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Q16I.

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Essentials Of Investments
Found in: Page 24
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. How might this practice have affected traders’ willingness to assume risk? What is the agency problem this practice engendered?

This encourages them to take extraordinary risks.

Misdeeds of one trader are most likely to be facilitated and carried forward by other traders

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Step by Step Solution

Definition

The potential conflicts of interests between shareholders and managers are known as agency problem. In such cases, the managers may pursue their own interests and not that of its shareholders, for a variety of reasons.

Explanation

Allowing compensation with a share of trading profits to traders is an agency problem as traders get incentivized but not penalized on trading losses. This encourages them to take extraordinary risks.

This also creates a vicious cycle where the misdeeds of one trader are most likely to be facilitated and carried forward by other traders.

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