Thursday, 9 March 2006

Getting paid for Gaming

Suppose you are a trader in an investment bank. Suppose the world is fair, so you get paid for every pound you make over your budget. In options terms, that means you have a call on the P/L struck at the budget. How do you increase the value of a call? One way is to make a lot of money: raise the forward. But another is to raise volatility of the underlying: make the P/L more volatile. Taking bigger risks is good for this. Now, was this the kind of behaviour we wanted to encourage when we designed the bonus programme?

It gets better. Suppose you manage traders. You get paid for every pound your group of traders makes over budget. So you have a call on a basket of P/Ls. How do you increase the value of a call on a basket? Well, the two methods above work, but so does increasing correlation - get everyone who works for you to take the same risks. Hmmm. Not quite what we wanted there either...

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