Some Firms Provide Stock Options to Managers as an Incentive

question 121

Multiple Choice

Some firms provide stock options to managers as an incentive to work hard and increase the value of the firm. A typical option contract gives the manager the right to buy the firm's stock at a set price (known as the exercise price) . If the firm's stock value increases and moves above the exercise price, then the manager's option becomes more valuable. What is the potential problem with this incentive scheme?

• A) The incentive does not include a performance benchmark, so it cannot be optimal.
• B) There is a dynamic incentive problem-the manager may focus too much on the firm's short-run stock value and not on actions that are in the best interest of the firm for the long run.
• C) The incentive value depends on the firm's stock value, which cannot be influenced by the amount of work or effort exerted by the manager.
• D) There are no problems with this incentive scheme.

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Definitions:

High Risk

Situations or investments that carry a significant possibility of loss or failure.

Low Risk

Pertaining to situations or investments that have a minimal likelihood of loss or failure.

Insurance Market

The marketplace where individuals or entities can purchase insurance products to transfer risk from themselves to an insurance provider.

Adverse Selection

A situation in which one party in a transaction has more or better information than the other, leading to an imbalance that can result in market inefficiency or failure.