Wednesday, February 25, 2015

Should we allow companies to buy deep out of the money put options?

Companies are not currently permitted to buy put options on their own stock or short their own stock.

The obvious concern is that allowing companies to profit from stock price drops incentivizes the executives and shareholders to fail.

The obvious benefit is that if a negative shock occurs to a company, the company receives a payout that helps fund the company with the company needs the cash the most. This payout is valuable if the cash helps avoid costly bankruptcy.

The opportunity to shield companies from negative shocks may lead companies to take on more risky projects than they otherwise would. The cost of more risk is more volatility but also bigger successes (i.e. innovations, profits) if successful. We probably would not want systemic organizations - like big financial firms - to participate though since their individual failures spark failures elsewhere. However, firms that are less systemic could take more risks without the negative externalities.

Is there a way to alleviate the incentives put options create to drive the stock to zero? Yes, require that managers tie their compensation to the firm's value and permit managers to only buy deep out of the money put options. A deep out of the money put option only becomes valuable if the stock price declines "deeply". So long as the managers have enough wealth tied to the firm's stock price, the drop in price prior to hitting the exercise price of the put options would damage the executive's wealth enough to reduce perverse incentives.

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