From Schweser, V3, p129 (in the blue box): “In Topic Review 33, equity swaps are discussed as part of potential moral hazard problem with upper management.” I just finished Reading 33 and do not recall seeing any discussion of swaps as moral hazard. Can anybody point me to it?
i can explain it. stock is granted to top executives. These executives are very material to the sucess of the business. And to motivate them properly, you want those executives to have a vested interest, and therefore motivation in the business. So you grant them stock. LOTS of stock. But to prevent them from taking the stock and running, you make the stipulation the stock vests over 5 years. So now the executives have a lot of wealth tied to the business and aren’t leaving. But they are underdiversified. So they want to limit this exposure. They enter into an equity swap, swapping the return on the company stock for the return on a diversified portoflio (in this example). Well, the executives have now just eliminated their exposure to the business they are supposed to be running, thus eliminating the reason for granting them stock in the first place (to motivate them to increase shareholder wealth). This is a moral hazard as investors won’t know that the executives compensation and wealth is no longer tied to the fortunes of the business. does this help?
I see. Thanks, Strikershank!