1. gaming (engaging in non-productive efforts to improve evaluation)
2. monitoring costs (protect interests of principals)
3. bonding costs (eg insurance against rogue trading = a cost)
4. residual loss (net losses due to agency problems)

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6
Q

Moral hazard

A

One party to a contract changes their behaviour to the detriment of another party after the contract has been established. Conscious malicious act of agent.
eg fire insurance taken out, but due care not taken by company to eliminate fire risk (as they are covered)

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7
Q

Problems with income incentive programs

A
  • interests of employers and employees not perfectly aligned

- actions not directly observable (cannot ensure productive working activity)

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8
Q

cash bonuses operate as:

A

operate as a call option with asymmetric payoff

base salary remains. Can increase the volatility, take on riskier schemes in order to achieve bonus

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9
Q

Factors favouring high incentive pay

A
  1. output is sensitive to employee effort
  2. employee is not very risk averse
  3. level of risk that is beyond the employee’s control is low
  4. employee’s response to increased incentives is high and positive
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10
Q

enhanced incentives from ownership

A
  • introduce ownership by issuing shares or share options to employees
  • this enhances alignment of incentives between general shareholders and employee - shareholders
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11
Q

why is ownership not used more extensively to minimise agency problems?

A
  • wealth constraints (agents may not have the capital for a significant ownership stake)
  • risk aversion (ownership stake will not be adequately diversified, so may represent inappropriately high degree of risk for agent
  • team production (free rider problem)
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12
Q

Employee share and option plans (ESOP)

A

advantage is the direct link between the company’s share price and their value

  • consider: typically unable to hedge or sell within a certain period
  • if executive leaves the company, will forfeit the securities
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13
Q

criticism of ESOP

A
  • in a bull market most shares rise irrespective of whether execs have added value
  • “royalty on the passage of time” (Warren Buffet)
  • out of the money options would be better to grant than ATM
  • accounting standards now require firms to expense options when granted
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14
Q

ESOP pros

A
  • alignment
  • encourage loyalty (lock ups, vesting)
  • potential tax benefits (no tax payable at granting, only at time of exercise/sale)
  • can reduce start up costs - employees work for relatively low salary at start with the promise of future growth
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15
Q

Valuing ESOPs - issues

A
  1. B-S hard to use because issuing of new options may dilute existing shareholders
  2. executives may leave firm, forfeiting option rights, will impact value
  3. Vesting may depend on performance hurdles
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16
Q

Executive value of options vs cost to owners

A
  • firm can choose between issuing options to mkt or execs
  • if options offered on mkt, firm can earn full B-S value
  • if options offered to execs, execs are undiversified and will value them at a lower level.
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17
Q

ESOP & risk taking behaviour

A
  • reputation risk can be a factor in determining behaviour of career-conscious, risk averse manager. (avoid risk, under-invest, fail to pursue projects that are value adding)
  • if execs hold high amounts of stock, may avoid projects with high systemic risk
  • options may avoid this behaviour : value of options increases with riskiness. Positive vega in remuneration package is associated with riskier policy choices
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18
Q

GFC implications on income incentives

  • bonuses
  • equity
A

Bonuses

  • should they be capped
  • should they be held back with clawback provisions
  • should they be replaced with equity based compensation

Equity

  • Share plans traditionally encourage low risk behaviour. However, consider moral hazard, govt bailouts
  • alternative: convertible equity (defined triggers would cause equity to convert to sub debt at a valuation discount
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19
Q

how should performance measures be designed

A
  • low cost
  • not easily gamed
  • achievable
  • avoid undue influence by agents in setting targets
  • relate to goals of firm
  • agent must be able to influence outcome
  • reflect time horizon of principals
  • objective measures where possible
  • multiple performance measures
  • relative performance measures
  • team performance measures where relevant
  • team measures subject to free rider problem - therefore consider individual performance measures
20
Q

Agency risk is most likely to occur where:

A

Agency risk is most likely to occur where incentive conflict is combined with informational asymmetry

21
Q

Minimise agency risk:

A

Minimise agency risk: adapt organisational structure

- allocate decision rights, establish reward systems, performance evaluation processes

22
Q

Reward systems should…

A

Reward systems should endeavour to align incentives of employees with owners

23
Q

Performance evaluation may align employees with owners if:

A

if measured on a risk adjusted basis

24
Q

*** 2 crucial conditions for Agency Risk to arise

A
  1. Incentive conflict (large bonuses not linked to risk)

2. information asymmetry risk measures reported to senior mgmt needs to contain accurate picture)

25
Q

Faulty risk measures may be motivated by agency risk: (4)

A
  1. intentionally understating risk positions -> staff can take higher risk positions without knowledge of senior execs
  2. this high risk strategy can result in higher bonuses for relevant staff
  3. shirking from responsibilities to shareholders (need to ensure risks are checked by competent people)
  4. failure to invest in risk management people and systems viewed as costly
26
Q

Principal - agent relationship in Ratings agency

A
  1. Difficult to argue P-A exists as ratings are not paid for. Interests are not normally conflicted
  2. P-A relationship exists between employees and owners of agency (the principals).
    - owners: LT perspective
    - employees: ST favourable ratings could encourage bond turnover & lead to job prospects through relationships
27
Q

Reasons for franchising rather than owning

A
  • incentives will be higher for franchisee than for an employee
  • franchisee will have specific knowledge of local area
  • franchisee likely to have the right skills
28
Q

Problems with franchise system

A
  • local bidders may get together and place low bid for business
  • may be short run incentive to generate huge profits at the expense of longevity
29
Q

Define “Efficient Risk Bearing”

What are the implications for incentive schemes

A

Efficient Risk Bearing =
Incentive based compensation:
- align interests of owners & employees (ideally). Employee accepts some risk
- employees normally more risk averse when taking on such schemes as they are not well diversified. Risk premium may be excessive for owner
- Therefore incentive scheme may not be efficient outcome for owner
- need to structure schemes to ensure the cost of compensating employees for risk does not outweigh the benefits

30
Q

Organisational architecture, consider:

A
  1. decision rights
  2. performance evaluation
  3. reward structure
31
Q

*** Remuneration Structures:
Compensation = W
Q = f(e) + error term

A
  • Remuneration is a constant
  • No incentive to work harder
  • If worker is lazy, will shirk, if not, firm will benefit
  • Firm bears risk, must hire motivated employees
  • Fixed wage is low risk for Eric so low/no risk premium required
    Security of wage
32
Q

** Remuneration Structures:
Compensation = BQ (where B is a variable, Q = output
Q = f(e) + error term

A
  • If worker produces a lot, will receive a lot. Pure commission, no fixed.
  • Eric bears a lot of risk, especially with the error term. If he has bad luck, E<0; and he will lose out (and vice versa)
  • Average salary cost to firm likely to be higher.
  • Positive = signalling - a commission structure may attract a certain type of person (self confident, driven).
33
Q

** Remuneration Structures:
Compensation = W + BQ (where B is a variable, Q = output
Q = f(e) + error term

A
  • If base is low, there is an incentive to generate Q
  • retainer + commission scheme
  • Puts more risk back onto the company with W payment; both company and employee are subject to E risk.
  • Must negotiate size & importance of W and B
  • Firm can probably adopt more risk than Eric, so may not nec insist no low W
34
Q

** Remuneration Structures:
Compensation = W + Lf(e)
= W + L * (Q-error)
Q = f(e) + error term

A
  • Note the multiplier L depends on effort. It is hard to measure effort.
  • Also, hard to measure the error term.
  • Eric can control his effort (f(e); but cannot control actual output Q because of the error term.
  • A lot of risk for employee, due to factors that can’t be controlled
35
Q

** Remuneration Structures:
Compensation = W if Q < Q
Compensation = W + W1 if Q > Q*
Q* = target personal output.

Q = f(e) + error term

A
  • used in investment banking
  • W1 may also be equity
  • Target needs to be achievable, but not too easy as it would be expensive for firm. If not achievable; demoralising.
  • No incentive for Eric to work harder once he reaches Q* as compensation is flat from there.
  • A random event (error term) may get Eric over Q* or put him under it,
36
Q

** Remuneration Structures:
Compensation = W if company’s target is not met
Compensation = W + W1 if company’s target is met
Q = target personal output.

Q = f(e) + error term

A
  • free rider problem; how much is attributable to you and how much to those around you.
37
Q

*** Remuneration Structures:
Compensation = W + C * (Q - Q’)
Q’ = average output of peers

Q = f(e) + error term

A
  • this structure would cause internal friction. Not collegiate.
  • Compensated for the difference between personal performance and peer performance
  • Can be good if it promotes extra effort, but bad if it encourages conflict.
  • Eric loses out if he is below the average of his peers
38
Q

*** Remuneration Structures:

Franchise structure: employee pays for rights to all revenues from efforts

A
  • needs to include risk premium. Need compensation for the risk that is carried
  • employee focuses on effort, firm just receives a payment (eg taxis)
  • ## remember to calculate optimal effort. may require differentiation
39
Q

Would value of options be more compelling than shares with options that have a longer term?

A
  1. Longer term -> options have higher premium. So you would get less options for your money
  2. Longer term ATM calls have higher deltas
  3. The combined effect is unknown.
40
Q

What is more risky for a CEO - options or shares

A
  1. Options. If share price falls below K, options are OTM and worthless. If value was in shafres, would still have some value. So downside on options is more risky. (Upside is higher)
  2. Risk return tradeoff
41
Q

Cash bonus vs share or option bonus

A

pros

  • one off incentive with no direct connection with share price
  • cash bonus is cheaper for company because no risk premium is required
  • inefficient risk is embedded in employee stock & option plan (employee often willing to accept lower cash value vs option value)
  • cash = steady income for employee

cons

42
Q

What is the impact of increased stock price volatility on the value of options? How would CEO behaviour be impacted?

A
  1. Increase vol -> increase vega. Options have vega, stocks do not. CEO may seek to increase vol as the option value would increase
  2. However, CEO is internal shareholder, not as diversified as external shareholders. Perceived value of his options would drop, so may become more risk averse, less likely to take on new projects and have a higher tendency to hedge currency etc. Underinvestment problem.
43
Q

WHat if bank is large, systemically important - explain behaviour with remuneration in options

A
  1. moral hazard: bail out by government
  2. senior execs get upside, downside taken care of by govt
  3. incentives between employees and owners (shareholders) not well aligned.
44
Q

How to capture the general up movement in stock price vs actual performance (free rider)

A
  • consider difference between stock price and an index, eg of like firms in similar industry. Reward would then only be for outperformance vs peers
  • grant standard call option with conditions attached (eg market share, profit relative to competitors etc)
45
Q

Two crucial pre conditions for agency risk to arise:

A
  1. Information asymmetry

2. Incentive conflict

46
Q

“Efficient risk bearing”

A
  • the use of incentive based remuneration and share/option based remuneration.
  • to reduce agency risk, should be alignment between owners and employees.
  • incentive based remun. forces employee to accept some risk.
47
Q

Middle office =

A
  • functions that independently monitor and control market risk taking.
    = provides management information and support to trading management

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