Category Archives: Announcements

Finance 4335 problem set 6 and Portfolio/Capital Market theory reading assignment

Finance 4335 Problem Set 6 will now be due on the first Tuesday after spring break (March 19). This coming Thursday, we will finish the adverse selection topic by illustrating an important pricing strategy which resolves adverse selection. We’ll also begin the Portfolio and Capital Market Theory topic, so there will be a quiz at the beginning of Thursday’s class meeting on my Portfolio and Capital Market Theory teaching note.

Important: Bring your Midterm 1 exam to class on Thursday for regrading!

I discovered some typos on one of the problems on the Midterm 1 exam booklet, so in fairness I need to regrade Midterm 1. Therefore, be sure to bring your graded Midterm exam 1 booklet to class on Thursday and hand it back to me so that I can make appropriate corrections. Worst case, there will be no grade change from what’s marked on your exam booklet, but I suspect that many, if not most of you, will end up with higher midterm exam 1 grades after I regrade your exams. In other words, the expected value of this prospective grade change is greater than or equal to zero for everyone! However, if you decline to submit your exam for regrading on Thursday, then the current marked grade will stand.

Sensitivity analysis of incentive compatible compensation contract

After class today, a Finance 4335 student asked me a particularly interesting question about the class problem; specifically, how much bonus is too much to offer? Clearly (based upon parts 4-5 of this class problem), if the firm is intent on hiring the CEO, then increases in her cost of effort require higher bonuses. For example, if the cost of effort is $200,000, then the minimum bonus comes to $701,038 (compared with a minimum bonus of $429,298 when the cost of effort is only $50,000). Under either of those cost of effort scenarios, the CEO will optimally work hard and expected profits net of CEO compensation (see the section of the spreadsheet labeled “Profit after proposed compensation”) are higher compared with the ‘Go Through Motions” scenario. However, if the CEO’s cost of effort is $500,000 (as it is in part 5), then the bonus comes out to $1,287,876. Even though expected profit net of CEO compensation remains higher under the “Work Hard” scenario, it turns out that the CEO will choose instead to go through the motions rather than work hard, since expected utility is 1,280.73 under ‘Go Through Motions” compared with 1,224.74 under “Work Hard”. In this case, the firm would definitely not want to hire a part 5 CEO and instead find a CEO who has a lower cost of effort (e.g., C = $200,000 or less as shown in parts 2-4).